Risk Latte - On “Air Pockets” and Vertiginous Declines

On “Air Pockets” and Vertiginous Declines

Aditya Rana
May 15, 2010

It sure has been an interesting few weeks in the financial markets, and one of my favourite news letter writers, and hedge fund manager, John Hussman provides an interesting perspective on the market action:

  • “Of all the mysteries of the stock exchange there are none as impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there are no buyers, and only after wide vertical declines could anyone be induced to bid” john kenneth galbraith, 1955, the crash.

  • There are only three post war periods, where stocks have hit an “air pocket” and have abruptly lost 10% or more within a space of about 6 weeks: Aug-Oct 1999, Sept-Oct 1987 and Sept-Dec 1955 (which were all followed by retest of the lows).

  • The eagerness of investors to identify the cause of decline as a “glitch” was fascinating – illiquidity is not a “glitch” but the feature of panicked markets.

  • Overvalued, overbought and over-bullish markets do not provide robust enough demand to match eager selling leading to vertical declines.

  • We are currently at an inflection point in stock markets- between 1080 and 1130 on the S&P, and a decline below 1080 would make market “internals” very negative and subject the market to the risk of further substantial declines.

-bailouts ultimately fail because they do not tackle the underlying problem - which is that there is too much debt which cannot be serviced, and they replace every dollar of bad debt with two dollars of debt – the initial dollar of debt which needs to be serviced (rather than written down) and the additional dollar of government debt issued to finance the bailout.

  • Bailouts reduce long term growth prospects by allocating capital to bond holders who originally made the bad investment decisions and are therefore the worst stewards of capital.

  • And finally some recent quotes from the well-known bank analyst Meredith Whitney (who called the banking crisis early) which are very relevant to the current state of the banking sector:

  • “The vast majority of the banking sector’s profits and capital creation was government induced”-by writing up assets and reducing provisions on bad loans (plus the zero cost of financing and a positive yield curve which is a massive hidden transfer from taxpayers/savers to banks!).

  • “House prices have stabilised because inventory has been kept from the market-prices can be controlled by controlling supply without controlling demand”

  • “The top four bank’s non-performing assets are 1.5 times the charge-offs which banks have incurred since 2005. banks are very likely to increase charge-offs in the second and third quarters and expect another leg down in housing prices as more supply comes into the market”.

John Hussman hits the nail on the head by pointing out that the 1,000 drop in the Dow the previous week was not a trading “glitch” but a symptom of extremely nervous market conditions. Other market indicators (“internals”) point to a skittish market: low volumes on up days and heavy volumes on sharp decline days, continued highs in advisory bullish sentiment (56% - the highest level since the peak in 2007!) and record low put (bearish)/call (bullish) ratios. The market is therefore likely to continue to be vulnerable to hitting more “air pockets” over the next several months - though a precipitous decline like we saw in march 2009 is unlikely due to the clear resolve shown by governments across the world to provide backstop bids to support risk assets . this supports the scenario of range trading markets for several years – before we get the final down-leg, likely to be precipitated by a massive sovereign debt crisis in the developed world. the graph below depicts an interesting valuation framework by comparing the percentage of the peak of the time-tested valuation barometer – the Shiller p/10e ratio– during the current structural bear market (which started in 2000) versus the average of the three previous structural bear markets of the past century. while the current period is likely to show spikes in the ratio above the average trend over the next few years, the bear market is unlikely to end until we get a final low in this ratio several years from now (which does not necessarily mean a price low!).

Treasury bond markets also saw a huge rally, with yields on the 30 year bond declining from a high of 4.84% a month ago to low of 4.06% the previous week (that is a price movement of approximately 13% on the long bond and 23% on the zero coupon long bond-not bad for bonds eh!). i expect treasuries to continue to grind down to lower yields over the course of this year and thereby take out the “famous” bond bears – in a similar fashion to what transpired in japan in the late nineties.

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