The Bottom May Be Falling Out of the market–Here’s some ideas of What To Do

Just a few months ago, all was quiet on the investing front, as most market indices continually broke new all-time highs. But in early August, the quiet was broken by a sudden surge by the dollar against the euro, the yen, Australian dollar and other currencies. At the time, the rallying dollar was merely seen as the beneficiary of a relatively robust U.S. economic growth rate in 2015, at least compared to Europe and Japan.

In hindsight, the currency shifts now appear to be the result of something more concerning: European economic activity has slowed to a crawl, the Chinese government is leaning towards a policy of reform over stimulus — compounded by brewing political troubles in Hong Kong — and U.S. investors are finally waking up to the reality that global economic growth will likely be subpar in 2015.

That dim view may also explain why West Texas Intermediate Crude Oil has now slipped below $90 a barrel for the first time in 17 months. Then again, oil prices may be slumping because the dollar is rallying, which always hurts the price of commodities such as oil. Or perhaps it’s the fact that too much oil is being produced at a time when global demand is slackening.

In other words, there are now a number of moving parts in play, and the factors behind these recent shifts are likely to persist. How you position your portfolio for the changing market can spell the difference between capital preservation and capital erosion.

Indeed many portfolios are already feeling the pain. Small caps are now in a correction, and despite a boost from Friday’s jobs reports, larger stocks have started to move off of their highs: the Dow Jones Industrial Average and the S&P 500 have both breached support at 17,000, and 2,000, respectively.

The key question, how will the markets play out from here? Let’s start with the dollar. We know that the Federal Reserve will end its bond buying program later this month, even as the European Central Bank and the Bank of Japan appear poised to stimulate their own economies. Foreign currency strategists think the divergent interest rate policies over the next few quarters could lead to a further 10 percent rally in the dollar. And that’s bad news for oil, gold or any other commodities priced in dollars — a stronger dollar erodes the buying power for people holding other currencies.

West Texas Crude

As a result, it’s time to re-check your portfolio’s direct and indirect exposure to commodities. For example, oil services companies such as Schlumberger Limited (NYSE: SLB) might see a sharp drop in demand if oil drifts towards $80 per barrel. At that price, many global energy drilling projects become less feasible, crimping demand for oil services equipment such as drilling rigs.

More broadly, investors need to know how each stock in their portfolio is valued. If the major indexes start to move lower, investors will quickly shed their stakes in the market’s highflyers. These were the first to crumble in 2008 when investors fled to the safety of value stocks.

EPS

This is a good time to prioritize your holdings in terms of their relative valuations. Any stocks that sport high valuations should be candidates for portfolio pruning. If history is any guide, you’ll be able to re-acquire these stocks at lower prices when the market finds its footing.

But when will the market find its footing? Understand that the market is driven by herd dynamics. Investors often sell because they fear that mass psychology will lead others to sell. And right now, investors are getting anxious. In the weekly survey conducted by the American Association of Individual Investors, 35% of respondents were bullish on October 2, down from 52% in late August. History has shown that this figure needs to fall to 25% for stocks to truly capitulate, which often sets the stage for next market upturn.

The good news: any stocks in your portfolio that generate solid metrics from a price-to-earnings or price-to-free-cash-flow basis, or sport a solid and sustainable dividend yield are likely to fare well in a tough market. That doesn’t mean they won’t drop in value, but will likely fall at a much lesser rate than more highly-priced stocks.

To be sure, the U.S. economy still appears poised for solid expansion in 2015. At least that was the conventional wisdom until a week or so ago. Since then, we’ve learned of a pullback in consumer sentiment and also in manufacturing and construction. Is the U.S. economy starting to feel the impacts of various global crises? It’s too soon to know, but we’ll know more about that as earnings season gets underway next week.

Risks to Consider: As an upside risk, perhaps the U.S. economy will grow as robustly in 2014 as many economists still believe, in which case stocks don’t have too much downside. The only reason to fear a growing bear market is if the U.S. economy starts to weaken in coming quarters. As of now, that is an unlikely scenario.

Action to Take — Net-net, this is a time for caution. It’s OK to begin to nibble at beaten down value stocks, many of which reside in the small cap market. But there is no reason to be a hero and buy the current market pullbacks with a lot of financial firepower. The recent market gyrations suggest that more choppiness lay ahead, and it pays to remember that stock markets can go down a lot faster than they go up. I am not anticipating a rapid market plunge, but history has shown that if buyers pull away in the coming days, then a 10% drop from here can play out in 8-10 weeks. Over the course of the current bull market, we’ve had several such mini-slumps. The good news: When the sellers exhaust themselves, idle cash can be profitably put back to work.

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SKEW "Is Flashing A Big Warning Signal For Stocks"

As stocks have pushed to new record highs in recent weeks, and VIX has dropped accordingly, the cost of protecting asset managers from a far bigger collapse in stock prices has been soaring.

SKEW measures the chance of an extreme or outlier event, compared to the VIX which measures the expectations for more ‘normal’ day-to-day volatility. SKEW is an indicator of how the market is pricing the possibility of a potential black swan event.

For the first time in history, prices have remained elevated for a considerable period. As Bloomberg reports, the SKEW “is flashing a big warning signal for equity markets right now,” Kevin Cook, a senior stock strategist at Zacks Investment Research, wrote, adding that, “big players are quietly and eagerly buying up put protection while they hang onto their stocks.” This institutional nervousness is occurring as retail investors dive into the market and AAII bullish sentiment surges back above 60 percent of investors.

This is a record high and record long period for SKEW to be elevated…

Skew [4]

In the past four weeks, the SKEW has exceeded 140 three times: on June 20, July 2 and July 3. Only four other earlier readings, in June 1990, October 1998, March 2006 and December 2013, surpassed this threshold since calculations started in 1990. The chart shows all but the earliest occurrence, which happened four weeks before the S&P 500 peaked for the year.

Skew Inv [5]

Source: Bloomberg

The Florida Real Estate Craze

It is our belief that in order to truly understand how our current economic situation has evolved and to decipher what to expect in the coming years, we should look first to history. What has transpired in similar circumstances in the past? What events triggered a crisis or lead to a market collapse? How did the the populace (“the mob”) react? What were the consequences of the crisis? In that light, today we look briefly at the Florida Real Estate craze. The Florida Real Estate craze is eerily similar to the nationwide housing bubble, which burst in 2006, just about 80 years after the Florida real estate bubble.

The scale of the 1926 Florida housing bubble boggles the imagination. During the craze, housing that could be bought for $800,000 could, within a year, be resold for $4 million, a 600 percent return. The prices were so inflated that in order to buy a condo-style property in 1926, you would’ve had to pay the same as you would now have to pay for a luxury home in the guard-gated communities in Miami – $4,500,000 – without adjusting for inflation!

Money grows on treesIn the 1920s, the United States of America was chugging along like the British Empire of the 1700s. It was human nature that people were beginning to believe such prosperity was infinite. But it wasn’t the stock market that was the recipient of a bubble – not yet anyway. It was the real estate market.

In 1920, Florida became the popular U.S. destination/residence for people who don’t like the cold. The population was growing steadily and housing growth couldn’t match demand, causing prices to double and triple in some cases. This was was not necessarily unjustified at this point. It was a matter of supply and demand. 

News of anything doubling and tripling in price always attracts speculators. So, once people began pumping huge amounts of money into the Florida real estate market it took off. Soon everyone in Florida was either a real estate investor or a real estate agent.

Unfortunately, the rules are the same whether you pay too much for a stock, or a house, or a piece of land – you have to make that much more to earn a profit. This happened for awhile. Land prices quadrupled in less than a year. Eventually, however, there were no "greater fools" to buy the vastly overpriced land, and prices began to adjust ever so subtly. Speculators realized there was a limit to the boom, and began to sell their properties to solidify their profits while they could.

Then everybody simultaneously saw the writing on the wall, and panic selling ensued. With thousands of sellers and very few buyers, prices crashed down with a thud, twitched a bit, and then crawled even lower.

Market Crashes: The South Sea Bubble

It’s said that those who ignore history are doomed to repeat it. I believe that examining historical market bubbles and crashes can provide valuable insight into our current economic condition.

It is frequently implied, or even outright stated, by today’s powers that be that “this time is different”. Well, I beg to differ. This time is not different. To help illustrate that fact please examine the South Sea Bubble and crash. The parallels between the South Sea Bubble and the recent Internet Bubble are many. In summary:

  • The South Sea Company was perceived to have a “can’t lose” franchise.
    No one questioned the inexperience of South Sea Company management.
  • Few (if any) investors stopped to examine the actual business plan and practices of the South Sea Company. The frenzy to buy was such that rational caution was abandoned. Ridiculous ideas were treated as viable business plans.
  • When the bubble popped, as with all  bubbles, the descent was fast and furious – even more so than the ascent.

    In the 18th century the British empire was the big dog on the block. Their economic and political influence spanned the entire globe. For the British, the period was a time of prosperity and wealth. A large percentage of the population had money to invest and were looking for places to put their money. As a result, the South Sea Company had no problem attracting investors. The South Sea Company assumed the national debt that England had incurred during the War of Spanish Succession for £10,000,000.00.

    South_Sea_BubbleThe few companies offering stock to the public at that time were difficult investments to buy. For example, the East India Company was paying out tax-free dividends to their mere 499 investors. The South Sea Company was perched on top of what was perceived to be the most lucrative monopoly on earth.

    The first issue of South Sea Company stock wasn’t enough to satisfy the voracious appetite of investors. Investors felt that the South Sea Company was blessed with a “guarantee” of dominance, i.e. it could not fail. The popular conception was that Mexicans and South Americans were just waiting for someone to introduce them to the finery of wool and fleece in exchange for mounds of jewels and gold.

    No one questioned the repeated reissue of stock by the South Sea Company. Investors bought the stock as fast as it was offered. It didn’t matter to investors that the company wasn’t headed by inexperienced management. Those who headed the company, however, were blessed with public relations skills. They knew the value of appearances. They set up offices furnished with affluence in the most extravagant quarters. People, once they saw the wealth the South Sea Company was “generating,” couldn’t keep their money from gravitating towards the company.

    Not long after the emergence of the South Sea Company, another company, the Mississippi Company, was established in France. The company was the brainchild of an exiled Brit named John Law. I’ve discussed the Mississippi Company in another post: The Mississippi Bubble and the French Bailout. John Law’s idea would warm the hearts of central bankers the world over. He advocated switching the monetary system from one based on gold and silver into a paper currency (fiat) system. The Mississippi Company caught the fancy of continental traders. Soon the Mississippi Company’s stock was worth 80 times more than all the gold and silver in France. Law’s success on the European continent stirred British pride. Believing that British companies were superior to the French, British investors became desperate to invest their money in the South Sea Company.

Those same investors were blind to indications that the South Sea Company was a poorly run enterprise (e..g. whole shipments of wool were misdirected and left decaying in foreign ports). Investors continued to buy stock, pushing up the share price. The price of the stock went up over the course of a single year from about one hundred pounds a share to almost one thousand pounds per share – a tenfold increase.

Its success caused a country-wide frenzy as all types of people—from peasants to lords—developed a feverish interest in investing. IPOs began to sprout everywhere, including companies that promised to reclaim sunshine from vegetables and to build floating mansions to extend Britain’s landmass. Among the many companies to go public in 1720 is, famously, one that advertised itself as “a company for carrying out an undertaking of great advantage, but nobody to know what it is”.

The share price reached £1,000 in August 1720. Then the selling started. The management team of South Sea Company realized that the value of their shares in no way reflected the actual value of the company or its earnings. They sold their personal stakes in the summer of 1720. The actions of South Sea Company management quickly spread. Soon panic selling of South Sea Company stock certificates ensued. The share priced collapsed, falling to one hundred pounds per share before the year was out,. triggering bankruptcies among those who had bought on credit.