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.

The Mississippi Bubble and the French Bailout

Why look at an event from 1720? The answer is simple. History provides perspective and lessons to be learned – lessons that, if ignored, may lead us to repeat the follies of the past. There are significant parallels between the economic bubble of the late 1720′s and today. The French government (like our own today) was in part responsible for the Mississippi Bubble. The French government contributed to the currency crisis which ultimately led to one of the largest economic crashes in history and required a massive government bailout – not so different from current events.

John Law, the central figure in the Mississippi Bubble, was a gambler and a ladies man. He was also intelligent, and early economic theorist and he had a charming personality. At the time, France was deeply in debt due primarily to war mongering. On May 15, 1716, thanks to his gambling association with the French regent – the Duke d’Orleans, Law was given a bank – the Banque Generale – and more importantly the right to issue paper currency. This was Europe’s first recorded foray into paper currency.

John Law

Thanks to the freedoms offered by paper (fiat) currency, Law was able to increase the the money supply slightly. The “stimulus” brought a new vitality to the French economy and John Law was hailed as a financial genius.

The  following year, as reward for his service, Law was granted exclusive rights to develop the new French territories of the Mississippi River valley, what we know as the Louisiana Territory. John Law’s Mississippi Company quickly became the richest company in France.

In a few short years John Law had gone from a penniless gambler to one of the wealthiest, most powerful men in Europe.

Law’s fairy tale rise to power and riches continued. In 1719 the Duke d’Orleans bestowed on him the exclusive rights to all French trade. Law formed the Company of the Indies. Law’s Banque Generale was awarded central bank powers and became the Banque Royal. Law was now at the helm of France’s central bank.

France’s currency supply continued to expand. Apparently they felt that if a little currency inflation helped the economy then a lot of stimulus would work even better. All this new currency along with the public’s first real opportunity to invest in the developing new world, led to what may be the wildest speculative boom in history. The share price of the West Indies  Company (formerly the Mississippi Company) exploded, rising more than 36 times in a period of months. This boom gave rise to the term “millionaire”.

Paris was booming due the rampant stock speculation and the increased currency supply. Shops were full and there was an  abundance of new luxury goods.  However, problems soon began to arise. Due to the inflation of the currency, prices started to skyrocket. Real estate values and rents increased 20-fold.

“New houses were built in every direction, and an illusory prosperity shone over the the land, and so dazzled the eyes of the whole nation, that none could see the dark cloud on the horizon announcing the storm that was too rapidly approaching.”

-Charles Mackay Extraordinary Popular Delusions and the Madness of Crowds

The speculative bubble spread throughout Europe. By the fall of 1720 the rampant creation of paper currency had a predictable outcome. The bear market collapse was so significant that by December 1720, John Law had to flee France. He died penniless in Venice, in 1729.

Compagnie des Indes Stock PriceThe French government was forced to step in and assume all the debts of Law’s company. And then to pay for their own folly, they began to raise taxes. That led to the collapse of the French economy and set in motion the resentment that led to the French Revolution.

Looking to government to bail out investment banks and failed corporations is a dangerous course of action. It shifts the blame for the bank’s (or corporation’s) folly to the government. It increases the risk of political instability should the government fail to improve economic conditions. What if we end up in hyper-inflation because of the massive currency printing? That will destroy the economy along with the common man’s ability to survive economically.

Our quasi-socialist way of life may be coming to an end because our promises exceed our resources. The bailout of the banks and corporations, along with the continuing monetization of debt is likely to push our government and our economy over the edge.

If we cannot see how similar events have played out historically, if we do not learn from the mistakes of the past, we are doomed to make the same mistakes over again.