Why Lehman Events Happen

Snow up the wazoo!

It’s Tuesday January 27th, and there’s 2 feet+ of snow outside my window. Nice to look at but I’m not going out, except maybe for a short quiet walk. The only time you can enjoy a moment outside without the sounds of some moron Boston driver beeping in the distance or screeching to a halt is when there is two feet of snow on the ground. So maybe I’ll go out.

In the meantime, I’ll ponder the thought – as the market falls hard today – of a common Wall Street saying (paraphrased): that the bond market is smarter than the stock market. I think of that as I watch the Russell 2000, an index of small company stocks, perform relatively the best today. If the bond market is truly the “smartest,” meaning the moves in that market best represent what is and what will happen in the economy, and stock markets aren’t as “smart,” where does that put people who mindlessly buy the smallest stocks on every dip, even as the economic news deteriorates?

Let me stop here to summarize a few things.

1. the 2009-2014 period is over – yes chronologically it is most certainly over. But the warm fuzzy feeling people had as every market dip was bought more ferociously and it seemed like market risk had disappeared, should be forgotten.

2. Volatility is back – meaning large price swings in assets as central banks the world over play with interest rates (some going negative!!!) and currencies. Historically, the textbook analyst values an asset based on a “risk free interest rate“ (usually a 10 year US treasury bond). When rates are up and down 1% every 6 months, and heading to 0% worldwide, then this idea of valuing an asset is hard to do.

3. Sucker punch probability rises – the chance of a market sucker punch, where prices move extraordinarily, in a day or a few days, is very large now in my opinion. Those of you that read my email newsletters know I have increasingly turned to using options as “placeholders” for full portfolio positions to eliminate the sucker punch risk.

Is the investor sucker punch coming? photo courtesy of Bark on Flickr

4. Bond yields heading to 0% worldwide means rate sensitive investments > bonds, real estate, MLPs, may just see some euphoric price increases – the temptation to short bonds (I have tried with many small paper cuts), is large but the risk is very high. The implications of 0% yields for 5 years in the US are being felt now and with Europe joining us, global implications are immense but unknown – scary stuff.

5. Most importantly, we have been getting company reports for 2-3 months now that economic action is slowing- “growth” is still there in the US but activity is decreasing. We also have some numbers negative (like today’s Durable Goods Report) which despite any excuses, to me is unfathomable (not really) after 6 years of 0% interest rates and $1T plus annual Fed monetary stimulus. Companies are blaming results on a rising US dollar (making our exports more expensive) but revenue growth has been anemic at many large US companies for a while. And a good chunk of earnings growth has come from stock buybacks where companies are NOT investing in the future but spending the money NOW to boost earnings.

So if risk levels are rising, and we’ve had a few months of sobering news (and granted some positive news) and the “least smart” part of the stock market is acting the perkiest, what conclusion should we draw? Here are mine:

First off, most people,  from what I read in the news – reporters, politicians, economists etc – have not fully accounted the boost to the economy from the Federal Reserve stimulus. So the baseline economic activity of this country is artificially high in my opinion, and the experts don’t fully account for that. Second, in my opinion,  the temporary boost the economy got from all of this stimulus is wearing off. we have been seeing this as some companies no longer wish to borrow money to buy back stock, and many of our foreign customers are running out of strength too.

Third – and this is the point of this all, and the reason Lehman events happen – is that people keep buying dips in stock prices robotically even when the underlying fundamentals have changed. Meaning, anyone 100% invested for the past 4 years should be reallocating to cash for now or other markets that are starting uptrends. The US market has been sideways for 2-3 months showing a possible top. If it isn’t the trend investor can always re-enter on the breakout to the upside. But why risk 100% now?

Any decline in the market the past 2 years has been bought aggressively

The truth is, many still are risking 100%, and many have loaded up their investments in the past 3 months as the market has made new highs – right as risks have increased. And with these clues of changing fundamentals, people are still buying – as witnessed by Russell investors/traders. At least demand more of a dip before you buy!!! Small dips are bought aggressively because people still have the 2009-2014 feeling. Events are telling you to reduce risk – one way or the other (reduce size, use options, sell and re-enter if trend continues). But most are not. Most will buy the first dip, then the 2nd dip, then the 3rd dip, then “what was I thinking” as noted hedge fund manager Seth Klarman calls that moment:

We Have Another Lehman Moment.

Thanks for reading – and as I finish this, markets are trying to claw back. Buy the dip!:)