Correction Looms?

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The FOMC meeting has come to pass, regardless of what adjectives are included or not in the text is immaterial, actions speak louder than words and actions remain accommodative. Alibaba IPO too much fanfare, the largest IPO ever and also the a Chinese company that by-passed the traditional foreign listing -> ADR methodology. So what should we expect going forward?

While it certainly looks like the market has moved passed the potential volatile events as we head towards the mid-term, which remains only true if we monitor the Dow Jones, tech-heavy NDX, or S&P 500. However, if we look at the Russell 2000 the big picture is slightly alarming as it has broken down and breaking supports.


Correction Looms?

One would think that if the Fed would remain accommodative with low interest rates and continue with their QE program (even with tapering); the market would continue its rally further. However, if the bulk of the rally is based on leverage (debt – margin – borrowed money) – regardless of how low interest rates are and how much the Fed accommodates, there reaches a point when those that lend become over extended.

Bubbles

Bubbles, when used in finance, have a negative connotation, which I find a little silly. No one has problem when the bubbles are inflating and everyone is participating and making money. Of course when it is inflating they are caught up in the euphoria, drinking the Kool-Aid, and believe this time it is different. They even convince themselves it isn’t a bubble.

It is only after if “pops” and the market bubble is crashing, that they all point fingers, blame games ensue, and the government intervenes with bailouts, regulations, fines, and uses the bubble bursting to blame the other party (a potential to win an election).

The fact is bubbles have and will always exist. They are simply created by the laws of Supply & Demand. They are not bad or good; they are just a byproduct of the herd mentality moving in one direction with fervor and speed. The slang on the trading floor in individual trades in which bubbles are forming is called a “crowded trade”. There are just too many investors on one-side of the equation.


courtesy of wikipedia


Why do they burst?

The question is very simple, so simple that most will not accept the simple premise because they don’t want to come to terms that they may have been fooled and been a participant. When there is NO ONE LEFT to buy, the bubble bursts. Seriously, it is that simple. Again, it is the law of Supply and Demand. When the demand ends, because everyone in the position, that is the end. When buyers are unable to keep buying, because there are no more buyers, then the value stops increasing. That is the top, the end, and sometimes the beginning of a correction (if we are lucky) or crash (if we are not).

Think of another horrible moniker, pyramid scheme. When there are no more buyers at the bottom, the whole thing comes tumbling down. I am not saying the stock market is a pyramid scheme, nor the housing market or any financial products. What separates a pyramid scheme from the stock market is that the stock market actually has measureable and intrinsic value. You own a piece of the company, benefit from dividends, its growth, and the possibility of a merger or take-over. A pyramid scheme has no fundamental value; it is simple built on the understanding of the laws of Supply and Demand.

Yet it is important to understand HOW a pyramid scheme works, because it is an excellent example of Supply and Demand and how quickly it can fail when there is either too much Supply or too much Demand. The stock market and all markets are also subjected to the same laws of Supply and Demand, we can’t ignore it and those that do are usually hurt badly.


courtesy of wikipedia


Shoeshine Boy

I recently mentioned the “Shoeshine Boy” story in a previous market preview. It is a parable as to why and how the bubble bursts.

In the 1920s, I believe it was J.P. Morgan that arrived at the Stock Exchange, like he did every morning. On this particular morning the shoeshine boy proceeded to give Mr. Morgan a stock tip. When Morgan entered the exchange he told all his staff to SELL everything and to get “short” the market. When they asked why, he said the shoeshine boy gave him a stock tip. When they seemed baffled by what seemed a silly response, Morgan said if the shoeshine boy is buying there is no one left below him to buy.


courtesy of wikipedia
Courtesy of hyperallergic

The parable tells the story of Supply and Demand and how when the bottom of the pyramid of buyers (the shoeshine boy) is exhausted, there is no one left to buy and it comes crumbling down. We all know that Morgan made millions in the collapse of the market, not because he was evil or betting against the shoeshine boy. He understood, just like the first one to buy benefits, so does the first one to sell.

We each experience our own shoeshine boy situations, unfortunately most of us don’t recognize when they happen. I was fortunate that in one particular case it was so apparent that it was impossible to ignore. I had gone to the same place for coffee every morning at 6am before heading to the trading floor. On this particular morning in 2006 I noticed the coffee barista was studying some books, I thought it was college. When I asked, he said he was going to become a Real Estate Investor and proceeded to give me a tip on Real Estate. A fellow trader turned to me and said simply “shoeshine boy”, I nodded in agreement. He sold his home in a couple of months after that encounter; I too exited the housing market and proceed to rent until 2009. The coffee barista was not the sole reason for getting out, but it was sure a catalyst event for me, a real world realization if you will. All around me people were becoming mortgage brokers, real estate agents, and getting in some way into the booming housing market. The slap in my face is when a teenager at a coffee shop was giving me a tip, we were reaching a top.


How bad?

Bubbles happen all around us and some slowly deflate and others crash bad that wipes investors out. What determines how bad the bubble pop will be? That again is a fairly simple answer; it depends on how much of the bubble is built on leverage debt or during the boom commonly referred to the more friendly term of credit.

I remember seeing people waiting in line outside of toy stores in San Francisco, waiting for them to open to buy up “beanie babies”. It was a bubble forming, you could see it. Many people like to call these a “craze” or a “fad”, but the fact remains it was a bubble like any other bubble. It is defined by the Supply and Demand equation. The “beanie baby” bubble was a slow burst for two reasons. First, it was not generally built on debt (sure there were a handful that racked up their credit cards and may even had taken out a mortgage on their home). The beanie baby was cheap, so debt didn’t really come into the equation. The second factor was supply. The company was not going to stop producing them, so the company created inflation. They saturation of supply deflated the bubble.

The Dot.com and Housing bubble however was built on debt. Retail investors automatically are subject to margin when they open a brokerage account and home buyers usually have to borrow to buy the home. In both of these bubbles we saw leverage debt expand quickly.


Leveraged Debt

When there is a demand, the suppliers will always figure out a way to meet that demand. We see that in the Drug trade all the time. They will figure out a way to get the drugs to their addicts, sometimes in ridiculous ways. They will also cut their drugs (dilute) to increase supply as demand rages. The U.S. war on drugs failed because it focused on the demand side of the equation. The fact is, regardless of what the product is, when demand reaches a fervor there is no changing it. I could have told all those idiots standing in line at 5:30 in the morning that beanie babies are not worth it and there is an oversupply, but these people are addicts, junkies, and act like cult members, any reasonable or rational argument will never get through to them.

In the housing bubble the suppliers of homes and credit figured out new ways to feed this demand addiction. We saw creative loans (80/20, interest only, balloons, etc.). Even our own government got onboard to feed this demand, some like Barney Frank (D) came out and said home ownership is a RIGHT for every American and lead the charge of Freddie and Fannie lowering lending standards. Home-builders were building entire subdivisions without even a clue they were creating an oversupply, because the demand was so strong. They knew (or thought they knew) that there would be an ever ending stream of buyers.

Yet here is the simple math that we can’t forget, regardless of the demand addiction, there are only X amount of households that can leave in Y amount of homes. Sure there are foreign buyers, vacation homes, and population growth – but those can also be easily factored in as well.

So you have two factors, both are part of the Supply and Demand equation.

Supply = if the growth of supply exceeds the demand, in combination of existing inventory, then you will have an over-supply. You have home inflation, too many homes and not enough households.

Demand = once the shoeshine boy or coffee barista has bought their homes, then there is very few people left. You have reached maximum penetration rate and there is no way to continue to drive the demand growth at its strong rate.


courtesy of wikipedia

The problem with the housing market was exacerbated by debt and leverage. Those supplying the credit to the buyers had far over-leveraged, much like the buyer – they too believed this demand would never end. Freddie and Fannie (GSEs) were running well over 100:1 leverage or in simple terms, for every dollar they had they lent $100. This was far beyond what was allowed by banking regulators, but Freddie and Fannie were government sponsored entities (GSEs) and had the full weight and support of those like Barney Frank (D) a Congressman who chaired the Congressional Banking Committee. Home ownership was a RIGHT!


courtesy of wikipedia

The size of the bubble bursting is based SOLELY on how much leveraged debt is used. Let’s imagine a ridiculous scenario, just for illustration purposes. What if the housing boom was built only on cash buyers, not a single mortgage or loan, do you think the bursting of the bubble would be bad? Of course not, in fact it would not burst at all – most likely it would be a small correction based on (again) supply and demand. Homebuilders would stop building because market saturation was reached and demand would end as buyers would have used up their own capital. No access to credit (debt) would mean the demand would end and supply would reach and equilibrium.


courtesy of wikipedia

Now let’s look at a more realistic scenario, Canada and a hand full of other countries that require 20% down, no interest only loans, no 80/20, no balloons. These more traditional and standard lending practices kept a huge bubble forming, prices did rise but not as much. When the collapse came, they had a minor correction. There was no over leverage that wiped out banks, investors, and homeowners. No doubt there was still a bubble, but it was not exacerbated by leveraged debt (credit).


Bond Market / Stock Market

The US stock and bond market are certainly in a bubble, for different reasons because of different participants. How big this bubble is however is still questionable.

I am not arguing that some stocks are not fairly valued or that these companies don’t have solid fundamentals and growth, they do. There remains great stories in the stock market and certainly sectors I remain very bullish in the long-term. The problem comes when the price of all stocks elevate from an injection of leveraged debt and exacerbated by artificial interest rates, currently at zero.

The Federal Reserve, much like Barney Frank and Congress with Freddie and Fannie, have created an environment that not only encourages, but permits excess leverage. Our government and Federal Reserve, in the best of intentions, have again pursued an agenda to create massive consumption on debt. Leveraged debt that is far beyond the capabilities for us to pay back.

Remember the housing bubble produced what seems in retrospect ridiculous borrowing standards that under reasonable consideration NO ONE could feasibly pay back. The problem was it was not created on the fact that the borrowers could pay back, it was created solely on the expectations that the price of the house would increase in value.

This concept is frequently referred to “inflating your way out of debt”. You believe that prices will rise enough to off-set your debt obligations. There is nothing wrong with this concept, if it is attached with a reasonable understanding that there must be a source of income or savings that can make sure that debt is repaid. Once a model is based strictly on price inflation, it brings forth radical lending practices, which only furthers debt creation well beyond reasonable means. If prices do not continue to rise, the model is doomed to fail.

Inflating your way out of debt is one of the core principal theories of Keynesian Economics. As you know the US government, since the Great Depression, has adopted Keynesian Economic theory. It is this economic theory and ideology that has spurred the lowering of the lending standards of Freddie and Fannie, which exacerbated the bubble. Today it is at the core principal of the Federal Reserve’s monetary policy of zero interest rates and QE program. Our Fed Chair, Yellen and her governors are staunch believers and supporters of Keynesian economics. They believe that consumption and inflating our way to prosperity is the only way.


Courtesy of advisorperspectives.com

This has spurred the massive rally in the equity markets. The Fed had made US treasuries unattractive by driving down rates to ZERO and then flattening the yield curve. Those who were savers, CD buyers, bond buyers, fixed income buyers, or money market buyers were punished. The Fed’s policy forced investors to yield hunt and search for returns, since real returns in Treasuries became negative when adjusted for inflation. It forced many savers into the risk trade, equity markets. The Fed’s plan worked and exceedingly well. The market has rebounded strongly and is touching all time-highs daily. It has brought forth a wave of optimism and has even pulled gun-shy retail investors into the market. We have also seen a rapid rise in debt investing. The NYSE margin index has reached all-time highs as well, almost $500 billion dollars. Think about that for a second, $500 billion of the stocks listed on the NYSE is based on borrowed money. That’s just the NYSE, if we look at the NASDAQ, ETFs, and other financial products, it is suspected to be well over $1 trillion of debt and growing exponentially.


Courtesy of advisorperspectives.com


When does it burst?

I don’t know when this bubble will burst and we have two bubbles. We have a bond bubble that is well known as being artificially created because of the Federal Reserve’s participation in their QE program, buying trillions of dollars. They were forced to buy the bonds when they lowered interest rates to zero. No one wants to buy a bond and get paid nothing, so the Fed had no alternative but to buy the bonds. There is no one that knows how or when they can unwind such a massive positions, in the trillions. Most likely they can’t and it will take well over a decade to unwind it solely.

What about the equity market? That is the more alarming question because the Fed (as of yet) is not directly a buyer that could support an exit. Who’s to say they won’t step it, Japan’s central bank has openly bought their own financial futures when they come under pressure.

The Fed will most likely step in, in some form or fashion if the market starts coming under pressure and that day of reckoning is coming. I am not sure how much more leveraged debt we can add at this point.

During the dot.com and housing bubble, the Fed was NOT a participant. We saw the NYSE Margin (debt) index hit almost $400 billion in 2000 before the Dot.com bubble collapse. We saw it hit almost $450 billion before the housing bubble collapsed. The market rebound has been huge since the 2008-2009 collapse and the NYSE margin index is currently outpacing the S&P 500 at a much accelerated rate. With the Fed’s help I think $500 billion is easily achievable, why not $600 or even $700 billion?

We just listed Alibaba (BABA) on the NYSE in the biggest IPO in history, how much of that stock buying is on margin and how much did that stock alone add to the NYSE margin? Perhaps the Alibaba IPO is the shoeshine boy indicator?


courtesy of wikipedia


Not Yet!

I don’t expect any serious correction and certainly not a crash before the mid-term elections. There is another FOMC meeting before the election in October. If the market comes under pressure, we could certainly see Fed interjections and I suspect we would.

Yet at some point we need to get off the “Fed Nipple” and I am not sure if the market can stand under its own weight. I also can’t fathom the how or when the Fed will raise rates or totally end accommodation. Because if they do, they know it will end the growth of leverage debt which is driving this market.

My recommendation is to recognize this is a bubble and while in this equity bubble there are GREAT companies that we should invest in. We should NOT ignore opportunities, even when we are in the midst of this bubble. However, just like with any reasonable investment we should hedge our positions against declines.

When the market does correct and it will, this should also be looked at as an opportunity. This Market Preview was not meant to scare you, but rather remind you that we live in a world that is govern by the law of Supply and Demand. To realize that there is nothing wrong to participate in the bubble, but to understand that it is a bubble and one must hedge and take precaution. The simple answer is to sit on the sidelines, but then if you do you miss out.

The more sophisticated can also play for the bubble bursting or correcting, this too is a great opportunity; the problem with this is timing. While I don’t expect a correction before the mid-terms, that doesn’t mean it can’t happen.

Remember when the bubble bursts, the good is tossed out with the bad. This is usually an opportunity to buy excellent companies that are significantly undervalued. These stocks sell off, not because they are bad companies, but rather those that own them do so on margin and are forced to liquidate.


Support & Resistance

INDU 17,000
The futures looks like we are under pressure a little. I would look at 17,000 as short-term support and I think we could flirt with it before the mid-terms. However, I am not looking for a larger correction at this point.

NDX 4000
Alibaba, Apple, Google, and the rest of the tech giants, there are great stories in this space. However, expect volatility.

SPX 2000
The S&P 500 has been trying to keep its head above this level and the market is watching. The VIX will most likely move a little higher in the 13 levels if we see more selling pressure.

RUT 1140!
It looks like we might break 1140 this morning and this is a little alarming to me. If we can’t hold the 1140 level and close above it we could see broader selling in the equity market. I don’t think the Fed will let a major correction take place and may step in. However, watch the 1140 level at the close.


It’s hard to be objective and far easier to get caught up in the euphoria and optimism. Remember J.P. Morgan and the shoeshine boy or the coffee barista. We can’t ever forget we are ruled by the laws of Supply and Demand. The government may wish to control these laws and they may be able to divert the river a little, but they can never stop the flow or change the direction.

Today we live in a world in which we are solely beholden to the Fed’s monetary policy, zero interest rates, and growing leveraged debt. It is not driven by a Free Market; we are inflating assets on cheap money. It will end, when and how badly is an unknown.

One Response to “Correction Looms?”

  1. [...] after my overly critical Market Preview yesterday. I tried to be clear in the previous and recent Market Previews that I didn’t think that we would see a serious correction yet, especially with the mid-term [...]