Monday, August 5, 2013

Thoughts on the Markets: Are we in for a crash?

The last few months have been challenging for my investment strategies.  As an options trader I tend to work with trades that make money within wide market swings and I attempt to remain neutral about market direction.  This makes it possible to avoid having to make predictions about price movements and just focus on predictable ranges of volatility.  Well, unless you have been living under a rock lately you know that the market has been on a tear and has gone beyond normal ranges of volatility.

Many many markets, both in the US and abroad, have been making all-time highs during the last few weeks.  I'll admit that I did not expect this to happen so quickly.  My own view is that while retail market participants are euphoric about the recent activity economists are starting to sound the alarm.  All the while institutional asset managers are quietly heading for the exits.  The most frustrating part of the equation is the US Fed.  While many of the people that I speak with about dismal employment reports and falling corporate revenue agree that many leading indicators are flashing red, they are quick to note that the next Fed meeting isn't slated to take place until September.  Thus, we should ignore fundamentals and keep buying.

This Fed logic is quite dangerous in my opinion.  I will admit, as a trader, that the only thing that matters is price action and getting caught up with other distractions is unwise.  As an investor and long-time market participant I know well enough to see complacency and crowd mentality taking over.  The fact is that the Fed's current action will keep asset prices elevated only until the market realizes that their policy is unsustainable.  For example, recent reports show that since March 2009 $2.3 Trillion has been added to US GDP by the Fed monetary support while a staggering $12.3 Trillion has been added to corporate market capitalization.  By and large, the real winners here are those that have sufficient resources to buy financial assets, not the broad base of the US population. 


Additionally, we have seen poor reports about US GDP growth.  While the Fed sticks to it's story about recovery and expansion in the private sector we are still seeing a downward trend in GDP growth rates for many quarters now.  What would these numbers look like without $255 billion in asset purchases per quarter from the Fed?  I fear what these number will look like if the Fed takes it's foot off the gas!  Every economist knows that GDP growth of less than 2 percent indicates a stalling economy. 

Of course we are talking economics now and not asset prices, right?  Let me make a note about another more technical point.  Professor Robert Shiller defined a very interesting statistic in his book Irrational Exuberance, the Shiller P/E ratio.  This ratio is a measure that divides the current market price of the S&P 500 by the inflation-adjusted average earnings of the S&P 500 for the last ten years.  Here is the chart:
Shiller PE Ratio Chart 
You will notice that the average range peaks around 29x and troughs just below 10x.  We are currently at 24x.  This is a bit distressing when the exuberance of the 2008 housing bubble resulted in this ratio peaking at 27x.  

While it is probably quite clear that I don't know what the broader financial markets are going to do, in light of these factors, I take comfort in my position that we cannot sustain the path we are on in the US and that unless the Fed, and Washington, can figure out a way to wean the markets off of the current monetary policy we are on, we are going to see an epic collapse in asset prices around the world as the easy money that we are all used to loses its power to keep financial assets afloat.

Thanks to the following sources for feeding my own addiction: