Tips for Surviving the Next Two Months, Market’s Most Volatile Time

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What a threatening month September is shaping up to be. Masked protestors threaten violence this week up in Sydney. Meanwhile, candid central bankers are calling the credit crunch a new kind of bank run. Rumours abound of 9/11-style options trades on the S&P. And investors are being “urged to ride out market volatility”, according to Karlis Salna in today’s Australian.

Would you ride out a cyclone? A tsunami? A tornado? How about the next two months in the market – traditionally two of the most volatile and worst-performing? Being a “long term” investor has worked since 1982. Stocks have gone up. But now credit is in a bear market. How will stocks continue to rise, or corporate earnings grow, with a bear market in credit?

Andrew Pease, the chief investment strategist at the Russell Investment Group, says that valuations are reasonable and the outlook for corporate profits is good. “The Australian share market is now on a forward PE ratio (ratio of share prices to 12 month ahead consensus earnings forecasts) of 14.4 times and the MSCI developed world index is on a forward PE ratio of just 13.6 times,” Pease said.

 “For Australia,” Pease ads, “EPS forecasts have lifted from 8.3 per cent to 9.8 per cent. June quarter earnings results were broadly better than expected in the US, Europe and Asia, and the current Australian reporting season is shaping up well.”

We’ve pointed out before that PE ratios are often low at the top of a stock market cycle because earnings have grown so fast. Our simple question is this: With a housing-led recession in America and rising interest rates in Australia, what will drive corporate earnings growth for the next two years? Now that we’re in a bear market for credit, we’d expect much slower profit growth and a recession in America’s real economy.

It’s not like we haven’t seen what happens at the top before. It’s just that we’re choosing not to believe the end of the credit bubble will result in falling stock prices. But why shouldn’t it? As the Nasdaq declined to 4,900, 4,800, 4,500 there were plenty of dip buyers. What a bunch of dipsticks.

Once the tech bubble burst, there was no going back. The Nasdaq fell 77% from its March 09, 2000 closing high of 5,041 to 1,114 on October 9th of 2002. Yes, it’s up 128% since then. But its Friday close at 2,542 is still 50% below the 2000 high. Asset classes that lead one bull market up rarely lead the next one up. Instead, they go into a generational bear market, like real estate in Japan. It takes a long time to wash the taste of a crash out of your mouth.

How is today so different that a genuine bear market in credit does not mean much lower stock prices? You could argue that there is real economic growth to this boom, and that this boom is global. That would give you some justification for buying stocks. But which stocks? And more importantly, should you be buying any stocks at all right now, when the bear market in credit appears to be getting ready for something spectacular, vicious, and completely unplanned?

“The current turmoil in the financial markets has all the characteristics of a classic banking crisis, but one that is taking place outside the traditional banking sector, Axel Weber, president of the Bundesbank, said at the weekend,” according to Krishna Guha in today’s Financial Times.

“What we are seeing is basically what we see underlying all banking crises,” Mr. Weber said. “Some Federal Reserve policymakers also privately see comparisons between the current distress in credit markets and the bank runs of the 19th century, in which savers lost confidence in banks and demanded their money back, creating a spiralling liquidity crisis for institutions that had invested this money in longer-term assets,” Krishna added.

You can take off your tinfoil hat now. A “bank run” outside the official banking sector is a real possibility in the next two months. “James Hamilton, a professor at the University of California, warned that – as in old-fashioned bank runs – sudden demand for liquidity can lead to a fire sale of assets that depresses their price, making otherwise solvent institutions insolvent.”

You need three things to profit from a fire sale. First, you have to be outside the warehouse when it burns down. Second, your assets need to be in your pocket in the form of cash rather than in the warehouse in the form of ash. And third, you need an idea of what’s worth owning at much lower prices, even if it’s damaged goods.

You can probably see where we’re going with this. Liquidating any shares that are dependent on the US consumer is no longer an interesting hypothetical. It’s probably a good time to do it. It may even be the last window you get to do it while stock prices still reflect the illusion that everything is fine.

Everything is not fine. But there are ways out of the US dollar. The key is to unhitch your portfolio from the performance of the US economy. You could also make a list of outstanding US firms worth buying after a steep fall in the markets. But for the next twenty years, the big driver of global growth is the East, not the West. Follow the money.

“Growth, especially of private consumption in the United States, will suffer because of the housing crisis and that can naturally not go without negatively affecting the world economy overall,” wrote Deutsche Bank CEO Josef Ackerman in a column published this weekend. He sees a coming dislocation in the global economy as the US loses its place at the top of the heap.

We agree. We’d only add that the short-term focus should be avoiding the loss of your capital during the dislocation…so that you can use that capital to scoop up assets after the worst is over. As for timing…this is always the tough part. However, right now we’d say there’s more to be lost by staying fully invested in stocks than there is to be gained.

There is also some unusual activity in the options market to consider. You may recall that prior to the 9/11 attacks in the US, someone bought a lot of puts on US airline stocks. Those puts soared in value when airline stocks tanked in the following weeks.

The Internet was abuzz with rumours last week of similar, seemingly inexplicable activity in the S&P options market. Specifically, someone seems to have sold around 65,000 deep in-the-money calls on the S&P. The strike price on the calls is 700. The S&P currently trades at 1,473. Who would write a call so deep in the money? And more importantly, who would buy a call like that? The right, but not the obligation, to buy the S&P at more than half its current level is rather expensive.

There are also a few sizable bets on puts as well. Either way you look at it, it would suggest someone is expecting a big move in the S&P before September 21 (options expire on the third Friday of the month). Not to worry, say Steven Smith and Aaron Task at the Street.com. The unusual activity is part of a “box spread trade”.

“Simply put,” they write, “two parties agree to trade the box at a price that essentially splits the difference between current rates. For example, the rough numbers would be that given the September 700/1700 box must settle at a value of 1,000 – it is currently trading around 997 – that translates into a 5% interest rate. For the seller it is a way to borrow money at a slight discount to the prevailing rate, and for the buyer, it is a way to lend money at a low rate of return, but it’s better than nothing at a time when others are scared and have painted themselves into a box (ha ha) because they have run out available funds.”

The technicalities baffle us. But the idea that a distressed hedge fund facing redemption requests and not able to borrow money from a bank can raise money by selling deep in-the-money-calls…that makes sense to us, although it’s unusual. Then again, we live in unusual times. And if you have to raise cash by selling options, well you do what you gotta do, don’t you?

“Reptitio est mater doctrinae” we read this weekend. Repetition is the mother of learning, to translate from the Latin. We point this out not because we are trying to fake a knowledge of Latin, or any kind of knowledge at all for that matter. Nope, we have a practical reason.

 “The repetition of events, sometimes in precise detail, teaches us that when similar forces converge, similar results emerge,” writes Sean Carroll in The Making of the Fittest. Carroll was writing about how evolution has often produced the same mutation in different species, in different places, at different times in history. Natural selection “selects” what’s needed when it’s needed.

But you can also apply this saying to the markets. All credit bubbles are the products of the same basic ingredients…too much money…too little discipline…too much greed and credulity on the part of investors. The South Sea Bubble, John Law’s Mississippi Scheme, the Dutch Tulip Mania, the tech bubble…they all were variations on the same theme. Yet the DNA of credit bubbles is always the same.

Credit bubbles are also “fit for a purpose” in the popular sense. They make people feel richer, for a while. They become “unfit” when the misallocations of capital…the money wasted on wars, bogus financial instruments, and plasma screen TVs must be reckoned up. The results are sharply falling asset values in the stock market. And as Bill Bonner and Lila Rajiva show in their new book, “Mobs, Messiahs, and Markets,” the political and sociological results are often more shocking and disruptive than the merely economic results.

Either way, here’s something to think about for the day. If the biggest, baddest, most global credit bubble in all of human history is popping – starting with the subprime mess in August, but ending God knows where or when – are there any safe stocks to own in the market at all? Or is it better to be in cash and well away from the coming firestorm? Send us your thoughts at dr@dailyreckoning.com.au or leave a comment at the end of this post.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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5 Comments on "Tips for Surviving the Next Two Months, Market’s Most Volatile Time"

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The Daily Reckoning
Editor
I think that the best option now is cash. Public capital markets have been a good way for people to make money for a few hundred years now. It’s important to realise that investors making stock selections during this time were performing an important social duty. They were putting at risk their livelihood in order to support a considered judgement about the development of technology / capital and it’s potential use to humanity. The time and consideration they made was rewarded by the returns. They were genuinely intellegent men who for their duration of their life had to forgoe general… Read more »
Alan
Guest

In a sharp repricing,why cash?A wall of money here in Australia will hit government bonds,particulary short term.We’ve seen that happen in the States.But don’t hold too long.The cries of the wounded will be drowned by the sound of printing presses.Come to think of it,are there any listed companies that make ink?

dubious pete in melbourne
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dubious pete in melbourne

govt bonds? Australian? Huh…Where?
BankWest or ING, 7.2% sounds very good. so do most resource companies. supply will still not satisfy demand.

Alan
Guest

Lewis securities or CBA Treasury Dept. for large amounts.

The Daily Reckoning
Editor
No matter how i look at it, now is not a good time to have money in shares (stocks), property, bonds (even though a fortuitous return could have been made now, thanks to Bernanke & co).. I worry about the Euro because of the diversity of nations and the power plays within the Euro zone. Can they hold a world currency? I reckon the likelihood of gold below $550 in the near future is relatively small, so holding gold is not a huge risk.The world demand for gold, Chinese and Indian particularly has to over run the artificial downward pressure… Read more »
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