The Real Reason Markets Crash

July 14th, 2014
in contributors

X-factor Report

by Lance Roberts, Streetalk Live

I wrote this past week that 'When bubbles are seen they do not exist, when disbelieved they burst.'

This is an important point to consider.

As I discussed 'Not Seeing Signs Of Market Exuberance' investors, just like amateur gamblers, are driven by the 'fear/greed' cycle.

Follow up:

As I wrote:

"The more the markets rise in the face of negative news, the more 'confident' that individual investors become in their own abilities. The lure of becoming 'rich' overwhelms logical thinking creating a 'willful blindness' to rising investment risks.

When casinos first open their doors they 'loosen' the slot machines so that they payout more often. Players are attracted by the whirling lights and buzzers that denote a sea of 'winners.' As individuals play, and win, they begin to become' confident' in their 'skill' of playing a slot machine. The 'can't lose' psychology begins to overwhelm the logic that the odds of winning are roughly 1-in-264,000 or higher.

Eventually, when enough 'fish are in the barrel' the casino begins to 'tighten up' the machines to put the 'odds' in the favor of the house. As players begin to lose more often than they win, they keep playing under the assumption that their 'cold streak' is about to end. Moreover, just 'as soon as they get back to even' they will quit playing. Eventually, out of money, they do leave the machine. There is truth behind the saying 'The house always wins.'

This analogy is what we see in the stock market today. The actions by the Federal Reserve to suppress interest rates and inject liquidity into the system have most definitely tilted the current 'odds of winning' into the player's favor. With asset prices being lofted higher, the 'hawkers' stand on the media street corners shouting: 'Ladies and Gentlemen, step right up and try your luck. Stocks are the only game in town.'

Of course, as the markets have risen in the face of adversity, weak fundamentals and economic growth, the 'can't lose' mentality has fostered excessive confidence in the player's abilities. Of course, this has always been the psychological cycle of investors over time and the reason why individuals always wind up 'buying high and selling low.'''

Investor-Psychology-Cycle-062414

However, the problem is that a period of "irrational exuberance" can last much longer than "logic" would dictate. This is because "exuberance" denotes a level of "illogic" as participants come to "complete acceptance" that the current bullish trend is infinitely sustainable.

For example, it was in 1996 that Alan Greenspan first uttered the words "irrational exuberance," yet it took almost four years before the "bubble" popped. While I am not suggesting that the current bullish trend will last for that length of time, I am suggesting that there can be quite a period of time between the bullish extremes and the panic to exit.

Now, let me throw you for a bit of a loop.

"Stock market bubbles have NOTHING to do with valuations or fundamentals."

I know. I know. That statement boarders on the verge of heresy but let me explain.

If stock market bubbles are driven by speculation, greed and emotional biases - the valuations and fundamentals are simply a reflection of those emotions.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you a very basic example of what I mean. The chart below is the long term valuation of the S&P 500 going back to 1871.

SP500-Chart2-071214

First, it is important to notice that with the exception of only 1929, 2000 and 2007, every other major market crash occurred with valuations at levels equal to, or lower, than they are currently. Secondly, all of these crashes have been a result of things unrelated to valuation levels such as liquidity issues, government actions, rising interest rates, recessions or inflationary spikes.

However, those events were only the catalyst, or trigger, that started the "panic for the exits" by investors.

Market crashes are an "emotionally" driven imbalance in supply and demand.

You will commonly hear that "for every buyer there must be a sell." This is absolutely true to a point. However, what moves prices up and down, in a normal market environment, is the price level at which the a buyer and a seller complete a transaction.

Ebay is a good example of how the stock market works. When you go to buy that new watch you have wanted you put your "bid" in to buy along with everyone else who wants that same watch. The more prospective buyers there are for the watch, the higher the price goes until the watch goes to highest bidder. For every transaction there is a "buyer" and a "seller," however, the price at which the transaction occurs is driven by the demand to buy versus the quantity available to be sold.

In a market crash, however, the number of people wanting to "sell" vastly overwhelms the number of people willing to "buy." It is at these moments that prices drop precipitously as "sellers" drop the levels at which they are willing for in a desperate attempt to find a "buyer."

(Note: this is also the danger of excessive margin debt in the financial markets. Margin debt is comprised of "loans" based on the value of a stock portfolio. As prices plunge, the drop in valuations trigger "calls" on margin loans which then requires more sells. The additional selling triggers more selling, and so on.)

In a highly complacent market environment, as we have currently, there is little attention paid to geopolitical tensions, economic or fundamental data or a variety of other relevant risks. The emotional "greed" to chase returns overrides the sense of logic. "Warnings" that do not immediately lead to a market correction are simply viewed as wrong.

The point is simple. IF stock market crashes are triggered by an "emotional panic," rather than a fundamental point, then a catalyst is needed to spark that panic. Something needs to happen that "surprises" investors and sends them fleeing for cover.

This is why stock market bubbles are "never" seen in advance, but only in hindsight. This is also why it is extremely important to focus on price. At the beginning of the "reversion to the mean," when it occurs, it is only a change in the trend of prices that will warn individuals that something has changed. Fundamentals, valuations and economic data move far too slowly to be of any value in protecting investor capital.

The one overriding positive of the "always bullish" financial media is that they live in a "bubble" of never being wrong. When asset prices are rising they continue to "sirens song" of the bullish mantras of long term investing, buy and hold, and beating some random benchmark index. However, when it inevitably goes horribly wrong costing individuals a major chunk of their life savings, the excuse is simply "well, no one could have seen that coming."

To survive the long term investing game, it is crucially important to use a logic based approached to your investing. Fundamentals, valuations, economics and politics are all extremely lousy investing tools for managing portfolio risk in the short term.


Economic Growth Much Weaker Than Realized

I have written much over the past couple of years that economic growth has been much weaker than what has been reported by the mainstream media and Wall Street economists. The ongoing need to spin a "bullish" bias in order to keep individuals invested in the various products they offer, leads to a "willful blindness" to the underlying facts.

The chart below shows the annual trend in real (inflation adjusted) final sales. In an economy that is driven by consumption, this is arguably the only real economic indicator that matters. Final sales reflect demand by consumers, businesses, and government. When demand is increasing, businesses have to ramp up production and employment to meet that demand. When sales are declining businesses tend to idle back on focus on cost cutting and other measures to maintain profitability.

Does this look like a strong economic recovery to you?

GDP-Chart3-071214

There is little real evidence that the economy is growing at the level that the current governmental bureaus are actually reporting. In the months ahead we are likely to see rather sharp negative revisions to past data. While these negative revisions will go primarily unnoticed by the mainstream media and the financial markets, it will simply confirm what the majority of "Main Street" America has suspected all along.

This past week Bank of America economist Michelle Meyer had a very interesting note in this regard:

"The outsized decline of 2.9% in 1Q GDP growth still leaves us puzzled. It stands out like a sore thumb relative to other economic indicators, particularly job growth which averaged 169,000 a month in 1Q. Moreover, it doesn't appear that we are getting as large of a bounce in 2Q, with growth only tracking 3.2%, of which 0.9pp is due to inventory build (which may prove to have been unintentional).

The BEA has another shot at estimating GDP with the annual revisions released on July 30 along with the first estimate of 2Q GDP growth. The data back to 1999 are set to be revised, but the most significant adjustments will be to the past two years.

If GDP growth is revised down over the past two years, as the source data suggest is possible, it would mean that the economy made even less progress at closing the output gap. Simply based on the revision from the source data, it would imply that the real output gap increases to 4.7% from 4.5% (using the CBO's estimate of real potential GDP). Although the magnitude is small, the direction of the revision is discouraging. The revision last year revealed faster growth in 2011 and 2012. It appears that the upcoming revision may partly reverse it."

GDP-Chart4-OutputGap-071214

"It is incredible how much revisions can alter history. What we think we know about the economy in real time can prove to be quite different after the fact. For example, at the beginning of 2010, we thought that real GDP growth was down 2.4% in 2009. We now know that the economy actually contracted by 2.8%. That is a big difference which occurred over a number of annual revisions.

Just as the data during the recession were revised to reveal a deeper contraction, we were hoping that data during the recovery would be revised to show stronger growth."

The ongoing "hopium" of mainstream analysts and economists continue to mistake market advances, driven by ongoing injections of liquidity and financial leverage, with economic recovery. However, only a small fraction of the economy is actually impacted by the inflation of asset prices. For the rest of America it is a time when the rising costs of living are outpacing the growth in employment and wages.

This is now showing up in reports from some of the leading retailers, like WalMart, as they warn that despite warmer weather consumers are not spending more, but less.

As I have often stated, there is a huge difference between the markets and the real economy. Eventually, reality and fantasy will collide and the end result will be much less favorable than currently believed by Wall Street.

Have a great week.

 









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