The Downgrade Triggered Flash Crash Was Inevitable: Why Stocks Will Go Up Now

by Guest Author Andrew Butter

There are many theories about how to value the US Stock market (as a whole); some said that stocks were 40% over priced in May 2009, same story in August 2011. All it took was the hilarious spectacle of the workings of what passes for “modern” democracy to be aired on prime-time, for those same tired-old theories to get dusted off and paraded like some sort of universal truth.Really! 40%?…grow up! The acid-test of a “universal truth” is whether it can make accurate predictions in real-time. For example my niece, aged six, has a theory about the sun; based on that theory she can predict with spellbinding accuracy where it will come up in the morning. Of course that doesn’t mean her theory is right, but it’s a start; and one thing is certain, if her predictions were completely wrong, then that would be grounds for saying “sorry sweetheart, but the definition of lunacy is doing the same thing over and over and expecting a different result”.

Here’s a theory that has been right five times out of five, that says (a) the reversal just now was inevitable, (b) all that the downgrade did was provide the trigger and (c) it’s over.

In January 2009 that theory said the S&P 500 would bottom at 675, which it did in March (intra-day), then it said in May 2009 that the index (then 900) would go up in a pretty straight line to 1,200 (it did over the next twelve months); then it would reverse by 15% to 20% (it did by 16% in April 2010); then it would meander back up until it went over 1,300 which happened in April 2011, at which point it would reverse again by about 15% (actually it was 18%).

If you know of a theory about how the US stock markets works that can do five-out-of-five, in a row; without a caveat, well that could be right too.

The “without a caveat” part is important. Put a number for the inflection point in the future, rather than saying something “profound” like… “US Stocks could go down 40% and test March 2009 lows”, as in “could” means “could not” too.

Meanwhile I’m sticking to that theory, at least until it doesn’t work. Perhaps sixth-time-lucky won’t work and the sun won’t come up in the place the theory predicted?

Use Valuation Standards

How does that work…if it works?

Simple you do a valuation in line with International Valuation Standards, crank the handle, and out pops the answer. That gets you to the “fundamental” (or intrinsic value), or what Farrell called “equilibrium” and what IVS calls other than market value.

The rest is just Farrell’s 2^nd Law, which re-states Mises’ idea that making stupid investments, particularly geared-stupid-investments (he called them mal-investments) is inevitably followed by forced liquidation of those investments at an unattractive price. Another way of looking at that is the “pebble in the pond” theory, where the dynamics of the “up” are inevitably reflected in the “down” that follows; and the net result is zero sum. That’s a law of nature and however hard those who call themselves God’s Workers try to defy nature, in the long-run, as Keynes pointed out, natural order always returns.

It doesn’t take long to build the valuation model and you don’t need to be an “expert.” The first time I did that for stock markets all I knew was that they existed and that you could download data from Yahoo Finance. To illustrate the depth of my ignorance at the time, back then I thought the DJIA was the same as SPX except that you multiplied by ten.

It took about half an hour to build the valuation model and about three hours to write the article and come up with the bad jokes. Only one thing about that which is hard to understand, is how come Shiller, Smithers, Prechter, and all those other guys who say things like “could” and “might” (instead of “will”), just can’t “see” how easy it is. For some history see here and here.

Bribing Readers

Why the bad-jokes? Truth be told, I didn’t actually want anyone to read the articles. I just wanted to put out a marker. I have this thing about giving free advice. My theory then was anyone who laughed at my jokes could get a little free-gift. Although I must admit it’s pretty sad when you got to pay people to laugh at your jokes, anyone who was in cash at 675 then bought and then sold at 1,200, then bought at 1,050 then sold at 1,300 got a nice free gift.

What will the law of nature spew out next?

The “theory” says that the fundamental of the S&P 500 (expressed in dollars) depends on (a) the nominal GDP (in dollars) of the economy that companies listed on the index play in (which is wider than just the US economy), and (b) the yield on long-term US Treasuries (whatever their rating).

That gets you to the base line; then you have to look at the periodicity of the oscillation around the base line.

With regard to the base-line, the irony of the downgrade is that the whole reason the Big Three US rating agencies exist is that they were granted a lucrative concession (by the government) to pontificate about what risk weighting can be assigned to a security put up by a financial entity (like a bank), as collateral on a loan…in order to prove (to the government) that they (the banks) were “adequate”.

So the “brave” S&P decision was a bit like biting the hand that feeds or the child who stupidly pointed out that the king wasn’t wearing any clothes.

Whether S&P will have their head cut off is an intriguing question right now. Personally, having spent a little time in places with really nasty “kings” where the reward for calling out a bunch of venal incompetent crooks is a bullet in the stomach and then you get thrown off a bridge (like in Syria for example). I’m standing well out of the firing line.

But calm down, it’s not a big deal, sovereign debt only loses its 0% risk weighting when it drops below AA- and so nothing really changed, although one wonders what’s going to happen to non-sovereign debt? The risk weighting of AAA synthetic collateralized debt obligations lovingly crafted by Goldman Sachs is 20%, so presumably that stuff is now supposed to be less risky than the debt issued by a country which has the option of simply printing dollars to pay the debt back?

I’m not quite sure how that will play out, but from a practical standpoint you can still borrow more money if you put up AA sovereign debt as collateral than if you put up some AAA rated toxic assets, unless of course you are dealing with the Federal Reserve, because these days the Federal Reserve Agent will accept any old rubbish as collateral.

So does that mean I can roll up to the Federal Reserve with a pair of smelly old shoes, and they will pay me what I paid for them, five years ago? Probably not, you need to have connections in the right places to be able to work a scam like that. One thing I learned in Syria, it’s all about connections and looks like it’s no different in America. Just over there they throw you in jail under the three strike rule for dissent.

And Treasury Yields Went Down?

What’s really confusing is that 10-Year yields tanked after the downgrade. The way it’s supposed to work is that when you get a downgrade, the yield on your piece of the toxic asset pool, is supposed to go up.

What’s also interesting is that the S&P 500 started to tank the day after Lehman folded, but it took another two months for yields on the 10-Year to start to tank. This time around, they both tanked in tandem.

Perhaps the difference was that back then there was the legacy of George Bush who, for all his failings, did manage to unite the nation behind him. See my Opinion Blog article this week.

In the Opinion article, I suggested it is more than likely nominal GDP growth will hover around 3% a year (how much of that is “real” is irrelevant insofar as the stocks are concerned), and so the 10-Year will hover around 3% too.

Plug those parameters into the valuation algorithm and this is what you get:

The line to watch is the bottom of the triangles. Whenever the price goes up faster than that line, there is a risk of a reversal.

So the model says that by August 2016 the S&P 500 will be flirting with 2,000 which works out at an average annual growth of about 10% a year, whether that will keep up with “real” inflation, is of course debatable.

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