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Musings Report 2022-7 2-12-22 Calm Before the Storm?
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Calm Before the Storm?
Human habituate very quickly to circumstances and soon anticipate these circumstances will continue on into the future. In economics and finance, we call this continuation a "trend."
Trends continue until something fundamental changes and the trend takes a new course.
If the economy and asset prices are expansive--money supply, credit, sales, jobs, tax revenues and profits are all expanding--we call this trend "bullish."
If the economy and asset prices are contracting, we call this "bearish."
People are much happier in bullish trends because they're earning more money and whatever assets they own are going up in value. They feel more financially secure and so they borrow and spend more money, which furthers the expansion.
This self-reinforcing feedback reverses in bearish trends as people feel poorer and less secure so they botrrow and spend less, shrinking demand for goods and services.
People don't like feeling poorer so bear trends are not favored. The focus of those in power is to reverse any bear trend into a bull trend and attempt to extend the bull trend as long as possible.
But eventually every bull trend runs into limits. People borrow the maximum their income can support and then they borrow a bit more to put on a bet that assets will continue rising in value: they buy stocks, bonds, real estate, collectibles, etc.
This flood of money pushes assets up far beyond their previous value, disconnecting them from the fundamentals of income-producing assets.
Houses are fundamentally valued by the income they generate when they're rented out. Stocks and bonds are valued by the yield or dividends they generate.
As valuations soar, those who bought the assets find that most of their profits are capital gain from the rising value, not from income. So they buy more assets, expecting the trend of soaring valuations to continue more or less indefinitely.
But valuations only rise when demand from buyers exceeds the supply offered by sellers. Once the valuation bubble reaches a peak, sellers who decide to take profits or sell to pay down debt exceed buyers and valuations decline.
This is called "the credit cycle" or "the business cycle" but it's really a cycle of human nature: when gains are effortless, we want to buy more assets to increase our gains, so we increase our borrowing, leverage and risk to expand our gains.
"Investment" becomes pure speculation unmoored from fundamentals. Eventually valuations, leverage and debt all reach extremes that exceed what the speculators and assets can support, and so valuations, debt and leverage all start to contract.
The euphoria of getting effortlessly richer is replaced by the fear of getting painfully poorer, and so slowly but surely, buyers turn into sellers.
This becomes a self-reinforcing feedback: as valuations drop, more people decide it's time to sell. Once valuations plummet, other owners are forced to sell by margin calls--debts taken on to buy more stock get called, i.e. the lender demands cash.
What makes this transition interesting is that humans are reluctant to let go of a trend that has been good to them.
So the natural tendency is to think /assume / hope that the asset that is sinking will stop sinking and recover its former bullish trend.
During expansive trends, this "buying the dip"--buying more whenever an asset drops--is rewarded, as every downturn is soon reversed and the uptrend is resumed.
But once the trend has reversed, "buying the dip" is no longer rewarded, it is punished, as valuations continue sliding.
Experienced traders look for evidence of this transition because they've learned the hard way that those who cling on to the idea that the bull trend is basically forever because The Powers That Be want it to be forever end up losing most of their wealth.
Inexperienced traders have great difficulty believing the effortless gains are ending, as the majority of other traders are still bullish and the financial media is also bullish. It's easy to find convincing reasons to believe the bullish expansion is simply taking a brief pause.
Experienced traders use charts and data to discern the difference between a brief dip and a change of trend.
The longer the price data being displayed, the more noteworthy the chart. A chart of monthly stock prices, for example, eliminates the daily noise of ups and downs. It shows only the long-term trend.
Technical analysts run price data through various screens and calculations to arrive at indicators such as MACD (moving average convergence-divergence), relative strength (RSI), stochastic, and dozens of other indicators.
The idea is that these indicators will capture the trends and trend changes much more accurately than the news flow or day-to-day price action.
Here is a monthly chart of the NDX, an index of large NASDAQ companies I've labeled the obvious trends.
What's noteworthy is the current downturn is clearly a change of trend from bullish to bearish.
It's impossible for a monthly trend to change in a few days. The chart takes months to signal a trend change. Monthly trend changes will take a long time to reverse back to the previous trend.
How long, nobody knows. The speculative bubble from March 2020 to January 2022 has broken. Nobody knows how far price will fall, but the history of bubbles is inarguable: prices eventually return to where they started.
Oftentimes, the drop is roughly symmetrical with the rise: if it takes a year to reach the bubble top, it will take about a year to fully retrace to the pre-bubble level.
Here is a chart (courtesy of Mac10) of the VIX, a measure of stock market volatility, and the S&P 500 (SPX).
To return to its starting point, the current bubble would have to fall more than half, from its peak of 4,800 to about 2,300.
Money manager Jeremy Grantham has long studied bubbles and he marks the long-term trend that the SPX will eventually return to at around 2,500.
Here is Grantham's perspective on speculative bubbles:
"I wrote an article for Fortune published in September 2007 that referred to three “near certainties”: profit margins would come down, the housing market would break, and the risk-premium all over the world would widen, each with severe consequences. You can perhaps only have that degree of confidence if you have been to the history books as much as we have and looked at every bubble and every bust. We have found that there are no exceptions. We are up to 34 completed bubbles. Every single one of them has broken all the way back to the trend that existed prior to the bubble forming, which is a very tough standard."
Grantham sees the current bubble as three simultaneous bubbles overlapping into a 'super-bubble.' The US stock, bond, and housing markets are all three standard deviations from their historical average. Grantham says there have been only four super-bubbles in history: in the US in 1929, 2000, and 2006, and in Japan in 1989.
It's entirely possible to endlessly debate why the bubbles can't pop or won't pop, and argue whether this or that will cause the bubbles to pop, and this is where charts are handy. Charts don't reflect opinion, they reflect a change in trend.
I titled this exploration of trend and trend change "calm before the storm" because the transition from bullish expansion to bearish collapse of speculative bubbles is an internal battle within bulls hoping for a quick return to effortless gains.
They have a great many reasons to want the rally to resume, and few reasons to willingly accept that holding onto the assets that made them so much money will now only reduce their wealth.
This tug of war is generally calm. The storm starts when the first "vital few" sellers (4% of owners, if the Pareto Distribution holds) cause 20% of owners to start selling. This avalanche of selling--the storm--triggers behavioral changes in the 80%.
Stocks don't vanish when sold; somebody owns the shares losing value all the way to the bottom. These owners who refuse to sell because they have convinced themselves the next dip will be the hoped-for resumption of the bullish trend are called "bagholders." Every experienced trader has been a bagholder. The reasons and psychology are always the same: we are reluctant to let go of trends and our belief that the change of trend is a chimera.
Maybe the trend is still bullish and the calm will never be interrupted by the storm of a trend change. That may be, but the monthly chart is not ambiguous. If it's correct, the trend has changed.
Highlights of the Blog
posts:
The Cost of Financialization-Globalization: You Lost $500,000 and Gained $137.13 2/11/22
The "Crapification" of the U.S. Economy Is Now Complete 2/9/22
How Empires Die 2/7/22
Best Thing That Happened To Me This Week
Finally received a few hours of light rain after 6 weeks of drought. January rain totaled about 1 inch as opposed to the typical 10 inches. That's tough on tropical trees and plants and tough for the gardener dragging hoses around for hours....
From Left Field
NOTE TO NEW READERS: This list is not comprised of articles I agree with or that I judge to be correct or of the highest quality. It is representative of the content I find interesting as reflections of the current zeitgeist. The list is intended to be perused with an open, critical, occasionally amused mind.
American Revolution as Total Revolution: Del Noce and the American Experiment (via Michael M.)
Review: ‘The Nutmeg’s Curse’ challenges dominant view of development
Polar bears settled on an abandoned meteorological station in Chukotka -- they look right at home....
Fintech Is a Scam — A Listicle in Eight Parts
Gemma Chan on the truth about her father’s life at sea
Long COVID could become Finland's largest chronic disease, warns minister
Why do leaders deny peak oil & limits to growth? -- because they're afraid we can't handle the truth....
A New Crop Of Farmers Is Helping Hawaii Grow More Food--heavy headwinds to earning a living growing food locally...
Why Education Is About To Reach A Crisis Of Epic Proportions
As Cryptocurrency Becomes Mainstream, Its Carbon Footprint Can’t Be Ignored
Radicalization: The strange psychology behind fusing yourself with one cause
The downfall of Evergrande foreshadows a difficult decade for China – and for Xi Jinping
"When the gods wish to punish us they answer our prayers." Oscar Wilde
Thanks for reading--
charles |
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