Pressure Points In The Market

I just took a look at areas of prospective bubbles in the market the other day and concluded there was nothing significant poking its head out. But I wanted to revisit that question and articulate or expand on a couple more pressure points in the market today:

1. The large decline in oil prices has crushed the energy sector which had been one of the drivers of growth in the US. There may be more risk and implications there than what the market is indicating.
2. The large decline in commodity prices, predicated on the slowdown in China, which has crushed Australia, Brazil and Canada. Australia, China, Canada and the UK have large residential real estate bubbles.
3. ECB QE and the financial repression of NIRP is leading to a recalibrating of currencies and a fight to the bottom. 
4. Japan QE and rebalancing could push Japan over the edge as the curtain is finally pulled back.
5. Geopolitical risks could escape beyond borders and proxies - Ukraine, Syria.

Where are we vulnerable

The seas appear to be calming, but the quiet reflects the passing of the storm, and rocks lie just beneath the surface.

So, where are we vulnerable. And, what are we vulnerable to.

Given the amount of debt outstanding, we are vulnerable to a rise in interest rates.

Given the fragility of the recovery, we are vulnerable to a rise in oil prices.

Given the trade imbalances in the global economy, we are vulnerable to a trade war.

Given the level of confidence in China, we are vulnerable to an asset collapse there.

Given the fickle nature of financial markets and the risks outstanding, we are vulnerable to a generalized decline in confidence.

Given a host of structural issues (prospective new wave of defaults, unemployment, monetary/fiscal exit) we are vulnerable to a double dip.


As we found out so painfully in 2008. Confidence is fleeting. We know and can see the vulnerabilities in the system. What we don't know is when the positive will turn to negative.

Eye of the hurricane

We are in the eye of the hurricane.

"the eye is characterized by light winds and clear skies, surrounded on all sides by a towering, symmetric eyewall."

The seas (economic data) are still choppy (mixed), because we have cross-currents coming from all directions (sovereign systemic risk concerns, stimulus withdrawal effects, state/local crisis, 2nd wave of mortgage defaults, high unemployment, China bubbling, commercial real estate teetering, Japan a mess).

This should be a time of preparation for the backend of the hurricane (more wind and rain). The consumer will continue to deleverage, while the govt will continue to bail. Should confidence in the govts ability to bail erode, then the system is at greater risk. It is going to be touch and go this time around, but if we do avoid another meltdown, then we have only deferred it for another day.

So What Is The Right Proportion?

So what is the right proportion? WRT "proportion," I am referring to the appropriate fall in asset prices given the decline in fundamentals. To answer that question, I think it is somewhat helpful to reverse engineer a fair market value for the stock market based on the fall in corporate revenues (and profits), and the fact that the market was overvalued at the peak (ie. risk premium was way too low).

To do this I work off the following assumptions. Public company revenues have fallen somewhere between 20%-30%. Public company profits have fallen somewhere between 15%-25% (stripping out financial write-offs). If I adjust for the undervaluation of risk at the peak of the market, and multiply those declines by say a factor of 1.7x, then I think a case could be made that S&P 500 fair value is somewhere around 1040. Peak S&P 500 = 1576. Decline in profits = -20%. Multiplier applied to decline in profits given the undervaluation of risk = 1.7x. Calculation: -20% x 1.7 = -34%. 1576 - 34% = 1040. All this is saying is, that the market should probably have only fallen about 34% given the decline in fundamentals. The fudge factor, of course, is the risk adjustment multiplier, and its level all depends on how overvalued you think the market was at its peak. And, of course, markets overshoot (both up and down).

The tricky task is in our business is marrying the economic fundamentals with an appropriate multiple for asset prices, adjusted for a reasonable risk factor. Previously, I looked at fair value for the market from a bottoms-up perspective (looking at normalized earnings) and put it somewhere around 900-950 ($60 normalized earnings x 15x = 900). What is confusing me at the moment, however, is determining whether to apply a higher or lower risk factor to the future (ie. what multiple to apply). In many ways I can see where a higher risk factor should be inputed (greater chance for fiscal and monetary policy error, higher taxes, lower consumption, structural shift, etc.), but in other ways I can see where a lower risk factor is warranted given that we have overshot fair value.

All of this speculation is independent of what actually happens in the future, which will tell us (in hindsight) what side of the risk factor I should have fallen on.

King Kong vs Godzilla

We're shaping up for a right royal battle between King Kong and Godzilla.

On the one hand, we have King Kong representing the myriad of risk factors likely to weigh on and mitigate against recovery (inflation specter, massive debt funding, twin deficits, global imbalances, dollar deterioration, rising taxes, anemic job market, consumer saving, debt deleveraging, etc., etc.).

And on the other hand, we have Godzilla representing the natural pull of a recovering business cycle (including massive fiscal and monetary stimulus).

You can't stay down forever, but you sure can wallow in the mire for a while.