Saturday, March 24, 2018

Are We Heading To a 1929 Situation???

Over the last few days, I have heard / read a lot of doomsday and apocalypse forecasts that we are about to witness the next 1929 like situation. The basis for this forecast is the current volatility in the market.

As of now, there are no indications that we are going to enter a 1929 like situation. The odds are one in a million. Then the next question is are we going to witness a 2008 like situation. That is definitely possible though the odds are still one in a thousand.

First of all, let us understand that the current corrective trend in stocks be it India, Europe or US, was expected. Stocks were highly overbought and a profit booking and corrective trend was but natural. This correction was overdue in November/December but took longer. History suggests that the longer the delay in correction, the harder is the impact. That is exactly what has happened as of now IMHO.

The technical structure and quantitative analysis experts were keenly anticipating this fall. For Nifty and for DJIA, I expect stability around 9725 and 23200 levels respectively. All this is assuming status quo and no Black Swan events. Black Swan events cannot be priced in!

Whilst all this is true, some of you may ask why a 2008 like situation is possible yet again. First and foremost, we must understand that the financial markets are largely driven by bonds. The bond market goes into several multiples of all stock markets and commodity markets put together. Be it 1929, 2000 or 2008, the troubles always began with the bond/fixed income markets.

For the last 8 years, we have had unparalleled easy money policy with near zero interest rates and ample liquidity. This liquidity although was meant to revive the economy, all the large banks largely used this money to prop up the stock market rather than stabilize economies of common people.
Bond prices and bond yields have a negative correlation i.e. when the interest rates are low, the bonds command a higher price and vice versa. This is where a ticking time bomb is running right now with the large banking corporations. The large banks paid higher prices for the near zero rate yield bonds and are now staring at large losses on their portfolio. Every basis point (100 basis points = 1%) increase in interest rate means millions of dollars worth of losses for bond portfolios of large banks.

This has to be accounted for on a Mark To Market basis and reported to shareholders and competent authorities. The common man perhaps does not get access to this information. Nothing on this front has been reported anywhere as of now. Cumulative quantitative easing history estimates that at least 4 trillion dollars/euros/pounds were released to the banking system. Now imagine the loss that will cascade to the stock markets and common man if 25% of this amount is booked as losses on bond prices. Hence, I am very cautious in the current bull market conditions. Given the fundamental nature of the bonds, these bonds are still valuable. In case of Lehman Brothers and all the financial institutes that followed, the bonds were junk. The bonds were issued on the basis of imaginary future payments and a perpetual 15% increase in housing prices. This time, the case is different. We are looking at bonds issued by central banks; they are real. The bonds may definitely lose some value due to changes in the yield curve but that is fine. Given the rate hike forecast, the US securities (fixed income) will at best see a 30% markdown. This will trickle to the stock and commodity markets as well.

The manifestation of these drops could be attributed to Trumponomics, Brexit or whatever - the point is that people are alert and aware of such a situation coming up.

To summarize - there is NO FINANCIAL MELTDOWN in the near future.
Possibility 1: The markets will go through the cyclical correction in the structural bull market. This is the phase we are going through right now. Till the Nifty holds 9725 and till DJIA holds 23000 (given or take a couple of %s) I will still maintain this view.

My probabilistic estimate: 95%

Possibility 2: The bond market jitters trickle into stock markets with the 25% to 30% markdowns. Then the stock market will about 40% to 50% corrections from the all time highs.

My probabilistic estimate: 4%

Possibility 3: We actually see bad turns out of things like Trumponomics, Brexit, Eurozone instability etc etc etc and a severe recession. 90% correction from all time highs

My probabilistic estimate 1% (2018 - 1929 = 89 : A Fibonacci Number!) Hence I am giving this a 1% change instead of a few basis points

So the view is largely in favor of the bull case. Anything can happen in the market - so for the common man, it is important to build some insurance in the stock portfolio by buying some protective puts. This is extremely easy in developed  markets. In India, the options market is highly manipulated and do not perform very efficiently. I will be writing a separate post on how to make best out of the Indian options market to protect your portfolio to some degree (Note that the article will be for genuine long term investors and not the short term punters who buy/sell options)

Happy Investing and enjoy the Easter festivities coming forthwith.

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