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Is This Recession, Depression Unique, And How To Short Using Fundamental Analysis?

23 August 2009 1,256 views 7 Comments

You might have noticed that in the last few weeks more and more of my posts have been about historical context. Quite frankly for the past couple of months (as the market has been increasing) I have been doing my historical fact checks. I am a discipline of statistics and when you have once in a lifetime opportunities you need to need to look way back, and I mean way back in history.

I started my search in the 1700’s and moved forwards. For my research I read books and papers, but I have found Wikipedia has some very nice links about panics, recessions and depressions. I was surprised at how many of the references were in Wikipedia.

So you want to know how many panics and depressions we have had up to the Great Depression, which could be considered equivalent to the Great Depression?

  • Tulip Crisis 1630’s
  • Stock Jobbing 1690’s
  • South Sea 1720’s
  • Government Bonds 1750’s
  • Panic of 1792
  • Panic of 1819, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893
  • Panic of 1907

Don’t believe me? Do your research and you will see that it is utterly amazing that the central banks and the governments of this world managed to hold this world together as they have since the Great Depression. We have been spoiled!

Between them all here is what I think are the common aspects:

  1. Its all the fault of the speculators! Does not matter what time period, but the culprit of the panic is always the speculator, not the average Joe on the street.
  2. There is always a new paradigm. Until the day of the collapse there are always people who said, “We have entered a new paradigm”
  3. There is always a scapegoat, like our current scape goat called Goldman Sachs! It is amazing that those who prosper in these times are the evil scapegoats who had insider knowledge and wanted to plunder the innocent person.
  4. There are always those that get wiped out financially.
  5. There is always a debate on those who say, “let the house burn”, and those that say, “we need to save them for the sake of the economy.”
  6. There is always a discussion on how to solve this so that it does not ever happen AGAIN.
  7. And finally there are comedians and smart a***s who knew better and gave out “wise comments”.

From looking at the various scenarios and weighing their causes one conclusion that I have come to is that actions like Bernanke and the central banks were the right actions. Capitalism is good, but when you let things burn down you are prescribing an overall hardship that affects all. As George Soros has iterated the problem is not capitalism, but that people like Friedman assume people stay rational, which is not the case. When people act irrationally then things happen that should not happen. I have always believed this, and it is the basis of my entire investing system. I expect people to behave irrationally.

Many of you readers will say, “hey that is socialism and not capitalism”. This is not an argument about socialism vs capitalism it is about populism and societal well being. If the people suffer then those on top will suffer as well. There is no amount of talking and rationalization that anybody can do if the person has no food on their table.

Thus by arguing political leanings, you are arguing against the statistics of what has happened in the past.

The real culprit of these panics are the bubbles themselves. The bubble basis does not matter and it could be tulips, railroads, canals, stocks or Internet companies. It is the bubble and the diversion of capital to the bubble that is the problem. I have come to the conclusion that a bubble forms when capital flows to a particular sector constrict capital flows to other sectors. When this commences you are witnessing a bubble.

This capital flows diversion is an interesting concept because in each and every depression, recession, panic there was always a capital flow problem. What happens is that when the capital flows to the bubble other parts of the economy have trouble functioning. Thus those people who lives should be ok, are in fact beginning to fail. But because the bubble overrides the failings (there are more benefiting from the bubble than loosing) you don’t notice the beginning of the end of the bubble.

Since I tend to invest over the long term, and do not short I have come to an approach on how I would short using fundamental analysis. I would look at the capital flows for a company, sector, industry what have you. And if there are capital flows issues then I would say it is a warning sign and should be kept as a reminder.

Then when you feel the bubble is getting big enough start shorting step by step. The advantage with this approach is that you pay little in service charges in keeping the short. Most people would think you are crazy shorting the company, since there is a bubble.

So what would I short now? Nothing actually since we are not in a bubble. I think right now we are in a functioning efficient market…

BTW does this sound too easy? Actually it is that easy, but there is a catch, do you have the stomach to not be affected by the market? It is the classical Behavioural Economics problem. I am a contrarian investor and let me tell you it was easy for me to buy buy buy in February… Could you have bought in February?

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7 Comments »

  • Bill said:

    [blockquote]So what would I short now? Nothing actually since we are not in a bubble. I think right now we are in a functioning efficient market…[/blockquote]

    pretty loose definition of “functioning efficient market” you have there. rules are changing on a weekly basis. SP with an estimated PE of over 140…[head asplodes] At what PE would you short the SP? With unemployment increasing at a decreasing rate based on ridiculous BLS models and deflationary pressure by credit destruction…how are companies going to support these earnings estimates?

    I guess you could say that this is a “functioning efficient market” from the perspective that…
    - the market rises when the underlying currencies are being beat down.
    - the market rises when analysts and major media misrepresent indicators.
    - the market rises when accounting standards change to “mark to myth”.

    imo, stimulus 2 is about to be brought back on the table after (if not before) nov and dec 2009 when consumers are no where to be found.

    please explain…
    [blockquote]So what would I short now? Nothing actually since we are not in a bubble. I think right now we are in a functioning efficient market…[/blockquote]

    # 23 August 2009 at 8:23 pm
  • Christian Gross said:

    “pretty loose definition of “functioning efficient market” you have there”

    Not loose at all. In fact I am following an article that was in SCIAM. They looked closer at this and talked about something that I have been following for a long time namely Behavioral Economics/Finance.

    In that article they said a functioning efficient market is when there are contradictory opinions on the future shape of the market. And that is what we have right now. Some say yes, some say no.

    When looking at PE values you cannot follow the current. You need to look at the past five years to get an average. At what PE values would I short a market? When the market is bubbly. I would probably short the market when PE values are in fact very low.

    Your pessimism is very indicative of the current moment. You are letting yourself being sucked into a negative tailspin. I remember at a Birds of Feather everybody in the room was negative. But then 15 minutes of me talking to them, and no negative opinions allowed, people felt good about themselves. People right now would rather act as a group and be wrong, then be the lone voice and potentially be wrong. That BOF was an example of it.

    Whenever I ask if I am doing ok, and then I ask if my family is doing ok, and then I ask if my immediate family is doing ok, and then I ask if friends are doing ok, and then I ask if business contacts are doing ok. And want to know what I hear…

    “The economy sucks, and everybody is doing badly…”

    I ask how are you doing…

    “Ok…” or “pretty good” or “not bad, but saving”

    So put the logic together. How can the economy suck and you the person do ok? Answer is that it does not work.

    After having talked to some American friends what I have concluded is that the American consumer is actually doing very very well. Except that they are saving.

    One good friend in particular was a notorious spender, and he has told me that he has saved money. I replied, “really, [name] you are saving?”

    Now you need to look at the remainder of the world economy and it is chugging along quite nicely. Just as I have blogged about many times. I explicitly said that the American economy will not pull the world economy out of the doldrums.

    If you had to push me on a bubble, I would say we are in an American savings bubble… It will not last.

    # 25 August 2009 at 12:55 am
  • Bill said:

    At what PE values would I short a market? When the market is bubbly. I would probably short the market when PE values are in fact very low.

    Why would you short when the PE ratio is very low? ultra-contrarian?

    After having talked to some American friends what I have concluded is that the American consumer is actually doing very very well. Except that they are saving.

    sample size?

    Maybe only 1 or 2 of my friends have lost their jobs, but we all attended a top engineering school. My wife and myself, we are actually doing very well…she was promoted and I just quit my old job and took a new one for better pay and better security.

    Here are some anecdotal data points to the contrary…

    - I see the homeless population growing in certain areas of town.
    - I see businesses closing down in all parts of town. Which means people who used to work there no longer do. People who will run out of money soon if not immediately as most Americans live paycheck to paycheck…especially the ones who work min-wage retail jobs.
    - I see record level spending by the US govt and I see tax revenues plummeting. I see tax hikes in the future.
    - I see US Govt and Central Bank struggling to reflate the credit bubble like its a good thing. Changes to accounting standards, changes to FICO score calculations, etc etc…its all an oasis.

    And I don’t think my pessimism is in the majority. Think about the drivel being spouted by major media (example: CNBC)…constant misreporting (or just mis analyzing) of economic statistics and indicators. This is where the majority get their perspective of how things are going in the US.

    - Cash for clunkers…”GREAT SUCCESS! – consumer demand is recovering”
    - $8000 “first home(in past 3 years)buyers credit”…”GREAT SUCCESS! – residential real-estate has bottomed and demand is recovering”.

    forget seasonality…forget incentives…consumers are recovering…gogogogogogog US economy!!!! (revisions to the numbers will come out a week or so later in an obscure footnote somewhere).

    I feel like the contrarian when I talk to friends who don’t follow the markets and news as close as I do…they make me feel like I’m a crazy tinfoil hat wearing lunatic: which makes me feel better about the US nearing a top.

    Am I being too negative for you?

    # 25 August 2009 at 5:39 am
  • Christian Gross said:

    “Why would you short when the PE ratio is very low? ultra-contrarian?”

    When the market is bubbly earnings tends to be inflated. And when earnings tend to be inflated the stock price does not reflect the true value.

    For example, take an example X (disclosure I am long this stock at 24). In 2008 they had earnings of 18 USD per share. Usually though X has earnings of 11, 7, 8, 9. Thus 18 is completely out of whack.

    Now take a share price of say 100, and 18 gets you a PE of around 5 and change. Take the average of say 9′ish and the PE becomes 10. Yet the market in 2008 will say, future earnings will be 25, thus future PE becomes 4, which would seem completely undervalued. When I see this divergence occurring I become very very bearish.

    BTW with X trading at 45 using past historical analysis it is not too crazy of a value. Though let me tell you once we hit 75 I will become very very antsy… Whenever I see earnings, PE, etc get out of whack I start selling…

    “Maybe only 1 or 2 of my friends have lost their jobs, but we all attended a top engineering school. My wife and myself, we are actually doing very well…she was promoted and I just quit my old job and took a new one for better pay and better security.”

    Two strangers who talk to each other over a blog and our situations seem fine. You say sample size. I say what is the probability that two strangers in the night are doing pretty well?

    I am a fan of statistics, but I also like probabilities. Thus while my sample sizes are not in the thousands I do use probabilities and they are telling me that this negative sentiment should be questioned.

    “- I see the homeless population growing in certain areas of town.”

    Not near you. ;) I mean this as a classical example of how “I am ok, but others are not doing so hot”. So how can this work? Because could not there exist the probability that poorer folk are saying, “Why I drove through these rich bastards area and there was one foreclosure after another and let me tell you we will see them in our part of the neighborhood soon enough.”

    “- I see businesses closing down in all parts of town. Which means people who used to work there no longer do. People who will run out of money soon if not immediately as most Americans live paycheck to paycheck…especially the ones who work min-wage retail jobs.”

    And they see how there are record number of for sale signs in not their neighborhoods.

    “- I see record level spending by the US govt and I see tax revenues plummeting. I see tax hikes in the future.”

    You see? Will it happen? Probably? Will it be bad? Maybe, maybe not. But then again people just add on debt…

    “- I see US Govt and Central Bank struggling to reflate the credit bubble like its a good thing. Changes to accounting standards, changes to FICO score calculations, etc etc…its all an oasis.”

    In one of my historical books they mentioned that money, and value are arbitrary concepts. And I completely believe that. Why is it that we think gold has real value? Why is it that diamonds have such a high value? Why was it that 300 years ago purple was only a color for royals? Supply and demand yes, but also perception. Humans do things to make themselves special and thus these “standards” are arbitrary and on the whim of society.

    From a personal perspective as an investor you need to be able to separate yourselves from this and form an opinion on what the ramifications imply.

    I am not arguing that there is no hardship. There is hardship. And I am not arguing that there are no debt issues. But to invest the question is what do you do? For example in March I bought, bought, and bought. Want to know something I am up 22% from Jan 2008! Not this year Jan, but Jan 2008 before the big drops.

    Do I buy now? No I have been trimming my positions and am back in 38% cash. I am waiting for the next pullback and it will come. This pullback will not be a March pullback, but it will be a pullback back enough to make bulls panic and bears glee, just before the market pulls back up.

    In the meantime I am selling premium and buying corporate bonds when they become cheap. Not great, but it gives me a few percentage points per month. Better than nothing….

    # 25 August 2009 at 8:30 am
  • Bill said:

    When the market is bubbly earnings tends to be inflated. And when earnings tend to be inflated the stock price does not reflect the true value.

    agreed…but here’s the way I’m looking at it…

    With the Q2 earnings announcement, we saw companies meeting and beating EPS forecasts causing a subsequent rally in stock price. However, after clawing through the data, we see that the EPS results were largely due to extreme operating expense cost cutting and asset selling to combat *plummeting* revenues.

    This brings us to a 3 digit P/E ratio for S&P.

    What happens in Q3 when companies have cut all the available fat and have no means to offset the continuation of very weak (if not worse than Q2) revenues? A lot of companies upped forecasts after smashing Q2 EPS forecasts (lol).

    Will we see the P/E ratio continue to climb? From 140 to 260? Or will we see a significant drop in “P” on accurately low earnings? Maybe “P” will remain unchanged for 5 years until “E” can catch up???

    your glasses are rosier than mine and your counters to my contrarian anecdotal-and-small-sample-sized evidence were garbage so I’m assuming you missed the part where I prefaced with “Here are some anecdotal data points to the contrary…”

    Btw, my timing wasn’t quite as good as yours, but I didn’t do so bad either…I bought in mid Feb09 and exited early July09.

    BTW, if you go short when P/Es are low, do you go long when they are high…like now?

    # 25 August 2009 at 9:16 am
  • Christian Gross said:

    The fact that companies beat earnings does not surprise me. After all in a recession what do companies do? They cut costs. In fact this is what I expect a company to do. Let’s spin this around. What do you expect to happen? I don’t expect them to beat the top line because they can’t.

    Now I am going to get pointed. Your timing is actually pretty good and you are making money. But here is the thing. If you are in 100% cash are you not wishing that the market will pullback so that you can step in again? Are you right now loathe to buy since you know the pullback will happen?

    I personally know your current situation as I am sitting on way too much cash. And I too am hoping for a pullback. But will it happen? I don’t know. So therefore I need to make money in the mean time. I am doing that by selling premium to get me in or out of positions. I am also buying bonds that will allow me to supplement my monthly income.

    And I am buying stocks because some companies are still pretty good buys. Of course it requires patience. Here is an example; solar companies. They are getting walloped and if you believe in alternative energies then solar will be a part of that. Another one is oil refiners. Again you need to be selective, but there are buys.

    # 26 August 2009 at 12:47 am
  • Christian Gross said:

    Here is an example of where I become skeptical of a company.

    Swiss Life. They announced earnings and it fell short of what was expected. And their revenue is falling short. Answer, cut more jobs.

    It is at that moment I start to wonder about the company. Because when the CEO says “cut jobs” at every corner you know something is wrong. Maybe it is the company, maybe it is the CEO, or maybe it is management.

    # 26 August 2009 at 2:35 am