What a Cycle

Posted 1 year, 4 months ago at 5:01 am. 0 comments

Sixteen years ago, I considered myself a rookie trader on the floor of the Chicago Mercantile Exchange. Bright eyed and eager to learn, I followed every market I could. I actively traded the S&P 500 but, I always went in early for the currency and interest rate openings, as well. I actively and, knowingly took advantage of any of the major market players willing to have a cup of coffee with me. The economic times were significantly different than those of today. Trading volume was ushering in a major stock market bull- run, even as memories of the ‘87 crash still lingered. The trading floors were flush with people who made more in one day than most make in a year or some, in a lifetime. The technology wave was just beginning to trickle in and financial modeling was at the forefront of quantitative investment strategies.

I still come in early and I still actively trade the stock indices. I still actively and knowingly pick the brains of the market players I am fortunate enough to gain an audience with. Sixteen years later, I find myself at the beginning of the cycle…..again.

I know many of you are thinking that I must be nuts. However, if you give me a chance to explain, I think I can tease this out in terms simple enough for myself to understand. I’ve read so much over the last month that I feel like I’ve learned an entirely new language. Separating the wheat from the chaff and allowing myself an opportunity to collect my thoughts, thank goodness for rainy weekends, I’ve come to the conclusion that we’re near equilibrium and will extend beyond the mean before finally reverting and building a base very similarly to the process of the early 1990’s.
Economically, the circumstances couldn’t be more different. In the 90’s, many of the excesses of the eighties had already been purged. The savings and loan crisis had been effectively dealt with (net cost- 85 billion) and the stock market crash provided everyone with a whole new perspective on what risk really was. Interest rates had been coming down for more than a year, falling from 7.25% to under 3% in less than a year. The U.S. Dollar was still king having been defended effectively from the Pound by George Soros. This helped check global inflation and kept commodity prices low while commodity demand remained, primarily, domestic. Finally, on a quantitative note, the S&P 500 was at 415 and had a price/earnings ratio of 19.6.

Trading volumes are soaring as technology has removed so many of the barriers between the pits, the customers and finally, the world. Money has never moved at a more rapid pace (good or bad). This same technology brought with it a generation of misguided applications. Historically, it will be my generation that brought computer modeling to the financial and commodity markets. We are the poster generation for “GIGO” garbage in - garbage out. Computer modeling and optimization provided us with “statistically valid” risk models that would allow us to take on more leverage and increase the bottom line. Apparently, the one market excess able to survive the savings and loan crisis as well as the ‘87 crash was greed.

History has proven time and time again that there is no economic free lunch. The tech boom of the ’90’s made millionaires out of John Doe’s the same way that the crash made overnight millionaires out of pit traders. Intelligence and ability should never be confused with being in the right place at the right time. The separation of those with ability from those with geographical good fortune can only be told over the course of time. The trading pits took away the free lunch of pit traders (The Epitome of Free Trade) just as the dot com bust erased other, unearned fortunes. Currently, it is the financial industry being forced to endure their comeuppance. Their computer modeled diversification of bundled risk and carefully designed tranches sold to global institutions allowed them to over leverage low interest rates and put people into homes and businesses that should never have been put into existence. The models that were designed were put into action based on their ability to compress risk while adding to the bottom line. Does anyone remember Long Term Capital Management or Enron?

Finally, it is the long term global nature of hubris and contrition that drives the long term cycles of the stock market. Contrition is clearly the leading factor since October. Fortunately, just like the oil market, we have tools to tell us when the fat part of the move may be over. Fundamental analysis has allowed us to determine under and overvalued markets fairly successfully while our humility has allowed us let the markets tell us just what over and undervalued means in real terms. I’ve been writing for more than six months that the stock market will revert to its mean… and then some. Markets always overshoot. If this is a normal bear market, we can assume the following set of parameters.

1) P/E ratios decline by approximately 60%. The peak for this run was around 43.
2) Average decline is approximately 30% form peak.
3) Average length is around 14 months.

If we look at these figures, it appears as though it’s going to be a gloomy holiday season. I believe we entered an, “official” bear market at a 20% decline from market peaks. Depending on the index, this started in July. The P/E ratio, even with today’s declines, remains near fair value, at 17 and change. Just as markets tend to overshoot on the upside, so too do they overshoot on the downside. We will grind our way through and there will be rallies and failures, just as there always are. The question investors should be asking themselves is, “How do I best manage my way through this period without affecting my long term goals or, giving into short term emotions?”
I believe that this is where the futures industry, through stock index futures like the S&P 500, Dow, Nasdaq 100 and Russell 2000 should be employed. They are offered in a wide range of sizes and can be tailored to cover most any equity portfolio. The margins and account sizes are exceptionally favorable, as well. Currently, an individual can still protect $30,000 worth of tech holdings with a $5,000 account.

Individuals who don’t utilize the futures markets to limit their losses on the way down or, to maximize their return on the way up are simply hiding their heads in the sand and pretending that they don’t know better. Any investor who feels they are responsible for the lifestyle of their retirement should act in their own best interest and take advantage of these opportunities. I thank goodness that I can see the beginning of the next sixteen years far more clearly than I was able to see the beginning of the first sixteen.

Andy Waldock

http://www.commodityandderivativeadv.com

866-990-0777