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Catalysts for a major correction


Uccmal
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In conjunction with my other thread on good companies to buy.

 

I have been raising cash (or at least reducing my borrowing) because the S&P is at unjustifiable all time highs and earnings are stagnant.  And this is with all time low interest rates, unprecedented stimulus, and low oil prices.  Selling down position sizes in great performing stocks is painful. 

 

Some:

 

1) Deflation - possible, although it is a known quantitiy and maybe priced in. "The Amazon effect"

2) The US presidential election.  I think just the fact it is over may cause a crash regardless of the outcome.  Generating a crash, and a recession, and building things back up for the next cycle has been the modis operandi of first term presidents - Obama had his crisis given to him - Bush was given one by the tech crash.  Clinton and Reagan each inherited a moribund econmy.

3) Negative interest rates - Title "What will Apple do with all that stranded cash?". Also a known quantity. 

4) Ennui: Its just been awhile since a good old fashioned bear market.

5) Soveriegn debt. 

6) Rising interest rates - further out in time (Imo). 

7) An oil price spike, whatever the cause.  According to Grantham this is the cause of all recessions including 2007/2008.

 

7) A black swan event - by definition - who the hell knows. 

8) A nuclear event. 

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Mine would be:

 

1. China.  So far every time they slow they stimulate like hell.  One day it might not work.

2. Japan.  A slo-mo car wreck and possibly the place that first demonstrates that central bankers are not all-powerful.

3. A common-or-garden US recession, driven by the fact that recessions happen sometimes.

4. Rate rises - although QE is currently at an all time high globally which may render this irrelevant.

5. More sellers than buyers.  What happens if a few more people start thinking this way? 

6. Europe - several elections coming up and the future of the EU will be a topic in all of them.

7. Inflation or deflation.  Both would be nasty.

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I am not predicting a major correction. (I'd still like a definition: 20-30%? 30-50%? 50-??%?)

I think 20-30% is likely in next couple years. Higher percentages less likely.

 

My guesses would be:

Likely:

- No big reason

- Meh generic recession after long business cycle

(Much?) Less likely, but possibly bigger crash:

- EU falls apart

- US presidential election (I have some scenarios, but won't post so this doesn't turn into another ... thread).

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A: Some unpredictable thing that will affect mass psychology and turn people more bearish than they were.

 

B: Conversely, some other unpredictable thing could make people more bullish, which would accelerate investment and capex, which would self-reinforce into better economic data...

 

Seeing as how lately half the time bad news are good news and vice versa, the very same unpredictable thing could lead to A or B depending on how the wind is blowing...

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I  think a very problematic scenario is a sudden, unexpected burst in inflation, driven maybe by commodity prices, maybe rising wages, or something else.

 

If we get sudden inflation, it would force interest rates to rise far more rapidly than people are expecting and cause all sorts of problems - government deficits due to higher interest payments, people unable to afford mortgages and losing houses, businesses unable to raise debt or too expensive debt, etc.

 

A slow gradual rise in rates is manageable and pretty much everyone is expecting this, but a sudden burst in inflation and rates would be unexpected and a big problem.

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The major ones as i see it, in no particular order:

 

1. Fed tightens too quickly ala 1937. They do seem pretty hawkish.

2. Market fatigue. Markets did have periods when they did go down without an external catalyst.

3. Foreign problem. Everyone is quite complacent now but there's a ton of issues out there. Middle East is... well the Middle East. European Union is a mess. Japan is looking a shaky again, and God only knows what's really going on in China. There's a lot places that are on the razor's edge.

4. US Election. Not so much the result. The markets may not the result and may react but I don't think it'll be major. More concerning is depending where the chips fall are there gonna be new big debt ceiling/gov't shutdown crises?

 

I don't see either inflation or deflation as big imminent problems for the US. Unless 1. happens. Then who knows?

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I am not predicting a major correction. (I'd still like a definition: 20-30%? 30-50%? 50-??%?)

I think 20-30% is likely in next couple years. Higher percentages less likely.

 

My guesses would be:

Likely:

- No big reason

- Meh generic recession after long business cycle

(Much?) Less likely, but possibly bigger crash:

- EU falls apart

- US presidential election (I have some scenarios, but won't post so this doesn't turn into another ... thread).

 

Sustained (> 3 months) 30-50% drop in S&P 500 and corresponding drops in most other markets.

 

 

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A: Some unpredictable thing that will affect mass psychology and turn people more bearish than they were.

 

B: Conversely, some other unpredictable thing could make people more bullish, which would accelerate investment and capex, which would self-reinforce into better economic data...

 

Seeing as how lately half the time bad news are good news and vice versa, the very same unpredictable thing could lead to A or B depending on how the wind is blowing...

 

You have a point with item B.  The problem I see is that we have had sustained lower oil prices for nearly 2 years, and continuous central bank stimulus worldwide, and company profits have stagnated. 

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You have a point with item B.  The problem I see is that we have had sustained lower oil prices for nearly 2 years, and continuous central bank stimulus worldwide, and company profits have stagnated.

 

I'm talking about psychology. People haven't felt that lower oil prices were bullish in the past 2 years. If anything, the whole event has been sold as a terrible crash that decimated the profits from an entire industry and that was partly caused by a slowing china and by OPEC going for market share.

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I'm also mostly in cash these days but not because I think that S&P is so over valued, I don't. The U.S. economy is fine and no recession is in sight.  However, there is a certain Global macro situation (not limited to economies) that is certain to increase volatility.  Playing it this way has worked well this past year.

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What about some triggering event with student loan debt?

 

It is at least 1.3 Trillion.  I would be VERY surprised if it is not significantly more than that.

 

ITT Education was shut down.  The whole company.  Thousands of "teachers" out of work.

 

What if somebody leaks that millions of people have defaulted or are seriously behind on their loans?  Maybe the real figures are worse than what is generally accepted?

 

I work with a bunch of younger attorneys.  The stories they tell are simply stomach turning.  They simply have no realistic way to pay off their student loan debts. There is not a ghost of chance, barring winning the lottery.  They simply can't pay it with their wages.

 

Maybe the feds start to turn their attention to "non-profit" skools?

 

I think this is a long shot, but not impossible...

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What about some triggering event with student loan debt?

 

It is at least 1.3 Trillion.  I would be VERY surprised if it is not significantly more than that.

 

ITT Education was shut down.  The whole company.  Thousands of "teachers" out of work.

 

What if somebody leaks that millions of people have defaulted or are seriously behind on their loans?  Maybe the real figures are worse than what is generally accepted?

 

I work with a bunch of younger attorneys.  The stories they tell are simply stomach turning.  They simply have no realistic way to pay off their student loan debts. There is not a ghost of chance, barring winning the lottery.  They simply can't pay it with their wages.

 

Maybe the feds start to turn their attention to "non-profit" skools?

 

I think this is a long shot, but not impossible...

 

I'm convinced the student loan bubble in the US will trigger a bear market some day (a large part of the loans will need to be written off fully). I just don't think that will be in the near future. What government wants to take the fall? Exactly, none, so the can will be kicked along the road for quite a while more I believe.

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Central Bank 'mistake'.

 

The globe has been in the Great Recession II ever since 2006, we just haven't seen the dust bowls of the Great Recession because central bankers have been very good students of history; and their combined sustained efforts have been herculean.

 

But even when an interventions risk of failure is small, it compounds UPWARD the more interventions there are; and there have now been a great many interventions. At some point a sneeze is almost certain, and we'll all catch flu.

 

SD   

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We are in the middle of a massive bull market. We may do a shakeout here before Trump is inaugurated, but once the new housing market takes off with millennial demand plus all the forces of deflation we are all familiar with, we'll have a combination of demand and deflation that will send the S&P to 3500 in the next few years.

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I think the catalyst for a correction could literally be as simple as the current environment:

 

Earnings growth has been negative for 6 straight quarters. Q3 is very likely to be the 7th as many companies have been guiding down expectations. Revenue growth has been negative for even longer. Traditionally prolonged trends, falling earnings, margins, and revenues

 

Interest rates are rising. Traditionally, tightening of financial conditions and liquidity has not been the best thing for the markets.

 

Lastly, inflation has been between 0-1% for most of the last 2-3 years. Traditionally, stable inflation has been the best environment for markets meaning that it can only remain the same or get worse from here on out. A trip to higher inflation or mild deflation would result in a less than ideal market impacting multiples. Traditionally, inflation trending out of the 0-2% zone has not been the best thing for markets.

 

We currently have 2 of these things occurring in tandem with the 3rd being speculated by many (either higher or lower inflation). How likely is it that the market can keep puttering along at record high levels on elevated multiples are revenues/margins/profits collapse and as liquidity is moved from the system while increasing your discount rate on financial assets?

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What about some triggering event with student loan debt?

 

It is at least 1.3 Trillion.  I would be VERY surprised if it is not significantly more than that.

 

ITT Education was shut down.  The whole company.  Thousands of "teachers" out of work.

 

What if somebody leaks that millions of people have defaulted or are seriously behind on their loans?  Maybe the real figures are worse than what is generally accepted?

 

I work with a bunch of younger attorneys.  The stories they tell are simply stomach turning.  They simply have no realistic way to pay off their student loan debts. There is not a ghost of chance, barring winning the lottery.  They simply can't pay it with their wages.

 

Maybe the feds start to turn their attention to "non-profit" skools?

 

I think this is a long shot, but not impossible...

 

Student loan debt could cause some losses, sure, but they will be localized and it won't be like the last crisis.  The biggest difference between student loan debt and the mortgage crisis is that student loan debt will not impact asset values the way the housing crisis did.  As we all know, mortgage defaults caused increased supply for sale and reduced demand (due to falling prices, tighter credit, and removal of speculators) which crashed housing prices.  As other borrowers including prime experienced income shock (loss of job, health care, etc) they too defaulted rather than sell (and don't forget underwater walk-aways).  Cascade effect. 

 

I don't see how that happens with student loans.  The defaulting borrower keeps the asset (the degree) which is not devalued (it may have been a worthless for-profit college degree, but nothing changes there).  A default by one borrower has no effect on other borrowers' asset values or ability to pay.  Student loan markets may tighten but I can't see it as a economic crisis causing a recession.

 

Of course, bankruptcy laws will prevent discharge so the debt burden won't go away.  But this is an argument for a muddle-through/slow growth scenario, where heavy debt burdens are preventing increased spending and use of credit (like mortgages) among those entering the workforce and reaching household formation years.  Indeed that might be one of the key reasons for our sluggish recovery.

 

That said, perhaps the market sells of on such news.  Buying opportunity.

 

In short, student loans are contained (oh wait...)

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It seems like there is just vast pessimism surrouding stock prices yet buying pressure is coming from somewhere.

 

Global QE is at all time highs (Europe and Japan) and money is leaking to the US, is my guess.  Plus China stimulating like crazy and I suspect money is flowing out.

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It seems like there is just vast pessimism surrouding stock prices yet buying pressure is coming from somewhere.

 

Global QE is at all time highs (Europe and Japan) and money is leaking to the US, is my guess.  Plus China stimulating like crazy and I suspect money is flowing out.

 

Up til recently, the only positive flows into equities were corporate repurchases. Retail and hedge funds were selling. I haven't seen updated figures to know if that's still the case or not, but was true 1-2 months ago.

 

What happens when central banks run out of bonds to buy? I also read many articles saying that yield hungry investors have been selling equity index puts. Could be a lethal combination - central banks losing control and large amount of derivatives outstanding

 

Central banks don't run out of money. They magically create more when they need it. The Federal Reserve never had $4 trillion in equity to purchase all of those bonds with. They're levered like 80x to their equity base and they just created the money to purchase those bonds electronically. Crazy that you can just use fake, electronic money to acquire real assets representing claims on the value of labor measuring in the trillions, right?

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