December 13th, 2014

Chicken Little is at it again

I waste time on the internet. One of my preferred (there is a list) locations for wasting time on the internet is Business Insider, which is a Henry Blodget operation. I've benefited, over the years, from Henry Blodget, when he gets it right and when it gets it wrong, so I have a soft spot in my heart for him. However, I feel compelled to jeer at him right now.

http://www.businessinsider.com/stock-market-crash-2014-12

In this outing, he describes how markets crash. It is (hey, it's a blog, what do you expect!) unsourced and qualitative. Alas, it suffers from its unsourcedness and qualitativeness. Here's how.

"Soon, we're down 20%-30%. ... Soon, we're down 30%-40%. ... Then, we're down 40%-50%."

Markets in which broad indexes drop 20-30% are actually not all that uncommon. If you've been in the market for a decade or more, you've seen at least one. Broad indexes that drop more than 40% are not that common, and this description (even with all the stuff I left out) does not convey that material point. At all. You could live your entire adult life -- decades of investing -- and not experience one. During that time period, some market, somewhere in the world will probably have that kind of drop, but it probably won't touch you. You could in fact be fully invested in stocks in a country that has this kind of drop in one index (say, the NASDAQ) and because of your investing preferences, barely notice.

Broad drops in the 50% range are incredibly rare, and it's dead easy to see these coming years in advance, because the evidence of economic dislocation on the way _up_ will be visible outside the markets (converting from horses to cars, type of thing, or everyone who never could ever afford a house suddenly having one forced upon them and a half dozen shows on cable TV explain flipping).

I get what Blodget is trying to do here, and I _suspect_ I know why he feels like a 40-50% drop is potentially in the offing. Most significantly, Blodget himself did a bad miscall on a really big drop a decade and a half ago. Recency of the most recent severe drop is a factor as well, in causing everyone to think that another is about to happen Real Soon Now (which is silly, because that is not how these cycles work). What he's trying to do here is counteract other people who are arguing various forms of Blue Skies Forever/Future's So Bright/This Time It's Different. He sang the future song just before a crash once before and doesn't want to be doing it again.

We really could have a huge drop broadly affecting the markets. I can tell you how to make it happen: have the Fed say they're going to raise rates by 5%. Boom. End of economy. Every financial institution in sight would go under, because look at all those 30 year mortgages issued at lower rates than that. But here's the thing: that isn't going to happen. The Fed governors are irritating people, but they do not suffer from _that_ kind and degree of stupidity. Blodget says:

"the Fed is now tightening"

Now, if you define tightening as, winding down putatively stimulative open market operations, sure. But that's not how anyone sane defines tightening. Tightening = raising rates. The expectation for the next meeting is that there will be a language change away from weswearwewon'traiseratesforyearsYEARSItellyou to wearenolongerswearingwewon'traiseratesforyears however wedon'texpecttoraisethemsoon. NOT actually raising rates.

Here, I am not making this up. Read on:

http://www.bloomberg.com/news/2014-12-08/fed-considerable-time-rate-pledge-under-scrutiny-ahead-of-fomc.html

Okay, too lazy? Here's the money quote:

"Federal Reserve Bank of Atlanta President Dennis Lockhart ... “I am not in a rush to drop the ‘considerable time’ phrase if it would in any way convey an imminent liftoff decision,” he told reporters after a speech in Atlanta in which he highlighted the perils of raising rates too soon. “I am comfortable with continuing with that language.”

Fed Vice Chairman Stanley Fischer last week said that while minutes of the October FOMC gathering showed “we’re closer to getting rid of that,” officials wouldn’t simply remove the commitment without replacing it with something else.

“You may assume we’re not going to suddenly stop that and not say anything, just take it out and leave no guidance” on interest rates, he said at an event in Washington on Dec. 2."

Saying "The Fed is Tightening" in the middle of this language change process is a bunch of foolishness. We will all know when rates are actually about to rise, because we'll see all the financial channels filled with talking heads explaining why the quarter point rise is too little and the Fed should be raising it more. That's how this thing is going to happen, when it does, and not any time soon.

Henry Blodget is climbing the wall of worry. And he's going to keep climbing it. We know this from the same post:

"crashes create the opportunity to buy stocks with much higher likely future returns."

Which is also how we know that an unusually large crash is pretty much Not Going to Happen Any Time Soon in the US. Because the few people who are gnawing on their dried lower lips worrying about a crash are still talking like Blodget.

In Blodget's defense, I completely agree with his rationale for staying invested through crashes. And in defense of me calling him Chicken Little, hey, he started it.

"So far, these concerns have just made me sound like Chicken Little."

ETA: I have a technical complaint about Blodget's average PE claims. Here is what WSJ says they are as of yesterday:

http://online.wsj.com/mdc/public/page/2_3021-peyield.html

Those look okay to me, and I don't understand what Blodget means by this:

"As you can see, today's PE ratio of 26X is miles above the long-term average of 15X."

WSJ sez SP500 pe yesterday as 18.66. I have no idea what the cyclical adjustment is that Blodget/Shiller are talking about. *shrug*

You could argue that any time things go above 15, it's a little worrisome, however, we are in a world in which retail was starting to get some momentum and a massive drop in fuel costs was, er, helicoptered in, so it is not unreasonable to expect corporate earnings across the board (generally -- obvs not for people who make their money extracting shale oil or mucking about with deep ocean drill rigs) to benefit from that combination, in which case a few quarters worth of earnings increases will make that PE ratio come down and all will be in line once again.

ETAYA:

Aha! http://en.wikipedia.org/wiki/Cyclically_adjusted_price-to-earnings_ratio

Do you think it is reasonable to do a 10 year earnings smooth on the SP500 ... in 2014?

I sure as fuck don't. Not any more reasonable than it was in 2011, say. Here is a bit more description:

http://www.investopedia.com/terms/p/pe10ratio.asp

Predicting the Fed

Mostly, people understand that this is really sort of a pointless activity. However, people engage in it anyway. I've been ignoring it all for, wow, years now, because the Fed has been super easy to predict: ain't gonna raise rates, can't lower them any further, and if you can work out what to do based on knowledge of quantitative easing and twisting, well, you are a lot more knowledgeable than I am.

Here are some people participating in the current round of nonsense:

http://krugman.blogs.nytimes.com/2014/12/10/jean-claude-yellen

"The Fed definitely seems to be gearing up for monetary tightening, even though inflation remains below target."

The balance of the post fails to mention that the current debate is about the language, which, if it parallels what happened in the 2003-2004 time frame, implies a significant delay (9 months). Krugman instead chooses to focus on the idea that there are asymmetrical risks for waiting too long vs raising rates too soon, and speculating about the Fed doing this to get some of the pressure off them. Economic policy as soap opera.

Two courtesy Calculated Risk:

http://www.calculatedriskblog.com/2014/12/goldman-fomc-preview.html

Goldman expects a language change, but with core vs. headline inflation predictions mixed and that change likely to increase, liftoff guidance is where the attention will be.

http://www.calculatedriskblog.com/2014/12/merrill-and-nomura-fomc-preview.html

Again, focus on the language, with inflation vs. employment numbers being noted (that is, employment is recovering, but with headline inflation dropping so fast from oil . . .) AND Krugman's complaint about asymmetric risk fully covered.

I do not understand why Blodget and Krugman see tightening. No one in the financial community is predicting tightening, at least not for another few quarters.

You could go out, get knocked up this weekend, and have the baby full term before we are likely to see a rise in rates. For reals. And if you have been paying attention to McBride's The Future's So Bright demographic analysis, that's not as irrelevant as it might seem.

http://www.calculatedriskblog.com/2014/12/the-futures-so-bright.html