Prominent formerly bearish fund manager Hugh Hendry was interviewed on MoneyWeek. Hendry had switched in November, 2013 to a bullish viewpoint after being possibly the world’s most bearish hedge fund manager. He feels that global Central Bank stimulus is so powerful that investors have no choice but to become bullish.
Should bearish investors do as he did and become bullish? Jeremy Grantham of GMO funds, a noted bear and expert on bubbles recently said that the SP may go to 2250 before it crashes. That’s only 10% higher. When the market is in an uptrend it may move up 10% in a year, implying that the top will be December, 2015. Should an investor buy stocks now in hopes of making 10% with a plan to magically get out at the exact top? The risk is great that it is very hard to spot the top and when the bubble bursts it could drop 23% in a day as it did in October 19, 1987, so a new buyer could make 10% and then lose 25% in that scenario. And if he continued to hold after the crash started he could lose 60% as the SP market index drops down to 1000. It is too risky to buy so close to the top. If the hypothetical reward is 10% and penalty is a 60% loss then the risk-reward ratio is poor.
Trying to chase the bubble all the way to the top by moving up stop loss positions is risky because the market could plunge 40% for a few hours as was the case of the flash crash of May, 2010. In that situation stocks dropped so fast that stop losses had to be filled at much lower prices than the planned stop-out point.
Using put options to protect a bullish position may be interesting but if the cost is 4% for a put that covers 90% of the current price then you will lose 4% and 10% for a total loss of 14% while attempting to make another 10% appreciation in stocks before the top. The risk of losing 14% compared to the possibility of making 10% is not a good risk-reward tradeoff.
Most people are tempted to believe that the Central banks have made stocks go in a risk free uptrend. People leap to the conclusion that the absurd high water mark of the 2000 dotcom bubble is a legitimate benchmark that stocks are fated to return to. In believing this they use that opinion to say that stocks are still cheap compared to the 2000 market. That is wrong. Two wrongs don’t make a right. Stocks went up too much in the great 1997-2000 bubble and needed to come back down to 1997 or even 1995 prices to be fairly valued in the years right after 2000.
Instead of assuming that stocks will repeat the market top of 2000 investors ought to consider the possibility that stocks will repeat the market bottom of 2002 when the SP was 770 and the 2009 bottom when the SP was 666.
The post-2009 era has been dominated by the unprecedented new wave of Central Bank zero rate policy and massive, never before used Quantitative Easing (QE). Since these are new, experimental things then the odds are that they may not work and will be discontinued. Thus the current recovery from 2009, to the extent it is caused by QE and ZIRP, is highly unreliable and could revert back to pre-QE stock prices of 2009. Why buy an overpriced stock market if it only went up because of a radical new experimental policy which is extremely difficult to test and which has no established professional economic theory to support it? If QE made stocks go up then that means stocks could easily retreat if QE’s credibility is impeached.
The physical world of GDP, wages, unemployment, etc. is very weak and doesn’t support the huge increase in stock prices since 2009. It is starting to look more and more like QE only helped stocks but didn’t help the physical economy.
One could draw an analogy between the dreams of 2000 tech bubble stocks and the dreams of the advocates of QE today. In 2000 the critics of tech stocks said it was a situation where the emperor has no clothes and that eventually the tech bubble would be deflated. Today the situation is a paper money QE stock bubble which is likely to be deflated.
Investing should be done based on reasonable evidence rather than radical untried experimental things like QE. Thus investing in stocks and other risk-on assets is excessively risky since the risk of unknown contingent damages caused by QE could result in a revisiting of 2009 lows. The bulls have no answer about the huge debt increase in the past 17 years to roughly double the traditional debt to GDP levels. A society with too much debt maybe unable to make use of the medicine prepared by the Federal Reserve and may suffer serious adverse reactions to those policies.
Investors need independent financial advice about the risk of bubbles and crashes. I wrote an article “Amazing stock bubble”.