Shorting the market: indecision

[mcgurme]

So, following both EJ's analysis and my own observation of the US stock markets being overvalued (as of December), I shorted the market (mainly with ETFs). This is only about 10% of my position. But I'm having a case of indecision about how long to stay short. I see several competing things at play here, on the + side and on the - side.

plus (+) side: inflation, inflation, inflation. If inflation is gearing up, can market prices keep sinking indefinitely? I'm seeing more and more stocks trading at P/E ratios that are reasonable, like 10:1. Not all stocks are there yet, but it seems that if inflation raises prices of most things, then earnings will increase, thus improving P/E ratios and placing upward pressure on share prices.

minus (-) side: psychology - When people think an asset is going to drop in value, they are more likely to sell it than hold onto it, producing the proverbial secular bear market. But at some point, the bargain hunters will be poised to come in and snap up shares to counteract the bears.

Given the above two, my own "gut" feeling is that the market has only a bit further to drop before it would bottom out, since in inflation adjusted dollars, this bottom may be similar to other recent historical bottoms.

But, here's the wildcard that I haven't seen considered here recently. The baby boomers. There are a huge number of those folks poised on the edge of retirement. Many of them don't have enough savings to begin with, and a lot of those savings have been invested in the market. If I was nearing retirement in the next 5-10 years, I'd be running away from the markets as fast as I could with my money, and putting it into "safe" investments. This is a large demographic, and if there is truly a panic that develops amongst these folks about their nearing retirements, it seems to me it could cause a longer term downward pressure on the market. Actually, I think this has played a role in the steepness of the housing downturn as well, since many boomers were invested in property thinking of that retirement in the bahamas....

So, I'm looking for speculation about how this could/might play out, particularly for factors I might not have considered in my (admittedly simplistic) analysis.

Morgan

[jk]

So, following both EJ's analysis and my own observation of the US stock markets being overvalued (as of December), I shorted the market (mainly with ETFs). This is only about 10% of my position. But I'm having a case of indecision about how long to stay short. I see several competing things at play here, on the + side and on the - side.

plus (+) side: inflation, inflation, inflation. If inflation is gearing up, can market prices keep sinking indefinitely? I'm seeing more and more stocks trading at P/E ratios that are reasonable, like 10:1. Not all stocks are there yet, but it seems that if inflation raises prices of most things, then earnings will increase, thus improving P/E ratios and placing upward pressure on share prices.
commodity and raw materials inflation raise costs, while economic contraction reduces demand. profits are being squeezed, and this will continue. the cost of necessities like food and energy goes up, incomes are stagnant, unemployment is rising, demand for non-essentials is down. profits were quite recently at historic highs. profits are mean-reverting, and will likely overshoot on the downside.

minus (-) side: psychology - When people think an asset is going to drop in value, they are more likely to sell it than hold onto it, producing the proverbial secular bear market. But at some point, the bargain hunters will be poised to come in and snap up shares to counteract the bears.yep, at some point.

Given the above two, my own "gut" feeling is that the market has only a bit further to drop before it would bottom out, since in inflation adjusted dollars, this bottom may be similar to other recent historical bottoms.there will be rallies, but the market has a lot of work to do on the downside, in terms of both price and time. take a look at a chart of the dow from 1868 to 1982. then take a look a look at the same chart corrected for inflation.

But, here's the wildcard that I haven't seen considered here recently. The baby boomers. There are a huge number of those folks poised on the edge of retirement. Many of them don't have enough savings to begin with, and a lot of those savings have been invested in the market. If I was nearing retirement in the next 5-10 years, I'd be running away from the markets as fast as I could with my money, and putting it into "safe" investments. This is a large demographic, and if there is truly a panic that develops amongst these folks about their nearing retirements, it seems to me it could cause a longer term downward pressure on the market. Actually, I think this has played a role in the steepness of the housing downturn as well, since many boomers were invested in property thinking of that retirement in the bahamas....there isn't enough fear yet. people are not dialing 1-800-get-me-out. in fact, my guess is that those boomers who are not in the process of prematurely emptying their 401-k's to pay down their credit cards, are fully invested, expecting their god-given right to double digit returns to bail out their retirement dreams.

as for your original question about your short positions, you need to think about your time frame, your conviction, and your tolerance for pain. you may be worried about a bounce next week, but at the same time you're thinking about demographic issues that will play out over the next 2 decades. if you're in inverse funds you need to be aware of the "friction" that means a round trip is not price neutral. i.e. if the index goes from 100 to 90 and back to 100, the inverse fund doesn't come out even, it loses money. [it gained 10% on the move from 100 to 90. it then lost 11% on the move from 90 back to 100. 1.1 * 0.89 = 0.979, or about a 2% loss.] thus inverse funds should never be held for very long, only to capture transients. if you want to be short longer term either sell short, or -more safely- buy long dated puts.

[mcgurme]

Thanks for sharing your insights.

there isn't enough fear yet. people are not dialing 1-800-get-me-out. in fact, my guess is that those boomers who are not in the process of prematurely emptying their 401-k's to pay down their credit cards, are fully invested, expecting their god-given right to double digit returns to bail out their retirement dreams.

as for your original question about your short positions, you need to think about your time frame, your conviction, and your tolerance for pain. you may be worried about a bounce next week, but at the same time you're thinking about demographic issues that will play out over the next 2 decades. if you're in inverse funds you need to be aware of the "friction" that means a round trip is not price neutral. i.e. if the index goes from 100 to 90 and back to 100, the inverse fund doesn't come out even, it loses money. [it gained 10% on the move from 100 to 90. it then lost 11% on the move from 90 back to 100. 1.1 * 0.89 = 0.979, or about a 2% loss.] thus inverse funds should never be held for very long, only to capture transients. if you want to be short longer term either sell short, or -more safely- buy long dated puts.


While I've been involved in the market for a while, it's only been trading long stocks. I'm not yet very educated regarding short selling and put options. I'll add that to my list.

So where does the friction come from in the ETF's? Is it simply from the costs of all the underlying buying and selling of securities for the fund? Why would a changing market promote more friction than a static one?

Anyway, on balance, I think your general point of view is spot on. The boomers don't seem in a panic yet. I mean, the news keeps talking about "possible recession" as if it's a minor thing that might happen. Recently, I've been trying to tell friends and colleagues about the deep pile of dung that our economy is in (thanks in part to my reading here), and most of them act like I'm a bit off my rocker. Well, actually some of them are now taking notice, but only because the economy is in the news. But most act like this will just be a minor "hiccup" in the ever upward spiral of living standards and growth.

I haven't seen this discussed here, but I happen to do scientific work at a major university. There's been a huge bubble in the academic research enterprise over the past 15 years, that is just now starting to show signs that it will pop. Yet again, people are ignoring the signs. Basically, federal health research spending grew substantially in the 90's, and so most institutions leveraged themselves to capitalize on the growth, building new buildings and hiring new scientists, which they expected would pay for themselves by bringing in new grant money. But now the federal budget is static or shrinking, and universities are beginning to scramble to cover their over-spending that isn't being covered by grant income. It will get worse as state budgets go into the red due to the collapsing housing bubble and economy. I expect it will be a bloodbath similar to what's happening in housing, just playing out on a longer timescale. Which is really unfortunate, since unlike the excesses in the housing market (leading to not much good that I can discern, and a lot of bad), "excesses" in science have led to major ongoing improvements in things like cancer treatments, understanding of the human genome, and so on.

But, these folks just think things will "get back to normal" as soon as we get someone in office who gets us out of Iraq. Yes, I used to think this way, but reading here has been an eye opener, to say the least.

Morgan

[jk]

re: the source of "friction" in inverse funds

these funds mark themselves to market every day. they produce an inverse result based on each day viewed as a separate data point. take the example i originally gave:
day..........index.........index change..........inverse change.........invervse
day 1........100.................0.................... ....0........................100
day 2..........90...............-10%...................+10%....................110
day3..........100..............+11.1%............. ....-11.1%..................97.8

what happened is that when the underlying index went down, your inverse fund went up and THEREBY YOU INCREASED YOUR EXPOSURE. the market then moved down, and you took the loss on the larger position, thus ending up with a net loss, while the index was flat. same thing if you have the index go down first, and then go back to its original value. you are buying high and selling low with every move. the "source of the 'friction'" is arithmetic.

[c1ue]

The boomers don't seem in a panic yet.

Actually, I don't necessarily agree with this one.

While it is possible the Internet and housing bubbles were both purely due to greed and inexperience, it is equally possible that at least some of the gullibility involved was due to the boomers' impending retirement.

It is not unusual at the least for some people to take a late stage plunge in order to enjoy a better upcoming retirement - kind of a longer term equivalent to 'doubling down on black' right before a vacation: win - you get a much nicer vacation. Lose, you eat cheeseburgers in Hawaii.

Of course, with the 17 year long bull market since 1981, it was even more dangerous as many, if not most, thought the market always went up.

Unfortunately now many of these people will be eating cheeseburgers for the rest of their lives.

[Verrocchio]

Unfortunately now many of these people will be eating cheeseburgers for the rest of their lives.

...or cat food. :(