The problems in the financial sector that started in mid-2007 have created problems for the real economy, and the problems in the real economy are creating more problems for the financial economy. This self-perpetuating downward spiral is in full force. Along with consistently negative surprises in economic data, this state of affairs has many commentators saying, ‘it’s going to get worse before it gets better.’ I find it annoying that they omit to specify which part of the economy they are talking about. Is the real economy going to get worse before it gets better, or is the financial economy going to get worse before it gets better? If they are referring to the real economy and suggesting that GDP is going to fall in real terms or unemployment is going to rise, then they are really not worth their pay. One look at the economic data will give you the short term direction of the real economy. If they are making a prediction about the financial economy, then I’d be curious to understand their logic. On what basis do they think that asset prices will continue to fall? And how can anyone confidently make this claim?
One coherent argument is that the deleveraging cycle is not over, and that continued equity write-downs along with funding withdrawals will create more and more forced selling. As long as expectations about deleveraging are an overhang on the market, there is not much incentive to buy because you expect to get a better price down the road. Forced selling does two things to the market: (1) it creates an inelastic seller who will push down the price, and (2) it creates an environment that pushes away buyers. If you know that someone has to sell a large chunk of stock, you’d rather buy the last piece of it than the first. You will only buy early if you are given a steep discount from the present price.
This analysis is sensible enough, but because we are well along into the deleveraging process I don’t think it validates a short position-or at least not a significant one-in risky assets. At some point the forced selling will stop, and when it does I expect the upward volatility to be higher than it typically is. The risk for short sellers trying to take advantage of the deleveraging in the market may be higher than they realize; not only does forced selling push the price down, it also scares away buyers. When the deleveraging is over, not only is the inelastic seller gone, but those buyers who had retreated will come back to the table. This is also the reason why downward volatility has been so nasty.
In an attempt to demonstrate this phenomenon I’ve compared the upward and downward volatility over time. Admittedly there are some conceptual problems doing it this way, but the graph is useful. Look at the bottoms in the stock markets, rallies off the bottom are more violent than other upward movements, meaning that the downside minus upside volatility (the blue line) is negative around a bottom (1987 being a major exception). The red line is the S&P 500 in log space.
Side Note 1: One more reason forced selling creates a terrible market: A wise friend was waiting on the side lines with a large pile of cash, thinking that the Dow would fall to 10,000 in this downturn and likely would have considered investing around that point. But the Dow fell from 11,000 to 8,500 in the span of a week. The idea of trading on valuation was offset by an increased sense of the unknown. Although the 10,000 mark seemed like a good value when he was watching the markets in early 2008 (when the Dow was at 13,000), his view on his own understanding of what was going on and thus his willingness to take risks changed when it fell to 8,500. When things don’t make sense you should step back. As the adage goes, invest in what you know.
