Inverted Economics

As the market spews volatility I wish to reflect not on the frantic closing ticks, but rather on the dynamic aspects that determine them. When times such as these present themselves, many factors reveal themselves, many of which weren’t visible previously.

I call these factors Inverted Economics. Yes, it’s a made-up term, but it serves as a solid definition for what the successful investor understands about investing. In this segment I would like to focus on Short vs. Long. Not regarding the technical methods of trade but the reasoning for their sentiment of being.

It’s said that every investor is always trading. He may be trading security for prospect, financial for material, or uncertainty for absolution. In any event he must chose whether or not he will act or remain solvent.

Why We Buy – or go Long
Buying is usually done with cash. Cash is nothing more than a vehicle of value. One that just like stocks fluctuates day to day. However, the primary difference is that while a stock or bond represents equity in a company, that if positioned with the proper enterprise will often offer an increasing return, money on the other hand stands for the faith entrusted to it by the masses. Hence, we buy financial assets when this interest is low and sell out when interest for money is rising.

Why We Sell – or Short
Many discourage selling, while in truth this is nothing more than the second element of a trade. Shorting, which many consider to be unethical or “unamerican”, has the same ramifications of buying on margin. (As a matter of fact it is shorting itself that guarantees better results for the long-term investor). We sell when we feel our upside has become realized or is no longer greater than our downside.

First the Good News
When entering a Bull Market times are often rough to say the least. Let’s take a look at the beginning of the Bull Market which began in 1981. In 1980 financial assets in general were shunned while stocks in particular weren’t just considered risky, but also lacked a future. Interest rates were at 15% with banks desperate to coax every dime into savings, rather than into commodity futures and spending, both of which had contributed greatly to the inflationary prices of its day. The good news? We’re getting there.

Then it started. Slowly the gigantic tide of liquidity began to find its way into companies selling for 5 times earnings, with some selling far below book value. Suddenly, all news turned positive as earnings began to increase – rapidly. Stock prices began to rise, gold plummeted with commodity prices, interest rates receded enabling cash to be borrowed at far more favorable levels. This ushered in a new age of buyouts, debt accumulation and an inflation of the credit supply.

Fast forward about 18 years and we found ourselves in one of the largest bubbles ever known to the rational mind. Stocks were selling for 45 times their own earnings, while any company sporting a promise for a position in the infrastructure of the world wide web was guaranteed multiples many times that. Any news was good news as the misconception arose “Stock prices don’t fall”. Dow 36,000 or even 100,000 were no longer fantasies, but short-term goals.

And Now The Bad News
Within just a few months of this euphoria the paradigm had shifted. Just as in 1907, 1929, 1965, the South Sea Bubble in the 1700s and the Florida Real Estate of 1926, investors soon realized they were indeed mortal.

Suddenly, all news was bad news. This is primarily due to the fact that all the good news had already been paid for, while the bad news had never been discounted. Additionally, through the years many companies found a number of methods for obscuring bad information. Bad reports often came out on a Friday afternoon after the market had closed, when many traders were already gone from their desks for the weekend. Sometimes bad earnings didn’t get reported thanks to some advanced accounting techniques for deferring losses.

Remembering 1971
Many investors look back in time and some devastating events in the business cycle. Some lasted years such as the Great Depression while others were shorter but far more painful. One such event took place in 1971. When looked at on a nominal chart it barely exists, but for those who experienced it will long be remembered. What occurred was just short of fascinating. In a matter of months a strong economy fell apart. Debt related financing came under pressure, the dollar began losing ground as the gold window closed and earnings fell off a cliff sending a previously booming stock market into a free-fall.

How could so much go so bad so fast? In a sense, we may simply observe from the present. Since Dow 14,000 we have been faced with fears of a mortgage fall-out, demand for lower interest rates, a full blown crunch in the credit markets, numerous liquidations of hedge funds and lenders, and recession.

But in my opinion it is not over yet. My reasoning: Earnings. As in the early 1970s much of the debt and bad earnings were deferred. What this means is that companies pushed off reporting bad numbers until a rainy day. When that “rainy day” came along, businesses overall threw out all the bad at once in the same way investors sell lagging issues at year-end to offset the taxes of their gains. Naturally, any negative news was blamed on the economy rather than on sound business practices.

I feel that the same could be true today. As soon as the general gist of earnings become negative they may just get a bit worse as these entities rush to dump their loads, obviously hurting stock prices.

But maybe this won’t occur. Maybe there won’t be a market crash, no bad earnings reported and no major bank failures. Maybe the Fed will bail out all those who have lost heavy and within months the economy will be back strong with stocks well above their all-time highs.

Maybe, but I wouldn’t bet on it.

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