The Gambler's Fallacy
Taipan Trader Brit Ryle, searching in vain for the big bottom, suggests something as simple as the "supply and demand" curve for money and stocks indicates the indexes still have a long way to go down…
It’s no secret that stocks just finished their worst quarter in nearly 15 years. Another US$1 trillion in market cap has been "redirected", bringing the total to US$9 trillion of investor capital lost since March of 2000. But is that any reason we should expect the bottom to be "in"?
During June and July, investors pulled US$71 billion out of mutual funds. Another US$20 billion is estimated to have been pulled in August and September. If you listen to Wall Street’s economists and strategists, this is a good thing. Lord Abbett & Co. economist and strategist Milton Ezrati says "…the current exodus from investing is a sign that this bear market is probably coming to a close." He goes on to say it may take another two weeks… perhaps a month, even.
Trouble is, Mr. Ezrati made his statements in a Business Week article published on July 12. That’s just shy of three months ago… and it points directly to the problem I see with the kind of superficial contrarian arguments you’re getting pummeled with by the mainstream press: they commit the Gambler’s Fallacy. If you were playing roulette, and red came up 5 times in a row, the Gambler’s Fallacy would have you put your chips on black, because black was "due."
But if you know anything about statistics, you know that every time the roulette wheel spins, there’s a 50/50 chance that the little ball will fall in the black slot. Actually, the odds are a little worse than 50/50 because of the two colorless slots on a roulette wheel. But what the little ball did the last time has absolutely no bearing on what it will do in the future.
Personally, I’m in no hurry to call a market bottom. Especially not if my conclusion is based on faulty logic. But I will say, based on money-flow studies, that this bear market could surprise a lot of people with its longevity.
Even more than weak earnings and high valuations, I believe the current problems with the stock market are the result of simple supply and demand dynamics. There’s too many stocks and not enough demand for them. Hence, the price on many will continue to go down.
TrimTabs, a market research company that monitors stock market liquidity, is reporting a number of alarming trends. Cash-strapped companies are issuing new shares and dumping them on the market to raise money. And the number of planned secondary offerings is on the rise. Corporate stock buybacks have dried up. Plus, insider selling is increasing. TrimTabs concludes that the rise in the overall supply of stock, coupled with the lack of corporate buying, indicates lower stock prices are coming.
But that’s only part of the story. The other half of the equation is demand. Who’s gonna buy up all that supply? Individual investors are running scared. And the professionals – well, mutual funds aren’t buying either. They’re already brimming with the stuff. ICI, a mutual fund industry association, reports that 4.5% to 5% of stock fund assets are in cash. With total stock fund assets now at US$3.3 trillion, that 5% in cash amounts to about US$160 billion. That’s it.
To my mind the question is: with US$50 billion to US$70 billion a month getting yanked from mutual funds, how much more can the industry withstand before it has to start dumping stock to meet the redemptions? The answer is 4 months, tops. Then the demand for securities will drop even more.
The wild card in this scenario is the fabled "fall rally" flitting about on everyone’s lips. As far as the funds are concerned, there had better be a fall rally this year. Their very existence is at stake. Of course, the PR machines are already working on it. The other day I saw Condoleezza Rice on TV saying that the economy was much stronger than the numbers indicate. While that may or may not be true, what makes me curious is why the National Security Advisor is making speeches about the economy. Perhaps the potential for a financial meltdown is more of a national security threat than the administration would like to let on.
In truth, a fall rally sounds pretty good right about now. The Fed and the Treasury will not want to see too many funds fail. And on that basis alone, I wouldn’t be surprised to see stocks get pumped up for the next couple of months. We may even get a rate cut before the year is out… and another round of speculative excess as individual investors seek to get back to zero.
But once the holiday season is done, and another round of liquidity gets sopped up, and the economy still hasn’t rebounded, and war with Iraq becomes imminent, and profits still stink, and inflation begins to set in, well, maybe then we can begin to start talking about a bottom. Until then, beware.
Briton L. Ryle,
for The Daily Reckoning
October 10, 2002
P.S. Money moves markets. Using simple supply and demand analysis of stocks and money, I’ve enjoyed some success trading right through this difficult market. When the Vivendi scandal hit, for example, trades we issued in the Taipan Trader hit 480% in just 30 days. For details on this trade and 16 other winners just like it, I invite you to view our special report on trading with money-flow analysis:
The Taipan Trader
Editor’s Note : In his capacity as the chief trading strategist for The Taipan Trader, Briton L. Ryle relies on a proprietary trading system he calls the Money-Flow- Matrix to successfully trade the supply and demand curve of money and stocks. The Taipan Trader has been assisting professionals and individual investors since 1995, making it one of the oldest and most successful trading services of its kind.
We know something’s gonna give. But we don’t know exactly what…or exactly when.
Investors have been making an orderly retreat, so far. But each day, they get hungrier, wearier, more desperate. How long can they continue?
Even major, old-economy stocks have been stripped bare. GE lost almost 6% of its value yesterday. Sears dropped 10%. Ford fell to a 10-year low. Ford is carrying $120 billion of long-term debt; people are beginning to wonder if the company can make it.
Consumer sentiment is falling sharply, jobs are harder to find, bankruptcies and delinquencies are at record levels – but mortgage refinancing is more popular than ever. Last week, more people lined up to add to their debt burden – even as the 30-year mortgage rate rose 3 basis points to 5.87%. Why would they do such a thing, we wonder?
Something’s gonna give… but what?
Could it be the dollar, which suddenly lost a penny against the euro yesterday?
Could it be that investors and consumers are near the breaking point – and that they will panic soon?
Pssst…do you believe in charts? Take a look at a chart of U.S. equities, 1997-2002. What you see is one monstrous "head and shoulders" pattern.
Gold, meanwhile, rose $1.40 yesterday. It doesn’t seem to want to go up or down very much. But that is what we like about it…its intransigence, its immovability, its unflappability, its inertness in the face of calamity.
It may not be so lifeless forever, of course.
We don’t know what will give, or when…but when what’s gotta give gives maybe gold gets going.
Eric Fry, reporting from Bear Market Central in Lower Manhattan:
– Boy, these bear markets are nasty affairs, aren’t they?
– Wall Street’s endless tale of woe continued yesterday, as the Dow dropped another 215 points to 7,286, while the Nasdaq dipped 15 to 1,114. Nor was the "new highs" list a thing of beauty. Twenty-nine New York Stock Exchange and Nasdaq issues managed to reach new one-year highs, but a whopping 1,108 stocks fell to new lows… Those aren’t good numbers.
– "Drip, drip, drip. The monotony of watching the world stock markets retreat to historic lows is starting to get to people all over the investment industry," writes the National Post of Canada. "Day after day, it seems, major indexes slip another 1% or so. There hasn’t been a climactic sell-off to spark hopes that the worst is over. Instead light volumes and a slow, steady decline in stock prices have become the order of the day." But don’t despair, says the Post, the stock market "is heading into its most positive season." The paper quotes one analyst who comfortingly observes, "Of the 10 great bear markets of the last 55 years, five ended in October." Wow, that’s a relief!
– However, after quickly doing the math here in the Daily Reckoning’s New York bureau, we have determined that of the 10 great bear markets of the last 55 years, there are also five that did NOT end in October. Hopefully, October 2002 will turn out to be the good kind of October, rather than the bad kind…
– Also from the "Grasping-at-Straws Department," Merrill Lynch technology analyst Steve Milunovich observes that the S&P 500 tends to do well whenever the New York Yankees chalk up a lot of wins during the baseball season. Based upon his "research," the fact that the Bronx Bombers won almost 65% of their regular-season games this year should mean better times for stocks in 2003…sure…that makes sense to us.
– The US stock market’s losses since the bull market peak in March of 2000 now total about $8.4 trillion – and rising – according to Wilshire Associates. But that means there’s still another $8.4 trillion to go before all US stocks sell for zero. Since that’s not likely to happen, we can comfort ourselves with the notion that we are somewhat closer to the bottom than to the top…Feel better now?
– Germany’s Deutsche Boerse has pulled the plug on its Neuer Markt growth-stock market. This Germanic version of the American Nasdaq burst onto the scene in the mid- 1990s amidst great fanfare. Europe would, it was hoped, finally host its very own world-class "growth-stock" market. Initially, the Neuer Markt lived up to its advance billing by outdistancing even the spectacular rise of the Nasdaq itself.
– But alas, many of the New Era companies that danced onto the Neuer Markt in the late 1990s have turned out to be little more than "vaporware." And, as is vapor’s tendency, most of these companies have evaporated. So too did billions of euros of naive investment capital. We will miss the Neuer Markt, and all of the wide-eyed optimism that it fostered…May it rest in peace.
– Why is it that hedge funds always seem to lose money whenever stocks fall?…Did somebody forget to hedge? "Hedge funds are well on the road to posting their first full year of losses since the year of the stock market crash of 1987," says CBSMarketwatch. "[They’re] heading into the fourth quarter down an average 5.5 percent, according to the Hennessee Group."
– But if Abby Joseph Cohen has anything to say about it, the hedge fund managers will be getting some welcome relief very soon. Goldman Sachs’ chief investment strategist has re-jiggered her 12-month price target for the Dow Industrials to 10,800 from 11,300 and for the S&P 500 to 1,150 from 1,300. It’s true that she has LOWERED her numbers. But even so, the Dow must rally a not-insignificant 48% in order to hit Cohen’s new price target. "We think that share prices already reflect ugly scenarios and that the large risk premium embedded in share prices provides a cushion," says Cohen, who also assures her clients that the "worst is past." For Abby’s sake, let’s hope that the worst of her forecasts is also past.
Back in Paris…
*** Speaking of forecasts…a couple of Daily Reckoning readers have written with forecasts of their own:
"Please consider the following: The 1929 DOW Bubble: Top in 1929: ~385; Bottom in 1932: 47
Total fall: 88%
Nikkei Bubble: 1989 Top: ~38,000; Oct 7/2002 Close: 8708
Total fall to date: 77% (and still falling)
"Current Dow Bubble: 2000 Top: ~11,750; So… if DOW falls 88% as in 1929, the Bottom will be: 1410; And if DOW falls 77% as current Nikkei the Bottom will be: 2702 "On the face of it, this sounds ridiculous. But on closer consideration it seems that there is nothing unreasonable about it. After all the DOW at the beginning of the Bull Market in 1982 was around 900. So if it falls just 77% (like Nikkei to date) to reach 2702, in effect the DOW would have tripled from 1982 to the present. Triple in 20 years. That’s more than the growth of GDP.
"Do you think that this is the way that all major Bubbles unwind? If not, there must be something unique about today’s circumstances that would mitigate against this market following the well beaten ‘unwinding’ path of all of the other major bubbles in the last 100 years? Can you put your finger on what that might be?"
Yours truly, J.D.
*** And another one:
"First, I read your commentary quite regularly and wanted to offer my analysis of your valuation of Dow 3600. I approach the valuation question without using P/E ratios since the E part is so variable (and of questionable measurement in this day and age). I use four different variables in the calculation –
Aggregate Market Value of US stocks/GDP Price/Free Cash Flow (for both S&P and NASDAQ from BARRA Site)
Price/Sales (for both S&P and NASDAQ from BARRA Site)
Price/Book (for both S&P and NASDAQ from BARRA Site)
"For benchmarks I used BARRA’s historical data (which goes back to 1977) and the charts from Comstock which go back further. I make the assumption that this market will visit the region of prior lows before we are said and done. I am actually being conservative – I did not assume the ratios go to the absolute bottom but just in the bottom range.
"I then come up with a simple average of the four approaches and give the MarketCap / GDP a double weighting. Applying these benchmarks (of where a market will go in the downturn) to today’s current data for Free CF, Sales, and Book Value I come up with the following ultimate values for the S&P and NASDAQ:
S&P at bottom: 392 NASDAQ at bottom: 384
"This assumes that current levels of Cash Flow, Sales, and Book Value exist over time. I suspect that these measures will also fall so the ultimate bottom will be much lower. And, as you have said, the ultimate bottom will also be marked by the absence of the question – "Is this the bottom?" I believe that an S&P number under 400 will eliminate that question.
"While I don’t directly estimate the Dow Jones Industrial Average – applying the % changes on the S&P to the current Dow level produces a Dow bottom at (hold your breath) 3673.
"Keep up the great work – you are a voice of reason in the otherwise mostly mindless noise of Wall Street."
*** Okay…for the sake of precision, we hereby officially adopt 3,673 as our guess for the Dow bottom. If the Dow doesn’t come to rest within a couple of points of this number – sometime between now and the second coming – well, it should.
*** What should you do, dear reader, in a deflationary world? My friend, Rick Ackerman, tells how to avoid the long march to bankruptcy:
"There is no easy way to profit from deflation; it will be challenging enough simply to preserve one’s capital on the way down. Many otherwise sage bargain-hunters are destined to lose their shirts as they try to bottom-fish a decline whose depths, it must be assumed, lie almost beyond the bearish imagination. My guess is that even the geniuses will need luck to come through it with 50% of their current assets intact. Among asset categories, the biggest losers will necessarily be stocks and residential real estate; but making money on falling stocks is relatively risky, and making money on collapsing home prices next to impossible. I brainstormed the latter scenario with Howard Hill, an expert’s expert on mortgage markets, but we failed to come up with a promising game plan. Let me say that if an intergalactic financial genius like Howard Hill cannot come up with a good way to "short" the housing market, there is probably no way to do it.
"I expect a decade of deflation, and this one is likely to be far trickier for investors to navigate than deflations of the past, since it will be the first to run its course with the backdrop of a bogus global money system. The dollar and most European currencies were sound when the U.S. entered the 1930s deflation, and this helped to stabilize their economies, albeit it at a moribund pace. This time, however, with hollowed-out money all but universal, and a relative dearth of hard collateral to settle debts, there is no predicting how deflation will play out. But it is an unassailable fact that the dollar, the euro, the yen and pound sterling have been rendered intrinsically worthless by a vast infusion of credit money from the world’s central banks. Which is to say, money is no longer "money," but rather a form of debt – an IOU from the respective governments that printed it.
"So how to secure one’s nest egg against the gathering storm? A good rule of thumb is to make safety a paramount concern, sticking with low-yielding but relatively safe Treasury paper that matures in 2-5 years… I think that the dollar’s impending collapse will be relative to gold rather than to other currencies. Because euros, yen and sterling are worthless, there will be no discriminating as to degrees of worthlessness. Real estate investments should not be ruled out, although the only winners will be companies with rock-solid tenants and positive cash flow. Speaking of cash flow, the ideal investment in a deflation might be a casino. Not Bellagio, Mirage or some other bloated Shangri-La that needs to attract billionaire baccarat players to make money, but a grind joint with ten thousand slot machines and a huge parking lot for buses. In the end, though, there is only one investment that qualifies as an absolute no-brainer. In a world whose currencies have been gutted and hollowed to the core, that investment is gold: coins, ingots, mining shares and all other forms of the asset that until recently had been shunned for more than two decades."