I think an easiest way to short SP500 is via inverse ETFs: https://etfdb.com/etfs/inverse/equity/ These move in opposite direction compared to the particular index (times 1/2/3 depending on type).
So, my question is: in a counterfactual world in February 2017, if I were to argue based on above data that you should move from equity to bond/cash/short positions as I am expecting 30% drop in US stocks within 2 years, how would you know that it was still to early?
A counter point could be that due to cheap index ETFs and the prevalence of passive investing it is possible that in general a lot of metrics will have a higher base level.
I completely agree. I made that point in the post (“Note that there could be reasons why the CAPE and PS ratios might not return to their historical average, e.g. increased savings chasing investments, which are not perfectly elastic. There may be risk of persistent inflation, which stocks hedge against.”)
I’m not basing this off of any one indicator. When inflation rose, that made every indicator I was looking at go bearish. I have this position because of the combination of all of these things, plus some other things I didn’t write down (indications of mania, like investment in zero-NPV “assets”). Price to sales ratios, which don’t have the same problems as PE ratios, are about 50 percent higher than it’s ever been. Margin-to-debt was 3 percent, yes, and now it’s nearly 4 percent, which is 33 percent higher.
The main thing I’m worried about is increased savings. (Second is persistent inflation without a corresponding increase in interest rates, but the Fed would have to be insane to do that, even if they are “overly optimistic” about future inflation.) As I said, 65 percent chance, not a guarantee. I could be wrong for some reason.
So, my question is: in a counterfactual world in February 2017, if I were to argue based on above data that you should move from equity to bond/cash/short positions as I am expecting 30% drop in US stocks within 2 years, how would you know that it was still too early?
Good question, essentially you’re asking for backtesting. If it helps, I didn’t short the market back then. I’d have a much lower credence because those indicators that I’ve mentioned weren’t at record levels across the board. Except in exceptional circumstances, go long on the market.
I understand the key issue with the Fed (and correspondingly other actors) misjudging inflation while being highly leveraged, and I do see it as a very good point in the current situation. If we were to see inflation going back to levels expected by the Fed (2-3% I suppose?) how would that change your forecast?
When you wrote “The main thing I’m worried about is increased savings” did you mean what you described in the previous paragraph (e.g. zero-NPV assets investing and alike), or was it something else?
If we were to see inflation going back to levels expected by the Fed (2-3% I suppose?) how would that change your forecast?
Great question. So my view is that there could be a few potential triggers for a sell-off cascade (via some combination of margin calls and panic selling), leading to a large drop. There’s also a few triggers for increasing interest rates, not just inflation: The Fed doesn’t have a monopoly on rates. When they buy fewer bonds, they shift the demand curve left, decreasing the price, leading to higher effective interest rates. I’m kind of baffled that they speak about “tapering” as if it’s possible to do so without increasing interest rates.
The particular problem with persistent inflation is that the Fed is less able to increase the cash supply in the event of a large crash. So while I think that inflation isn’t necessary for a 30 percent drop (I’d say it’s over half of my credence), I expect it to magnify the downside if it is higher than normal right before a crash.
When you wrote “The main thing I’m worried about is increased savings” did you mean what you described in the previous paragraph (e.g. zero-NPV assets investing and alike), or was it something else?
When I say zero-NPV assets, I mean anything that doesn’t pay out future cash flows to investors, like gold, silver, bitcoin, and NTFs. Certain stocks are being traded as if they were these assets too (AMC, GameStop). I think investment in these things is indicative of mania.
I’m worried that the Fed has flooded the market with so much cash that the new normal for the CAPE ratio and PS ratio are close to what they are now. If it is, then margin-debt-to-GDP isn’t the relevant ratio anymore, margin-debt-to-total-market-cap is, which is not at as high of a level as margin-to-GDP. Basically, supposing we have a smooth exponential curve for the S&P 500, I’m worried about a one-off discontinuity in the graph. I’m also worried about people investing more of their income and net worth, which would have the same effect.
I think an easiest way to short SP500 is via inverse ETFs: https://etfdb.com/etfs/inverse/equity/
These move in opposite direction compared to the particular index (times 1/2/3 depending on type).
I’m fairly sure that’s not the most efficient way to bet on this belief. The payoff is linear. So if I bet on the market going down 99 percent, I’d make 99 percent (or 3x that if the ETF is 3x leveraged), whereas the options bet payoff would probably be over a billion to 1.
Where are you getting a billion to 1 odds for the options bet payoff of the S&P going down 30% in the next year? Because if that’s true, I’d invest a thousand dollars in that and have a solid chance at becoming a trillionaire.
No, it is certainly not the most efficient, but it is the easiest to execute: if you have a brokerage account, you can just buy an inverse ETF and you are in a (leveraged) short position.
I think an easiest way to short SP500 is via inverse ETFs: https://etfdb.com/etfs/inverse/equity/
These move in opposite direction compared to the particular index (times 1/2/3 depending on type).
A counter point could be that due to cheap index ETFs and the prevalence of passive investing it is possible that in general a lot of metrics will have a higher base level. This has happened before, e.g. before the 90s, CAPE of 20 was quite high, but since that time it seems more of a base level (we haven’t been below 20 since 2010). In particular: highest before 2008 crash was a bit above 27. We are above that since Dec 2016. https://www.multpl.com/shiller-pe/table/by-month
So main argument (based on high CAPE levels) was true almost five years ago. The same is true for a lot of other metrics:
Margin to debt was 3% in Jan 2017: https://www.gurufocus.com/economic_indicators/4266/finra-investor-margin-debt-relative-to-gdp
Interest rates were also pretty low (though not this much, but still very low compared to pre 2009 levels): https://www.macrotrends.net/2015/fed-funds-rate-historical-chart
and inflation (though still consistently below 3% all year) was clearly higher than in the preceding 4 years: https://www.usinflationcalculator.com/inflation/current-inflation-rates/
So, my question is: in a counterfactual world in February 2017, if I were to argue based on above data that you should move from equity to bond/cash/short positions as I am expecting 30% drop in US stocks within 2 years, how would you know that it was still to early?
I completely agree. I made that point in the post (“Note that there could be reasons why the CAPE and PS ratios might not return to their historical average, e.g. increased savings chasing investments, which are not perfectly elastic. There may be risk of persistent inflation, which stocks hedge against.”)
I’m not basing this off of any one indicator. When inflation rose, that made every indicator I was looking at go bearish. I have this position because of the combination of all of these things, plus some other things I didn’t write down (indications of mania, like investment in zero-NPV “assets”). Price to sales ratios, which don’t have the same problems as PE ratios, are about 50 percent higher than it’s ever been. Margin-to-debt was 3 percent, yes, and now it’s nearly 4 percent, which is 33 percent higher.
The main thing I’m worried about is increased savings. (Second is persistent inflation without a corresponding increase in interest rates, but the Fed would have to be insane to do that, even if they are “overly optimistic” about future inflation.) As I said, 65 percent chance, not a guarantee. I could be wrong for some reason.
Good question, essentially you’re asking for backtesting. If it helps, I didn’t short the market back then. I’d have a much lower credence because those indicators that I’ve mentioned weren’t at record levels across the board. Except in exceptional circumstances, go long on the market.
Thank you.
I understand the key issue with the Fed (and correspondingly other actors) misjudging inflation while being highly leveraged, and I do see it as a very good point in the current situation. If we were to see inflation going back to levels expected by the Fed (2-3% I suppose?) how would that change your forecast?
When you wrote “The main thing I’m worried about is increased savings” did you mean what you described in the previous paragraph (e.g. zero-NPV assets investing and alike), or was it something else?
Great question. So my view is that there could be a few potential triggers for a sell-off cascade (via some combination of margin calls and panic selling), leading to a large drop. There’s also a few triggers for increasing interest rates, not just inflation: The Fed doesn’t have a monopoly on rates. When they buy fewer bonds, they shift the demand curve left, decreasing the price, leading to higher effective interest rates. I’m kind of baffled that they speak about “tapering” as if it’s possible to do so without increasing interest rates.
The particular problem with persistent inflation is that the Fed is less able to increase the cash supply in the event of a large crash. So while I think that inflation isn’t necessary for a 30 percent drop (I’d say it’s over half of my credence), I expect it to magnify the downside if it is higher than normal right before a crash.
Interestingly, the Fed itself was (and probably still is) concerned about the current high valuations.
When I say zero-NPV assets, I mean anything that doesn’t pay out future cash flows to investors, like gold, silver, bitcoin, and NTFs. Certain stocks are being traded as if they were these assets too (AMC, GameStop). I think investment in these things is indicative of mania.
I’m worried that the Fed has flooded the market with so much cash that the new normal for the CAPE ratio and PS ratio are close to what they are now. If it is, then margin-debt-to-GDP isn’t the relevant ratio anymore, margin-debt-to-total-market-cap is, which is not at as high of a level as margin-to-GDP. Basically, supposing we have a smooth exponential curve for the S&P 500, I’m worried about a one-off discontinuity in the graph. I’m also worried about people investing more of their income and net worth, which would have the same effect.
I’m fairly sure that’s not the most efficient way to bet on this belief. The payoff is linear. So if I bet on the market going down 99 percent, I’d make 99 percent (or 3x that if the ETF is 3x leveraged), whereas the options bet payoff would probably be over a billion to 1.
Where are you getting a billion to 1 odds for the options bet payoff of the S&P going down 30% in the next year? Because if that’s true, I’d invest a thousand dollars in that and have a solid chance at becoming a trillionaire.
A billion to 1 chance of a 99 percent drop, not a 30 percent drop.
No, it is certainly not the most efficient, but it is the easiest to execute: if you have a brokerage account, you can just buy an inverse ETF and you are in a (leveraged) short position.