Crash alert?to short the stock market or not?

May 7th, 2007

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Back in October last year (see Strange rally), we were suspicious about the stock market?s optimism. Other then a short correction in February this year, the market had been in a strong upward trend since then. Were we wrong?

Well, yes and no.

There is a saying in the market: ?Never predict the timing or price target because eventually, you will at least get one or the other wrong.? At least, we got the timing wrong. Also, since we did not offer any price (or index points) target, we could not be wrong on that. But we are very sure of one thing: this limitless optimism will sooner or later end in tears. Why?

Think about it: for the US economy, had anything fundamentally improved since last October? No, in fact, the bad news tells us that the US economy is in a downtrend. But the stock market behaved as if the US economy is in an uptrend. It has come to the point that market commentators had to find excuses to ?explain? this strange behaviour of the stock market.

For the Australian economy, though the news were not as dire as the US economy, it is clear that it is at the top of the business cycle. As we said before in Where are we in the business cycle?,

If we assume that the current trend of companies? profit growth will extend indefinitely into the future, we will be in for a nasty surprise.

As we explained in that article, in order for the Australian economy to grow further, it needs to rebuild and expand on its capital stocks. The only way for it to do so is to:

… increase our national savings… we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful.

Yet, despite all these bad (or at least lacklustre) economic reports, we keep on hearing news of record highs for the Dow and ASX 200 indices. The US S&P500 index is nearing its record high too. Even the dangerously bubbly Shanghai stock market is at or near record highs too.

All these boils to one point: it is the spigot of liquidity that is driving stock markets around the world, not fundamental valuation (see Marc Faber on why further correction is coming?Part 1). The danger is that the global financial system is vulnerable to a contraction in liquidity, which will set off a spiral of deflation (see Spectre of deflation). A ?crash? is what you will see in such a scenario. Today, with the stock market at such an extreme end of upward momentum (see Dow… since 1929), we feel very tempted to short the stock market (i.e. bet that the market will go down). Should we?

Well, if you decide to short the market, remember that you are going against the trend of the market. Many short sellers lost their shirts by being wrong on the timing of the coming crash and were forced to buy back stocks in panic to cover their short positions. Perhaps it has come to the point that almost all short sellers are driven out of the market and almost everyone is taking long positions (i.e. making bets that the market will go up)? Maybe right now, there is an overwhelming concentration of bets that the market will go up?

When you see that, a crash is probably nigh. This is because if everyone is betting that the market is going up and no one is betting the opposite, any downdraft will catch everyone by surprise. This will result in everyone rectifying their wrong bets simultaneously, resulting in a self-reinforcing feedback loop of falling prices (see Crowding at the exits for an example of how it will work out in real life). The outcome is a crash.

The problem is, we cannot predict the exact moment when this will happen. But at the very least, we have already anticipated this.