Quote from Ghost of Cutten:
Ok, so what are the chances this is the start of a serious correction, or even a bear market, rather than a typical bull market pullback, or move into a sideways trading range for the summer?
Firstly, we should assess the potentially bearish macro themes. What is their likelihood of developing, how likely are they to spook the market, what would be their impact on US corporate earnings, and how badly would the market react? I'll address the main ones that darkhorse mentioned (not because he mentioned them, but because they are the main 4 being thought about in the markets).
Before digging in, note the asymmetric profile here.
If a bearish trader is positioned to minimize risk of loss via high quality entry points in the right vehicles, these macro downside scenarios represent positive optionality. If nothing happens, not much is lost. If a gray swan does kick in, however, the potential gains are outsized.
Much of the point of risk management is cutting off undesirable tail risk, while letting favorable fat tail risk work in your favor.
Quote from Ghost of Cutten:
China: even if China has a huge recession, this will be hardly a blip on the US economy. In fact, it might be a bull point as it will reduce prices for China imports and manufacturing costs, which are a major overhead for much of the S&P 500. It will also make commodity prices fall, further boosting the bottom line of US industry. The only impact a China bust will likely have is to scare people for a few weeks.
This is an incredibly aggressive assumption. We have no idea what the true impacts of a China hard landing might be.
What happens if China starts selling USTs in size, for example (or just stops buying in size)? The Fed would be forced to stabilize the bond market through aggressive monetization policies, which would in turn dramatically weaken the dollar and have a whole raft of unknown downstream effects, including a potential outbreak of protectionist measures as various overheating E.M. economies are negatively affected. And that is only one of multiple scenarios.
To a large degree China is a big black box -- with the potential to be Pandora's box. Nobody thought subprime was going to be a problem either -- the issue was "tiny" until it wasn't.
Quote from Ghost of Cutten:
Europe: old news. At most it will scare the weak longs for a few days or weeks. It will not have the impact it had in 2011, which was a few months correction. So, maybe down 5-10% from the highs, but unlikely to be more. We're already off almost 5%, so not much upside for shorting here. Also, even if Europe implodes, this is highly unlikely to cause a US recession. The US generally does not have recessions due to foreign countries going into recession - trade is about 10% of GDP. If the UK, with half of GDP being trade, does not go into recession due to Europe wobbles, why would the US, which has 1/5th of the UK's dependence on external trade? This is why people blew that recession call in 2011.
Another aggressive assumption that does not fully account for tail risks and the nature of macro crises.
Mr. Market's general tendency is to blithely ignore the prospect of a macro crisis -- until the day he doesn't. There is ample historic evidence of problems being ignored for great stretches of time, until finally the problem explodes.
In addition to that, as stated, the real turning point re Europe might not be fear of another blowup, but rather dawning realization that Europe could be stuck on the precipice of severe recessionary conditions for quite a long time, regardless of what the ECB does.
Quote from Ghost of Cutten:
Contracting margins. This one is easy. You sell *when there is evidence of it happening*. Not on arm-waving that it might, at some indefinable point in the future, possibly happen. In 2005, it was 99% certain that housing would blow up. The market still went up for another 2 years until housing *actually started to blow up*. And contraction of margins is not a 99% racing certainty like the housing bust was. Sell when something starts happening, not years in advance of it.
Earnings season will provide some color here. And markets are supposed to be discounting mechanisms (forward looking) in the first place. One does not need hard evidence of the rear-view mirror type for profit margin contraction concerns to hit markets hard. All that is needed is a general perception shift towards the view that, in light of global slowdown concerns (stalling Europe, China and U.S. in tandem), investors have been paying too much for future profits.
Further as to "evidence of it happening:" You mean like volatility increasing markedly at a potential turning point after months of calm?
Quote from Ghost of Cutten:
Federal Reserve 'fails'. This one is also easy. If they want, the Fed can print money. Bernanke clearly 'wants' to avoid any deflation, he's shown it by words and repeated actions. So, it won't happen unless he is replaced as Fed chairman. The Fed has unlimited 'firepower' so there is no way they can fail to create as much inflation as they want. Besides, this is another silly 'what if?' scenario. If deflation takes hold and starts ravaging corporate profits and asset values, you will have plenty of warning because companies will start missing earnings estimates and suffering large write-downs. Clearly it's better to wait for evidence that it's starting to happen, rather than just gambling that it might one day happen.
Ha ha ha... now you are lobbing softballs that are almost too easy to hit.
Yes indeed, the Fed can create "as much inflation as they want." The Fed could also recreate the conditions of Argentina or Zimbabwe if they felt so inclined. They won't, of course, because such would be disastrous.
There is good inflation and there is bad inflation. "Too much" inflation almost invariably turns bad. Do you recall the infamous "Death of Equities" Businessweek cover from August 1979? (I was 3 years old at the time but make a point of studying historic events.) What people forget is that the horrible performance of the stock market in the 70s was blamed on the pernicious effects of inflation: Rising input costs and compressed discretionary income profiles everywhere you look.
And also, re, gambling, who is the real gambler here? The astutely positioned trader who can take advantage of a gray swan has tail risk and optionality in his favor. His profile is beautifully asymmetric.
The overly sanguine long investor, in contrast, who writes off mounting risks in a couple of hand-waving paragraphs is assuming that "nothing will go wrong" on the strength of surface level assessments, and betting the health of his investment accounts on same.
Quote from Ghost of Cutten:
Iran: this could definitely cause a hefty correction, say 10-15%, maybe 20%. But, it's like any 'grey swan' - you don't bet on it until you see that it's actually started to happen. If Iran kicks off, just exit and get short on the day of the news.
Agree that Iran is mostly white noise. Probabilities bear this out -- same with North Korea etcetera. But that's why Iran wasn't mentioned, along with risk of suitcase nukes going off in Washington DC blah blah blah.
Quote from Ghost of Cutten:
There are always potential bear scenarios in the markets. To get an actual bear market though, you need the scenario to start happening, AND for it to have enough impact to justify a bear market in prices. It is rare to find both. Usually what happens is that many of the scenarios don't happen at all, thus providing dips to buy; and that the ones that do happen, usually don't have the impact that people were scared of. There are only a few scenarios that do have genuinely bearish impact - things that massively reduce corporate profitability and solvency i.e. domestic recessions, banking panics, wars that credibly threaten national survival, communist revolutions, soaring inflation etc. None of those are anything other than outlier possibilities at present.
We just have different perspectives of how the world works.
As for the last statement, "None of those are anything other than outlier possibilities at present," that looks like a combination of straw man (assuming the odds of a large equity market decline are entirely predicated on "extreme" scenarios) and wishful thinking.
Perhaps the largest difference in our thought patterns is 1) willingness to predict, versus emphasis on attractive risk:reward scenarios, and 2) attitude towards tail risk.
I don't know precisely what the future holds, and nor do I much care. My main goals are to find the most attractive risk:reward setups possible, and to work hard to cut off unattractive tail risk while putting positive optionality in my favor.
