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Monday, January 14, 2013

A Survival Guide for Bears in a Bull's World


Ah, it's open season here my friend.
It always is; it always has been.
Welcome, welcome to the U.S.A.
We're partying fools in the autumn of our heyday.


And though we're running out of everything,
we can't afford to quit.
Before this binge is over,
we've got to squeeze off one more hit:
We're workin' it.

.....

We got the short-term gain, the long-term mess,
we got the suffocating, quarterly consciousness.
(Yes man, run like a thief.)

New York to Hollywood, hype and glory,
special effects, but no story.
(Yes man, run like a thief.)


- Don Henley, Working It

There's been no material change in the market outlook, so today I'm going to focus on discussing the world's fundamental debt problems, and how those problems may impact investor psychology.

Let's imagine you found yourself in an H.G. Wells novel, and used his famous machine to time-travel into the future to a random, unknown year.  As fate would have it, you just happen to land in the exact year when there's a worldwide financial meltdown -- but before you can find out what year it actually is, your time-machine whisks you back to the present, and then ceases functioning.

You are now in possession of powerful, and somewhat frightening, information.  You know this financial meltdown will happen at some point in the future, but the problem is: you don't know when.  It could be in two weeks, it could be in two decades.

You are an investor and a trader, so suddenly you look at the market and wonder:  "What if this future I experienced happens tomorrow?"  You react emotionally, rightfully worried, and you immediately pull all of your investments out of the market.  Then the market starts going up, and you wonder again:  "Hmm.  What if this future happens many, many years from now and I miss out on everything in-between?"  You have powerful knowledge of the future -- but how can you profit from knowing something will happen, if you have no actual time frame for knowing when it will happen?

I use this analogy because I think many bears have fallen into a very similar trap for years.  Bears tend to be smart, free-thinking individuals, who are a bit contrarian in nature.  This feeling of being contrarian isn't really by choice; it comes from the fact that bullishness is packaged as the "American Way," and the mainstream media often mocks bears openly with a variety of semi-demeaning nicknames.  These names run a wide gamut, from Nouriel Roubini's media-dubbed nickname of "Doctor Doom" all the way to Peter Schiff's media-dubbed nickname of -- you guessed it -- "Doctor Doom" (nobody ever accused the media of being creative).  The mainstream media's propensity to nickname anyone who's bearish as "Doctor Doom" (also: "Professor Doom," "Mister Doom," "Cousin Doom," "Big Daddy Doom," etc.), understandably makes bears feel they are ostracized and outcasts.

The funny thing is: many bears started off as bulls, and then felt they had some type of catharsis -- some type of "informational awakening" -- which converted them into bears.

I had this fundamental conversion experience in the late 90's, and yet I have been very bullish on the market at several points since.  I'll explain why in a moment.  In my heart, I'm bearish on the fundamentals, because I believe the massive debt that the world has accumulated is completely unsustainable.  We have reached levels of public and private debt that are wholly unprecedented, to the point where the term "record levels" is an understatement.

According to the Bank for International Settlements, the debt of governments, private households, and non-financial companies rose from 160% of GDP in 1980, to 321% of GDP in 2010.  After the figures are adjusted for inflation, the world's governments have more than four times the debt levels of 1980, and private households have more than six times the debt.

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The biggest problem is that this new debt has been used primarily to consume and speculate (in real estate, stocks, etc.), and to service existing debt; it has not been used to create new economic growth.  In the first decade of the 2000's, each dollar of new credit produced a mere 18 cents of new GDP (contrast this with 59 cents per dollar in the 1960's).  This makes the world debt trend unsustainable, for the same reason that it would be unsustainable in your personal finances.  The math is pretty simple:  If you're borrowing $100,000 each and every year, but your income is only increasing by $18,000 per year, it won't be long until you're buried up to your eyeballs in debt you cannot ever hope to repay.  Under these conditions, it's not a question of "if" you'll eventually go bankrupt; it's only a question of when.  The same is true for the world.

Most bears already know this -- the problem is, going back to our time-machine analogy, how long can the world's governments keep kicking the can?  We don't know, because this particular debt experiment has no precedent.  But I do know one thing with certainty:  they can kick the can a lot farther than most of us imagine is possible.  I know this is true because they already have.

As a result, when it comes to projecting and trading the market, bullish and bearish are relative terms to me.  Despite my fundamental bearish bias, I've always tried to be a "neutral trader," at least as much as possible.  When the charts suggest higher prices, I try to position accordingly; and vice-versa when they suggest lower prices.  I let the charts lead, because there is no way I can accurately predict the incredibly-complex fundamentals of "if and when the wheels will come off the Debt Machine."  There are entirely too many moving parts to know at what point things will break, which parts will break first, and exactly what happens when they do (the governments are not going to sit idly by as things break down; we've seen that in action already).  

Because this is the reality, I always do my best to look at the charts fresh, and trade in a neutral manner -- thus I am bullish or bearish on the market based solely on what I think is correct directionally. As one of our forum members (who goes by the name "Benedict Arnold") recently said so eloquently: "I'm for whichever side is paying the most."

Which brings me to another point for bears to consider:  In late 2011, I think the wheels were on the verge of coming off, not only from the market, but from the world.  I do believe that's a prelude of what will eventually happen one day -- but I think the Fed (and the rest of the world's central banks) stick-saved everything exactly where they needed to, and that inflection point was huge in retrospect.  How long they can keep the show going is anyone's guess, but many bears have been playing emotional catch-up ever since.

It's human nature to get a bit shell-shocked and overwhelmed by big events, whether those events happen to us personally, or on a global level.  Our nervous systems are wired in such a way that we sometimes continue to react to these past events as if they were still going on. Have you ever nearly been in a car wreck, then noticed your hands were still shaking some time after the danger had passed?  The wreck was a near-miss and the disaster never happened -- yet your nervous system is still on fire, and the adrenaline continues. 

From that near-miss, some of us will even decide to live out the stressful event in our imaginations, and consider "what if?"  Still others will relive whatever did happen in memory (a form of imagination) -- and thus stretch-out the reaction from their nervous systems even longer.  Our imaginations can be incredibly powerful tools, because our subconscious simply does not know the difference between fantasy and reality.  We can actually create chemical reactions inside our bodies, purely based on imagination. I don't want to get too far off-track, but this is why things like "positive thinking" have proven medical benefits. 

The point I'm getting at is that many of us have programmed ourselves to continue reacting to events even after they've passed, or to react to imaginary events that are not actually occurring.  This type of tendency is dangerous in trading, because trading often requires us to reverse on a dime and let the past go. 

Further compounding the psychology of this issue (for traders) is the fact that we all base our future expectations on the past.  This comes about from our observations of how things work in the physical world.  If we throw a baseball, we can actually predict exactly how far it will travel based on its trajectory, velocity, etc..  Everything in the macro-physical world is subject to the laws of inertia.  This leads us to look at the market through eyes that are conditioned to expect things to travel in a straight, orderly, and predictable way.  Yet it goes without saying that the market rarely does that.

Bears have to recognize that while gravity is a law of physics, it is not a fundamental law of the market -- and bulls have to recognize that "what goes up isn't necessarily going to keep going up forever and ever, amen."

Thus I think that in order to achieve maximum success, no matter what our bias is, we should all strive to be "neutral" traders -- at least as much as is humanly possible.

I think one of the edges bears have is that they recognize and acknowledge that there are very real dangers present in this system. Some bulls are of the "blind faith" variety, so when the tide turns, certain folks won't see it or accept that until it's too late.  I think one edge bulls have is they aren't afraid of every little piece of bad news -- sometimes bears can get hyper-focused on certain things and miss the fact that the Fed is pouring liquidity into the market to the tune of $120 billion dollars a month.

Anyway, since I cannot foresee or predict anything as complex as public and private finances on a worldwide scale, I'm bullish or bearish primarily according to what I'm reading in the charts (and based on short-term fundamentals like Fed liquidity).  Despite my fundamental bearish bias, my read of the charts has led me to favor a bullish intermediate outlook fairly consistently for a number of months now, and my intermediate upside targets from November are now finally within a few points of being reached.  I have not committed whole-hog to the long-term bull case yet, because there are a number of key levels that serve as demarcation lines for a long-term bull market (which I've covered in previous updates), and until those levels are crossed, I am only "cautiously bullish."  But the reality is, unless bears can put a dent in the current chart picture, I will have to remain cautiously bullish -- not because "I'm a bull" (far from it), but because that's where the charts and the liquidity picture presently lead me.  Trade safe.

Reprinted by Permission; Copyright 2012, Minyanville Media, Inc.

8 comments:

  1. What an outstanding assessment.  Thank you.

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  2. Pretzel - you're a genius. Exactly right on all counts.

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  3. Thirded, if that's a worded?

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  4. Thought provoking in that anyone with the use of their insight should be able to see themselves and if willing to, become a better trader. You've provided quite a service PL. Thx.

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  5. If one day we open with a big down gap, are we going to see island reversals for several indices?

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