Investing is an inherently risky business with lots of uncertainties. At any
given moment, the bullets can fly from any direction, and at a bare minimum,
the investor hopes to emerge unscathed from the battlefield. But of course,
the goal of investing is not just to break-even, but to earn a sizeable profit
in the marketplace. And for the past 5-½ years, there has been no better
way to maximize gains, than sticking with the traditional "Buy-and-Hold" strategy.
It requires a lot of patience, a lack of emotion, and a firmly held belief
that the Federal Reserve and its central bank allies will always bail you out
of a difficult position.
Billionaire investor Warren Buffet reminds us that most investors are often
blinded by the markets' gyrations and the latest quotations, and foolishly
listening to market pundits, rather than dollar cost averaging for the long-term. "Forming
macro opinions or listening to the market predictions of others is a waste
of time," Buffet says, and warns against "letting the irrational behavior of
other investors, make you behave irrationally as well." Instead, "Ignore the
chatter about markets, the economy, interest rates, price behavior of stocks,
etc, and don't listen to pundits and, don't consider acting upon their comments."
Legions of analysts have tried to predict the future trends in the marketplace,
by collecting whatever information is available, connecting the dots, and making
deductions about the future. However, there are so many moving parts in the
equation, such as P/E ratios, central bank intervention, geopolitical events,
the macro outlook, corporate revenues and profits, the direction of interest
rates, terrorism, droughts, bumper crops, and leveraged trading, etc.), which
makes it very difficult to accurately predict the future. "The only value of
stock forecasters is to make fortunetellers look good," Buffett says.
Instead, computer programs have replaced human analysts and traders, and the
US-stock market is now mostly running on algorithmic auto-pilot. New developments,
including high-frequency trading, a proliferation of exchange-traded funds
and free information via bloggers and social media, are behind this seismic
shift. Algorithms can analyze 150 different variables at any moment in time,
and fire off trades in milliseconds based on complicated fundamental and technical
models and front-run the average small investors, before the human eye can
read company or government news releases. This kind of trading accounts for
up to 70% of volume on some days with the full support of the US-exchanges.
However, there are very rare events that occur somewhere around the world,
otherwise known as "Black Swan Events" that can befuddle "financial science" and
the best designed computerized models. For example, heading into 2014, few
traders could've predicted that the Kremlin would act to seize Crimea's territorial
waters along with the region itself, and that Moscow would deploy 20,000 to
45,000 troops along the eastern and southern borders of Ukraine, thus marking
the start of the biggest confrontation between Moscow and the West since the
Cold War, and triggering a round of economic sanctions with Europe and the
US.
By definition, a "Black Swan" is a chain of events that radically deviates
beyond what is normally expected and with only a 1% chance of happening. This
term was popularized by Nassim Nicholas Taleb, a finance professor and former
Wall Street trader. "If it's a Black Swan Event, - it's unpredictable." Yet, "the
odds are very good that unpredictable things will happen in a lifetime," in
a manner that can stump even the most sophisticated algorithims, because one
just cannot include the truly unknown into a computer program. The 9/11 attacks
would qualify as a Black Swan event. Some would argue that the sequence of
events that led to the bankruptcy of Lehman Brothers in Sept 2008 was a Black
Swan, certainly by those who never dreamed that half of the value of their
homes could be wiped out.
Likewise, the recent sequence of events that led the European Union and the
United States to launch stinging sanctions against Russia's energy, banking
and defense sectors, - can probably be regarded as a "Black Swan" sequence.
The situation worsened dramatically after another unforeseeable event, - the
downing of Malaysian flight MH-17 over Ukrainian territory on July 17th by
what the West says was a Russian-supplied missile. As such, over the course
of the past 4-weeks, the German DAX-30 index, - Europe's top benchmark stock
index began to stumble, skidding -11% from the psychological 10,000-level to
as low as 8,920, as the specter of economic warfare with Russia became a reality.
In turn, the slide in the German DAX acted as a catalyst that knocked the Dow
Jones Industrials index -4% lower.
German companies are some of Russia's biggest trade partners, and if the deepening
standoff between the West and Moscow is sustained for an extended period of
time, Germany's blue-chip DAX-30 companies could feel the pinch . Germany exported
about € 36-billion worth of goods to Russia last year, from defense to
car manufacturing, almost a third of the EU's total, and some 6,200 German
firms are active in Russia with € 20-billion of direct investments. Despite
active lobbying by German industrialists, Chancellor Angela Merkel has backed
a hard line with Moscow, supporting the imposition of tougher economic sanctions
by the EU.
Mr Taleb says protecting against Black Swan Events should be the cornerstone
of any financial planning. However, die-hard "Buy-and-Hold" investors disagree,
arguing that the Fed can always be relied upon to come to the rescue of the
ultra-wealthy class, no matter what unforeseen crisis erupts and upends the
markets. With a long-term view, any correction of -10% or more is considered
by "Buy-and-Hold" enthusiasts as a chance to buy US-stocks at a bargain price,
with new found profit potential. And history does show this has been the case.
The US-stock market has overcome varying degrees of economic recessions and
unexpected financial and geopolitical crisis over the past few decades, - because
the Fed has always come to the rescue of the equity markets, with injections
of cheap money and clandestine intervention in the futures market, dubbed the "Greenspan
- Bernanke Put."
Central Bankers and Cohorts warn about Market Risks, By now, it's almost universally
recognized that main aim of the Fed's radical monetary policies, supported
by its G-7 central bank allies, is to push investors into the stock markets
. Dallas Fed chief Richard Fisher warned 2-½ years ago that the markets
were hooked on the Fed's "monetary morphine," and Bank for International Settlements
(BIS) noted 1-¼ year ago that the European and US-stock markets were "under
the spell" of the world's central bankers, with cheap money driving stock prices
to record highs despite a lack of good economic news.
Even though the Euro-zone's economy has remained stagnant, and corporate earnings
are disappointing, investors continue to bid-up EuroStoxx prices. On Wall Street,
there hasn't been a correction of -10% or more, for the past 36-months. There's
only been four other times since World War II that US- stocks evaded a correction
for as long as the current 36-month stretch. Historically, corrections of -10%
or more occur about one every 18-months.
While Fed officials are happy to see the stock market hit new all-time highs,
there's also a growing concern, that if left unchecked, - "irrational exuberance" could
kick in, and the stock market could suddenly go parabolic - into what's called
a "Melt-up." If that happens, the rally would become unsustainable and would
inevitably be followed by a nasty -10% correction that could possibly morph
into a grizzly Bear market, - or a loss of -20% or more. In turn, losses of
-20% or more could cause serious problems for the US-economy.
As such, several actors in the brokerage business and central bankers have
started to issue a chorus of cautious comments on the stock markets in recent
weeks, in what appears to be a concerted effort to take some the of steam out
of the "Least Loved" Bull market, and shake out some of the speculative froth.
In doing so, central planners aim to restore the framework of two way market,
and prevent the outbreak of a "Melt-up." Policymakers usually turn to "Jawboning" as
the first line of intervention to influence trader psychology.
First in the batter's box was Goldman Sachs chief Lloyd Blankfein who told
viewers of CNBC on June 12th, that the "low level of volatility (in the stock
market) won't last forever." With the S&P-500 index opening at the 1,942-level,
Blankfein warned quite prophetically that, "Stocks are rather calm, but investors
need to be vigilant against complacency, because it can lead to shocks in the
market. The luxury of a steady, calm, quiet market might last for a while,
but it can't last forever. The danger of some exogenous event that's going
to cause people to have to reset their portfolios, - constantly lurks. There
is always something coming that we don't know about because nobody knows what
the future is. My most important skill is to worry about everything. I am highly
paranoid," Blankfein added.
Five weeks later, Blankfein's warnings appeared to be prophetic. On July 19th,
there was a "Black Swan" event that occurred out of nowhere and began to ruffle
the markets' feathers. US - intelligence officials concluded that Moscow gave
the SA-11 Gadfly surface-to-air missile antiaircraft system to pro-Russia separatists
in eastern Ukraine that shot down Malaysia Airlines Flight-17, killing all
298-passengers aboard. On July 21st, Senate Intelligence Committee chairwoman
Dianne Feinstein declared the US was in a new "Cold War" with Russia. " I think
the world has to rise up and say, we've had enough of this," she said.
One June 29th, the BIS reiterated its warning that the G-7 central banks could
keep monetary policy "too loose for too long, with potentially damaging consequences." " Ultra
low interest rates and the failure of policy to lean against the build-up of
financial imbalances are in danger of making the global economy permanently
unstable." Instead, "monetary policies are needed to "tame the financial cycle" and "lean
against financial booms, rather than just ease aggressively and persistently
during busts," the BIS advised.
On July 15th, the Federal Reserve issued an unusual warning, saying the valuations
of small cap companies, listed in the Russell-2,000 index, social media and
biotechnology shares, and lower-rated corporate debt, (junk bonds) appear to
be "stretched ," with ratios of prices to forward earnings remaining high
relative to historical norms," the Fed said in its semi-annual Monetary Policy
Report delivered to Congress.
On July 16th, Carl Icahn, the "King of Corporate Raiders," - told CNBC that
he was "very nervous about the US equity markets." On July 17th, Bank of America
Merrill Lynch joined the growing ranks of Wall Street strategists who think
a -10% correction isn't too far away. "A necessary condition for an equity
market correction is greed and measures of greed are increasingly boosting
the case for volatility and a correction in the autumn, in our view."
On July 22nd, German Finance chief Wolfgang Schäuble added his voice
to the naysayers, in a interview with newspaper Handelsblatt. "We cannot just
leave the prevention of (asset) bubbles to the state supervisors. Central banks
must keep that in mind when they take their decisions about money supply," Schäuble
said.
On July 26th, Goldman Sachs analysts did a 180-degree turnaround, suddenly
warning about a pullback, saying "Global equities and bonds may retreat in
the next three months, with stocks at risk of a brief selloff, as rising inflation
boosts yields." On July 30th, Pimco's bond chief, Bill Gross warned; "investors
should say "good evening" to the prospect of future capital gains in asset
markets as interest rates are set to rise while the economy grows at a slow
pace."
However, when these words of caution failed to nudge the markets out of their
serene sense of complacency, it was left to former Fed chief "Easy" Al Greenspan
to throw down the gauntlet and strike a little bit of fear into the marketplace.
On July 30th, Greenspan rocked the markets, saying, "The stock market has recovered
so sharply for so long, you have to assume somewhere along the line we will
get a significant correction," he said in an interview on Bloomberg Television's "In
the Loop." "Where that is, I do not know," he added.
The impact of Greenspan's verbal intervention was felt the next day, when
the S&P-500 index plunged 40-points lower, to close at the 1,930-level
and the Dow Jones Industrials plunged -317-points, to close at 16,563-points.
The CBOE's Volatility Index, known as VIX, which measures the cost of purchasing
insurance as a hedge against a decline in the S&P-500 index jumped to above
16.5 on July 31st, after trading at a seven year low of 10.5 in the beginning
of July. Greenspan was able to engineer the minor pullback, even though S&P-500
companies were beating earnings and revenue estimates by a significant margin.
However, the shakeout in the US-stock markets was also the result of a steeper
-10% correction in the European equity markets, which in turn, were negatively
affected by the rising tide of confrontation with Russian kingpin Putin and
his cohorts at the Kremlin. The Pentagon reported a flow of heavy weapons from
Russia, including tanks and rocket launchers, to the separatists battling Kiev's
forces in eastern Ukraine. The Russian military fired artillery shells at Ukrainian
army positions, and two Ukrainian fighter aircraft were shot down over their
own airspace . Speculation was rife that Putin might order the Russian army
into Ukraine.
Market sentiment was worsened by a report showing new orders for German factory
goods had plunged -3.2% in June - the steepest monthly decline since Sept '11.
New orders from countries in the Euro-zone plunged by a stunning -10.4%. Also,
t he market learned that the Italian economy shrank -0.2% in the second quarter,
taking economists by surprise. The second straight decline in Italian economic
output was caused in part, by a slump in exports, and was the first concrete
sign that friction with Russia were hurting the European economy.
However, these negative signals about the Euro-zone economy didn't rattle
the EuroStoxx index. That's because the European Central Bank (ECB) chief Mario
Draghi, was quick to inform traders that the ECB is ready to print massive
amounts of Euros, and buy sovereign bonds if necessary to prop-up the markets.
Draghi said he expected banks to take up to € 850-billion of the ultra-cheap
four-year loans, which will be tied to lending to smaller companies, which
would also serve to weaken the Euro's exchange rate.
Despite Draghi's verbal intervention and promise of massive liquidity injections,
there was another "Black Swan" moment, - on August 7th, when the markets briefly
spiraled lower after NATO's Secretary General Anders Fogh Rasmussen called
on the Kremlin to pull its troops back from the border with Ukraine and "step
back from the brink." The specter of an outright military confrontation between
Russia and NATO, over control of strategic territory in the Ukraine, sent the
German DAX-30 index and the S&P-500 index reeling . The panic selling went
into overdrive on the night of August 7th at around 11-pm EST, - when US President
Barack Obama ordered airstrikes in Iraq against the jihadists of the Islamic
State.
In Tokyo, the Nikkei-225 index plunged -3% after the opening on August 7th
and closed at 14,778, - the low of the day, - suffering its biggest daily decline
in five months, as investors were gripped with fear that the crises in Ukraine
and in Iraq could disrupt Japanese exports. Each of the 33-sector sub-indexes
on the Tokyo Stock Exchange posted losses as investors rushed to reduce exposure
to risk assets. Just a week earlier, the Nikkei-225 index had reached a six-month
high at 15,759, on expectations of increasing purchases by the country's largest
pension fund. Instead, the Nikkei Volatility index spiked up to as high as
23.6, up from a historic low of 15.2 hit last month, as investors rushed to
insure themselves against losses. The broader Topix fell -2.4% to 1,228, with
trading volume +30% above its average.
Obama's announcement about airstrikes against ISIS triggered a knee-jerk panic
selling spree that knocked the nearby Nikkei-225 futures contract to 14,700.
Trading volume in futures shot up to 142,342 contracts, more than double the
average in the past three months. Likewise, in a chain reaction, German DAX-30
index futures skidded to below the psychological 9,000-level, and the S&P-500
index futures fell below the 1,900-level. In turn, yen carry traders scrambled
to unwind margin loans, and briefly pushed the US$ fell below ¥102, where
the Bank of Japan has staunchly defended the yen's dirty float for most of
this year.
However, prior to the close of the Tokyo Stock Exchange, the Bank of Japan
(BoJ) began buying ETF's linked to the Nikkei-225 index, to stabilize the market.
The BoJ intervened in the currency market, purchasing the US$ at around ¥101.75,
to keep the carry trade intact. At the opening of the Frankfurt Stock Exchange
on the morning of August 8th, - traders noticed a sizeable up-tick in the Dow
Jones Industrials and S&P-500 futures market. Traders suspected the US-Treasury's "Plunge
Protection Team," (PPT) was busy at work, - purchasing stock index futures,
in order to put a safety net under the markets. As such, at the NYSE opening,
six hours later, the S&P-500 index futures market was +24-points above
its intra-day bottom at the 1,890-level. Likewise, the German DAX-30 index
rebounded +120-points from its intra-day bottom low of 8,920 to reach the 9,040-level.
In turn, Nikkei futures rebounded +300-points off their panic bottom low, to
close above the 15,000-level, by day's end. The rally in Nikkei futures was
supported by short covering in the US$ to above ¥102.
There wasn't any public news to explain these "miracle" rallies. However,
on August 8th, at 2:08-pm EST, or about 2-hours before the NYSE close, Russia's
Defense Ministry issued a statement, saying it had finished military exercises
along Ukraine's border. "Aircraft taking part in exercises have been redeployed
from temporary to their permanent air bases, anti-aircraft missile their permanent
positions," Russia's Interfax news agency quoted the defense ministry's news
service as saying. The statement ushered in a big sigh of relief for jittery
stock market Bulls, and enables the equity markets in Germany, Japan, and the
US, to recoup more of the previous losses that were caused by Greenspan's warning
about a correction.
The Kremlin Grapples with Economic threats on Multiple fronts, By pulling
back from the brink of a military confrontation with NATO, the Kremlin has
won a little reprieve for the Russian rouble and its credit markets. The rouble
had fallen to an all-time low of 36.73 per US$, following Moscow's decision
to ban most food imports from the West in retaliation for sanctions over Ukraine,
but recovered to 36-roubles /US$ today. One of the biggest unknowns is how
many foreign investors and Russians will dump their roubles for other currencies,
or Gold, if relations with the West sour further. Around $75-billion poured
out of Russia in the first six months of this year, - the fastest pace in more
than four years.
On July 25th, the Russian central bank unexpectedly hiked its 1-week repo
rate, +50-basis points (bps) higher to 8%, trying to head-off capital flight
from Moscow's already battered currency and financial markets. The central
bank, in one of its most hawkish statements in recent years, said the +50-bps
rate hike was due to higher inflation and geopolitical tensions. The Bank of
Russia has hiked its 1-week repo rate by a total of +250-bps so far this year,
and Russia's 6-month Libor rate has jumped to 10.30%, in order to defend the
rouble's exchange rate. Since the start of July, the yield on Russia's 5-year
note has surged to as high as 10%. However, after Moscow backed away from the
brink of a military confrontation with NATO on August 8th, the 5-year yield
has dipped to 9.44% today.
Still, Russia and the West are engaged in a mini trade war that will produce
winners and losers. For Moscow, the primary battle is over the rouble's exchange
rate. A further weakening of the roubles' exchange rate against the Euro and
US$, could lead to higher inflation and interest rates, and if sustained for
an extended period of time, might topple Russia's $2-trillion economy into
a recession. Russia's economy grew at an annualized rate of +0.8% in the second
quarter after shrinking -0.5% in the preceding three months. Russia , earns
$350-billion annually by exporting its oil and natural gas. However, capital
and technical expertise are fleeing the country, investment is shrinking, and
inflation hit 7.8% in June - well above the central bank's forecast of +6.5%
for the whole of 2014. "If high inflation risks persist, the Bank of Russia
will continue raising the key rate," the central bank warned.
For all the sanctions Western leaders can throw at Russia, the biggest threat
to Putin's hold on power is something beyond his control: the price of crude
oil. The Kremlin's finances are heavily dependent on exports of crude oil and
natural gas, - (tied to the price of oil), and their prices are closely monitored.
As long as oil, which accounts for 50% of Russia's tax revenues, remains above
the average of $104 per barrel written into the 2014 budget, Moscow has little
immediate need to worry. However, the alarm bells will start ringing if Urals
blend crude oil falls significantly below $100, forcing the Kremlin to dip
into its $470-billion stash of foreign currency reserves, in order to maintain
government spending at current levels and prop-up an economy that's already
flirting with a recession. Moscow's School of Economics estimates that a $10
drop in oil prices would strip 700-billion roubles ($20-billion), or 5%, from
Russian budget revenues a year. That translates to about -1% of GDP. Local
economists estimate that a sustained $10 price drop could cost -4% in annual
economic growth. If the price of Urals blend crude oil tumbles to $75 and stays
there, Russia could have regime change.
While Russia goes on pumping oil, the rest of the world is developing new
sources of energy and energy-saving technologies. Oil from shale has boosted
US-oil output by 3-million barrels per day (bpd) to roughly 8.5-million bpd
today. The nation's output is forecast to climb to 9.28 million barrels a day
next year, - the highest since 1972. On the demand side of equation; Europe
and the US reduced their consumption by 440,000-bpd over the past 12-months.
German demand for oil -4% less than a year ago, - and the same for Italy and
Japan.
The economic sanctions and trade bans that have been put into place will chip
away at the vitality of Russia's and the Euro-zone's economies in the months
ahead. Already, the Euro-zone's GDP ground to a halt in the second quarter
as Germany's economy shrank -0.2%, and France's stagnated at zero growth for
a second quarter in a row. The zero growth rate for the Euro-zone as a whole
is cause for alarm throughout the 18-nation region, which is already feeling
the deleterious effects of sanctions before they begin to bite.
Periodic sell-offs in the European stock markets could rattle the S&P-500
index. However, US-investors can rest easy knowing that the "Plunge Protection
Team" is monitoring the market, 5-days per week, and 24-hours per day, and
will intervene to put a safety net under the market to prevent a -10% correction
from unfolding. However, the PPT is not adverse to -5% pullbacks from time
to time, to prevent the emergence of frothy bubbles. Still, taking out cheap
volatility insurance (ticker VXX), without abandoning long positions is a good
idea.
