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U.S. Downgrade Triggered Flash Crash, Why Stocks Will Go Up Now

Stock-Markets / Stock Markets 2011 Aug 12, 2011 - 12:18 PM GMT

By: Andrew_Butter


Diamond Rated - Best Financial Markets Analysis ArticleThere are many theories about how to value the US Stock market (as a whole); some said that stocks were 40% over priced in May 2009, same story in August 2011. All it took was the hilarious spectacle of the workings of what passes for “modern” democracy to be aired on prime-time, for those same tired-old theories to get dusted off and paraded like some sort of universal truth.

40%...grow up! The acid-test of a “universal truth” is whether it can make accurate predictions in real-time. For example my niece, aged six, has a theory about the sun; based on that theory she can predict with spellbinding accuracy where it will come up in the morning. Of course that doesn’t mean her theory is right, but it’s a start; and one thing is certain, if her predictions were completely wrong, then that would be grounds for saying “sorry sweetheart, but the definition of lunacy is doing the same thing over and over and expecting a different result”.
Here’s a theory that has been right five times out of five, that says (a) the reversal just now was inevitable, (b) all that the downgrade did was provide the trigger and (c) it’s over.

In January 2009 that theory said the S&P 500 would bottom at 675, which it did in March (intra-day), then it said in May 2009 that the index (then 900) would go up in a pretty straight line to 1,200 (it did over the next twelve months); then it would reverse by 15% to 20% (it did by 16% in April 2010); then it would meander back up until it went over 1,300 which happened in April 2011, at which point it would reverse again by about 15% (actually it was 18%).

If you know of a theory about how the US stock markets works that can do five-out-of-five, in a row; without a caveat, well that could be right too.

The “without a caveat” part is important; like put a number for the inflection point in the future; rather than saying something “profound” like… “US Stocks could go down 40% and test March 2009 lows”, as in “could” means “could not” too.

Meanwhile I’m sticking to that theory, at least until it doesn’t work; perhaps sixth-time-lucky the sun won’t come up in the place the theory predicted?

How does that work…if it works?

Simple you do a valuation in line with International Valuation Standards, crank the handle, and out pops the answer. That gets you to the “fundamental” or intrinsic value, or what Farrell called “equilibrium” and what IVS calls other than market value.

The rest is just Farrell’s 2nd Law, which re-states Mises’ idea that making stupid investments, particularly geared-stupid-investments (he called them mal-investments) is inevitably followed by forced liquidation of those investments at an unattractive price. Another way of looking at that is the “pebble in the pond” theory, where the dynamics of the “up” are inevitably reflected in the “down” that follows; and the net result is zero sum; that’s a law of nature and however hard those who call themselves God’s Workers try to defy nature, in the long-run, as Keynes pointed out, natural order always returns.

It doesn’t take long to build the valuation model and you don’t need to be an “expert”; the first time I did that for stock markets I knew was they existed and that you could download data from Yahoo Finance. To illustrate the depth of my ignorance at the time, then, I thought the DJIA was the same as SPX except that you multiplied by ten.

It took about half an hour to build the valuation model and about three hours to write the article and come up with the bad jokes. Only one thing about that which is hard to understand, which is how come Shiller, Smithers, Prechter, and all those other guys who say things like “could” and “might”; instead of “will”…just can’t “see” how easy it is.

Why the bad-jokes? Truth be told, I didn’t actually want anyone to read the articles, I just wanted to put out a marker. I have this thing about giving free advice; my theory then was anyone who laughed at my jokes could get a little free-gift. Although I must admit it’s pretty sad when you got to pay people to laugh at your jokes, and anyone who was in cash at 675 then bought, then sold at 1,200 then bought at 1,050 then sold at 1,300; got a nice free gift.

What will the law of nature spew out next?

The “theory” says that the fundamental of the S&P 500 (expressed in dollars) depends on (a) the nominal GDP (in dollars) of the economy that companies listed on the index play in (which is wider than just the US economy), and (b) the yield on long-term US Treasuries (whatever their rating).

That gets you to the base line; then you have to look at the periodicity of the oscillation around the base line.

With regard to the base-line, the irony of the downgrade is that the whole reason the Big Three US rating agencies exist is that they were granted a lucrative concession (by the government) to pontificate about what risk weighting can be assigned to a security put up by a financial entity (like a bank), as collateral on a loan…in order to prove (to the government) that they (the banks) were “adequate”.

So the “brave” S&P decision was a bit like biting the hand that feeds or the child who stupidly pointed out that the king wasn’t wearing any clothes.

Whether S&P will have their head cut off is an intriguing question right now; personally, having spent a little time in places with really nasty “kings” where the reward for calling a bunch of venal incompetent crooks, just that, is a bullet in the stomach and then you get thrown off a bridge (like in Syria for example), I’m standing well out of the firing line.

But calm down, it’s not a big deal, sovereign debt only loses its 0% risk weighting when it drops below AA- and so nothing really changed, although one wonders what’s going to happen to non-sovereign debt? The risk weighting of AAA synthetic collateralized debt obligations lovingly crafted by Goldman Sachs is 20%, so presumably that stuff is now supposed to be less risky than the debt issued by a country which has the option of simply printing dollars to pay the debt back?

I’m not quite sure how that will play out, but from a practical standpoint you can still borrow more money if you put up AA sovereign debt as collateral than if you put up some AAA rated toxic assets, unless of course you are dealing with the Federal Reserve, because these days the Federal Reserve Agent will accept any old rubbish as collateral.

So does that mean I can roll up to the Federal Reserve with a pair of smelly old shoes, and they will pay me what I paid for them, five years ago? Probably not, you need to have connections in the right places to be able to work a scam like that; that’s one thing I learned in Syria, it’s all about connections; looks like it’s no different in America just over there they throw you in jail under the three strike rule for dissent.

What’s really confusing is that 10-Year yields tanked after the downgrade, the way it’s supposed to work is that when you get a downgrade, the yield on your piece of the toxic asset pool, is supposed to go up.

What’s also interesting is that the S&P 500 started to tank the day after Lehman folded, but it took another two months for yields on the 10-Year to start to tank. This time around, they both tanked in tandem.

Perhaps the difference was that back then there was the legacy of George Bush who for all his failings; did mange to unite the nation behind him.

For example when he said “Hey guys, last night I had a talk with the person who I have a special telephone line to, and he say’s it would be a good idea to borrow $1 trillion and blow that looking for WMD in Iraq”; the American people and Congress rallied round, and God’s Workers set about helping to facilitate the money.

No pun intended on the “blow” word, although it might be worth noting that according to some analysts that piece of Rambo Diplomacy may actually have cost $4.7 trillion by the time it’s over, but I’m sure every American feels safer when they tuck themselves up in bed at night, so I guess that was money well spent?

When George’s minions suggested TARP, he got a green-light to sign the check and when Ben started talking about TALF which started off as a $200 billion loan facility, and grew into a $1.6 trillion repository for second-hand shoes, no one batted an eyebrow.

But when Obama stood up and said, “come on guys, we got to roll over the debts that George and his policies (and God’s Workers) ran up, or we will get a downgrade”.

Congress and the nation said “we would prefer to have the downgrade”.

That’s democracy in action just like it works in other places where you don’t have the option of ticking “None of the above” on the voting slip, like in Syria.

What next?

Well nothing much really, the exhibition of crass incompetence was the trigger for the inevitable to happen, it could have been something else.

But nothing has really changed, the unhappy ship of America will stagger onwards, and Americans with money will continue to spend it and continue to resist the efforts of the government to put its hand in their pocket so that the crumbling infrastructure and optimism of a once-great country can be re-built.

There is a lot of money in America, and there is even more owned by (a small minority) of Americans, kept outside America. Outsourcing was nothing to do with labor costs; if it was, then why didn’t that happen in Germany or Japan? Outsourcing was about tax avoidance, period. 50% of the profits of S&P 500 corporations are made outside America where it’s much easier to avoid paying tax, and so what if the US economy tanks? The value of the S&P 500 is about what happens to the money that rich people control, what happens to the 20% of Americans who have zero or less, is irrelevant to that algorithm.

It wouldn’t be hard to get America back on track and Americans back in work, for example, here are three easy wins:

1: Charge a wealth tax of 3% a year on what Americans and foreigners with a right of abode in USA own; that would bring in $1.5 trillion a year. Is that unfair? Not at all, if you can’t make more than 3% on your assets a year, you don’t deserve them, and in any case setting the base rate less than inflation is doing that now, just poor people and people on fixed incomes are the ones that suffer.

Meanwhile the rich can make hay, borrowing from the Fed at 0% and lending to the Treasury at 3% (which is where the 10-Year is headed).

And if the rich don’t like that they can forsake the protection that they get by living in America, and go and re-locate to places where you need to pay much more in “protection” money; like Mogadishu or Damascus. Getting rich people in a community to pay money out to support the less fortunate is one of God’s Laws, the Christians call it tithing; the Muslims call it Zakat, and by-the way that’s not supposed to be spent on Rambo to defend the rich against evil; that’s extra.

2: Put a $4 a gallon tax on gasoline to bring prices in line with prices everywhere else in the developed world; that would bring in $500 billion a year, and probably halve America’s current account deficit, which has to be financed by borrowing from aliens.

3: Cut military spending by half, I know Americans love to play Rambo and GI Jane so that rich people can go to sleep at night and dream of making more money, but $1 trillion a year for a country that just got downgraded, is a ridiculous luxury.

There you have it, $2.5 trillion a year; and if you wanted to get Americans back to work, just forget about corporate taxation altogether; it’s not as if it generates much money, particularly since corporations can avoid paying it by outsourcing, and the increased investment and employment would easily generate more tax than was lost.

And if you really want to get the show on the road, scale back income tax.

Will that happen?

Not likely, American politicians will do what they know best, they will dither and look for lobbyists to give them kickbacks, it’s no different in Syria, so more than likely nominal GDP growth will hover around 3% a year (how much of that is “real” is irrelevant insofar as the stocks are concerned), and so the 10-Year will hover around 3% too.

Plug those parameters into the valuation algorithm and this is what you get:

The line to watch is the bottom of the triangles, whenever the price goes up faster than that line, there is a risk of a reversal.

So the model says that by August 2016 the S&P 500 will be flirting with 2,000 which works out at an average annual growth of about 10% a year, whether that will keep up with “real” inflation, is of course debatable.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2011 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


13 Aug 11, 05:13
Bubbles and busts

Mr. Butter, if 1995-2000 period was a bubble, as all sober people agree, why the subsequent bust period have not been much more severe? But according to your 2nd chart S&P index moved along with fundamental values of your theory for a long period of time (2002-2008). Frequently you use geometric mean to estimate the reversals from bubble territories. But this time it looks you have ignored the geometric mean.

I think Wall Street criminals will force FED to announce a new round of QE by year end or after Christmas at the latest. So-called Wall Street "experts" look at "inflation expectations", that is as you know, 10-year treasury nominal interest rates MINUS 10-year TIPS rate. Now this rate stands at 2.3% If it comes at or below 1.5% probably FED will succumb to demands. For this to happen S&P must return to 1,000-1,050 area to break the back of "inflation expectations"

15 Aug 11, 13:46

3 words. Dead cat bounce!

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