I am a bear in a
bubbly bullish market. Here are my thought processes.
In Mar, with the virus hot on our heels and the world reeling in shock, the stock market plunged. The STI shed 1,000 points from its recent high to a low of 2,208. Over in the USA, the S&P 500 index gave up close to 30%.
I remembered telling anyone who cared to listen then, that this is going to be the greatest transfer of wealth in our life time. I was expecting the markets to fall through bottom after bottom, for the property market to capitulate, and for the entire financial system to be turned upside down. I could not have been more wrong.
In the US, President Trump signed a US$2.2 trillion aid package into law in double quick time. Amongst other things, it provided US$350 billion for small business loans and US$250 billion for unemployment aid.
In Singapore, Deputy Prime Minister Heng Swee Keat rolled out four budgets aptly named the Unity, Resilience, Solidarity and Fortitude Budgets to help combat the economic fallout. Just under S$100 billion will be distributed via a plethora of schemes to individuals and businesses.
The market was placated. From its 2,200 low, the STI has clawed back some of its losses and is now trading in the 2,600 region. The S&P 500 did even better – it is now only 10% off what it was trading pre-covid.
In the local property market, there were very little property foreclosures. For every seller in the market, there seems to be a pool of ready buyers. The lockdown did little to deter genuine home buyers, with multimillion dollar properties transacting during the circuit breaker period. The financial system remained robust.
The transfer of wealth failed to come about. I was wrong on all accounts.
Austrian vs Keynesian
I have always had a thing for free markets. I like the idea of allowing nature to run its course, and periods of recession, inflation and deflation are but part of the nature. It is the economy’s way of cleansing and regenerating itself. After a crash, some businesses will burn and collapse. From the embers, others will emerge, and the entire economy becomes stronger and more anti-fragile as a result. Such is the Austrian school’s approach to economics.
The Keynesians other hand, believe that Governments are a crucial intermediary. Free market mechanisms are insufficient to properly allocate resources, and the state must intervene to moderate markets and to prevent extreme cycles of boom and busts. For COVID-19, many governments have gone full on Keynesian.
The flip-side of government intervention is that sometimes the aid could be excessive or even misguided. Despite unemployment rate being the highest ever, the stock market has not batted an eyelid. Imagine going to sleep on the 1st of January with the market at 3,200 and waking up six months later to find it trading at 3,115. Had no one told you, you might not even have realised that COVID has happened.
The lockdown has produced a liquidity problem which governments have rightly tried to solve by flooding the economy with cash and cheap credit. In doing so, they have effectively unleashed the liquidity monster. At this moment it is this very liquidity that is propping up the market. Money is like water, it has to flow somewhere and it will choose the path of least resistance. It cannot sit still doing nothing and earning zero interest. A lot of this money has found its way into the stock market.
The truth is, the gap between economic data and the stock market has never been bigger.
Liquidity vs Solvency
In analysing the financial health of a company, liquidity is defined as the firm’s ability to meet its short term liabilities. Liquidity is a short term concept. The more cash a company can raise in the shorter a period of time, the more liquid it is said to be. Without liquidity, the best companies would not be able to survive.
Solvency on the other hand is the ability of a company to meet its long term financial commitments. No matter how liquid, a badly run firm with a lousy product or flawed business model will eventually run into solvency issues.
A good central bank can soothe emotional investors and calm the markets by moderating the flow of money. But that is only the first cut. To combat the COVID fallout, the whole of government needs to come together to create jobs, conjure up economic demand and to eventually turn bad debt into good credit. To that effect, we are still in early days.
Bull or Bubble?
The stock market is a voting machine. By buying (or selling) stocks, investors vote with their money on the direction of the market. And as any major market event unfolds, there will be market pundits, commentators, analysts and talking heads on TV telling us how the market should move and how investors should react.
In response to them, I constantly remind myself of Wittgenstein’s Ruler.
Unless you have confidence in the ruler’s ability, when you are using a ruler to measure the table, you are also using the table to measure the ruler.
What I read and hear is merely a reflection of the person’s view of the market direction. It is not how the market will react. In reading and listening to someone, I can tell more about the person than of the market. For every bear that proclaims that the end is near, there is another bull with upbraided optimism making calls for the greatest bull run in the century.
In fact, I have come to realize that whether you think it is a bull or a bear moving forward, is largely a determinant of your dominant thinking process.
Deductive vs Inductive
Let us first examine two common approaches to problem solving.
Deductive thinking starts off with a statement or hypothesis and then verifies it through observations. Inductive on the other hand, starts off with an observation and then moves backwards to arrive at a theory.
Deduction is top down, while induction is a bottom up process. Deductive arguments arrive at unassailable conclusions if and only if the primary statement is true. As a result, induction is easier to apply in everyday life because the world is rarely operates on absolute premises. There is no better or worse process – both functions complement each other.
If you are bearish, chances are you are using your deductive processes. The deductive investor will say – Bubbles are formed when price is not supported by fundamentals. All bubbles eventually end in tears.
The inductive investor turns the table around and say – The market keeps going up because of unprecedented moves by the Fed to provide liquidity. Never before has it happened on this scale. The world has changed and we can no longer use outdated methods to value the market. Inductive investors are bullish by nature.
For me, I belong to the former camp. I am of the opinion that the four most dangerous words for investors are – ‘This time it’s different’. When the liquidity euphoria wears out, the market will be forced to confront solvency issues. It is tethering on wobbly legs and it is a matter of time before the music stops.
Of course, what I say is more a reflection of myself and my biases than what the market will do. I am sure readers will need no further reminder of that. #Wittgenstein
It is easy to express bullish ideas on the market. You simply need to go out there, buy some stocks and hold them till the investment pays off. Unfortunately things are not quite as simple for bearish folks – there are more limitations when you short stocks.
I have been trading options on and off for the past few years. It has always been a side-hustle, one that I occupy my pockets of free time with. Along the way, when life happens, trading gets pushed aside. Work demands, family commitments, and even social activities have always ranked higher than trading. With the lockdown and no work, it is easy to devote more time to this venture.
I first read about Nassim Taleb in 2002, from this Malcolm Gladwell article. It tells of how Taleb adopts a contrarian strategy of buying far out-of-the-money options. Most of the options expire worthless and he loses money on most days, months and years. But when the trade turns profitable, his profits are supersized. From that moment on, I was hooked.
I have been fascinated by these low probability – high profitability trades for the past decade. It is against human nature to lose money on an ongoing basis, we are not wired for that and it is against investing principles. The normal psyche would demand small and constant wins, which is why passive income from dividends is such an attractive proposition.
I had some moderate successes over the years. My best trade happened in Feb 2018 where the market corrected sharply. A $200 put on the SPY option contracts went up to $13,025 for a 6,500% gain in a couple of weeks.
There were many other notable >10x gains. Over the years however, most of my options would expire worthless. Having been at it for a while, I have to agree with Taleb that it is a draining endeavour and that it demands a lot from the trader. It can be extremely demoralising to see your capital depleting on a weekly basis.
In recent times, many bullish investors, especially those who had invested in growth stocks such as the FANMAG gang have seen their portfolio grown massively. Great profits come with great bragging rights. I get a fair bit of ribbing from my friends for sticking with this unorthodox strategy and missing out on the gains. But I always find peace in telling them that they need to be lucky always, and I only need to be lucky once.
Other than reading books on option trading I have also recently found time to explore option coaches and courses. Unfortunately most option traders I have come across tend to be either option sellers who want hanker after the premium, or highly speculative social influencers. If there are traders out there who are fans of the fat tail strategy, do drop me a note so we can bounce ideas off each other.
Everyone has a view on the market direction. The bulls have been on the winning side thus far but I am one of the bears who believes that liquidity is a short term fix. The Fed is able to pump massive liquidity but it would not be able to resolve the longer term solvency problem. That’s my deductive instinct speaking. An inductive thinker would say otherwise and tend to be in the bullish camp. Nevertheless, I would bet my belief by buying put options. I may be on the wrong side for a long time but I only need to be right on a few occasions.