3 Things Worth Thinking About (Vol 4)

The first half of this week has been very interesting from an economic, financial and geopolitical viewpoint. Despite what appears to be globally increasing risks, the financial markets have seemed relatively unfazed. Historically, such calm has always existed prior to the eventual storm. This week’s “3 Things” takes a look at some of the “rising risks”that I believe are being ignored which could potentially be harmful to individual’s portfolios.

(Note: Identifying risks does not mean to “sell everything and run to cash.” As noted in this past weekend’s newsletter that discussed the markets recent “sell signal”:

‘The current ‘sell’ signal does not mean ‘panic sell’ everything you own in your portfolio and run to cash. Initial sell signals can be short lived particularly when the Federal Reserve is still intervening in the markets.

Furthermore, by the time a WEEKLY sell signal is issued the markets are already OVERSOLD on a short term basis. It is very likely, that a rally will ensue in the markets over the next week back to resistance that could be used to rebalance portfolios and reduce the risk more prudently.”

By being aware of “risks,” we can make better portfolio allocation decisions in order to preserve capital and produce better-long term returns.

Oxymoron

There is an interesting phenomenon occurring in the financial markets that absolutely, positively, will not last indefinitely – the “Giant Shrinking Correction.” The chart below shows the S&P 500 (weekly closing data) since the beginning of 2009, with all relevant corrections identified in terms of percentage.

 

There are two important points to note. First, each correction since the end of QE2 has been increasingly smaller. This is very much in line with a prediction made in November, 2013 by John Hussman when he stated:

“A discussion of bubble risk would be incomplete without defining the term itself. From an economist’s point of view, a bubble is defined in terms of differential equations and a violation of ‘transversality.’ In simpler language, a bubble is a speculative advance where prices rise on the expectation of future advances and become largely detached from properly discounted fundamentals. A bubble reflects a widening gap between the increasingly extrapolative expectations of market participants and the prospective returns that can be estimated through present-value relationships linking prices and likely cash flows.

As economist Didier Sornette observed in Why Markets Crash, numerous bubbles in securities and other asset markets can be shown to follow a ‘log periodic’ pattern where the general advance becomes increasingly steep, while corrections become both increasingly frequent and gradually shallower. I’ve described this dynamic in terms of investor behavior that reflects increasingly immediate impulses to buy the dip.”