Sunday, 11 February 2018

Some reasons to be bearish that make sense

I wrote about some reasons to be bearish that don't make sense last week. Since then, the Dow Jones Industrial Index had posted its worst week in two years with 2 days of free fall exceeding 1000 points. In fact, had the Dow lost any ground on Friday, it would have been the index's worst week since the financial crisis in October 2008.

I guess this provides the perfect context for discussion on reasons to be bearish that makes economic sense.

1) Treasury Bond yields are rising

10 year treasury bond yields have accelerated since the start of the year and now sits 0.841% more than it's 1-year low in September. While 0.841% itself is rather insignificant on an absolute basis, it is actually quite a big deal due to September's low 2% base.

Source: CNBC

The major question is what has this got to do with equities? 

Bonds are a major alternative investment asset class to equities. Ceteris paribus, rising bond yields makes this asset class more attractive relative to equities. We will therefore see money flow from equities to bonds.

Rises in Treasury bond yields have the greatest impact on overall fixed income as Treasury bonds are seen as the safest investment. Consequently, other fixed income instruments will also see corresponding increases in yields in order to maintain their respective risk premium.

2) Inflation is rising (more than expected)

The US Labor Department reported in early February that wages in January were up 2.9% compared with a year earlier, the best pace since June 2009. Higher wages serve as a leading indicator for higher inflation.

Given the spike in expected inflation, it appears that the pace of wage growth has caught investors out by surprise.

Source: Federal Bank of St Louis

The direct impact of inflation on equities differ between businesses. In general, businesses that can pass on inflation to the consumer tend to fare better. As such, industries where demand is price inelastic might be better placed than industries where demand is price inelastic.

However, the direct impact of inflation is minute compared to its indirect impact. When inflation rises more than expected, so too nominal interest rates:

 π + r
i = nominal interest rates
π = expected inflation
r = real interest rates

Higher nominal interest rates can impact borrowing costs and discount rates. As such, the impact of unexpected fluctuations in inflation on equities can be rather drastic.

3) Margin calls

Definition of 'Margin Call', as quoted from Investopedia -

A margin call is a broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when the account value depresses to a value calculated by the broker's particular formula.

An investor receives a margin call from a broker if one or more of the securities he had bought with borrowed money decreases in value past a certain point. The investor must either deposit more money in the account or sell off some of his assets.

TL;DR - When stocks plunge as suddenly as 10% in a week, investors trading on margins might be forced to sell off assets in order to maintain minimum maintenance margin. This worsens the free fall, which might then trigger another round of margin calls. If widespread, such a vicious cycle is devastating for both affected investors and the entire market.

Bull or Bear

Just as writing about some reasons to be bearish that don't make sense is not to be construed as bullishness, this post is not to be taken as an indication of bearishness. Rather, I advocate understanding the arguments for both Bull and Bear. This will help us remain calm and make rational decisions on investing (and divesting).

For those who wish to hear it from someone with more authority on the subject, here is Mark Cuban:

This is neither a recommendation to purchase or sell any of the shares, securities or other instruments mentioned in this document or referred to; nor can this blog post be treated as professional advice to buy, sell or take a position in any shares, securities or other instruments. The information contained herein is based on the study and research of Dan O (“the Author”); is merely the written opinions and ideas of the Author, and is as such strictly for educational purposes and/or for study or research only. This information should not and cannot be construed as or relied on and (for all intents and purposes) does not constitute financial, investment or any other form of advice. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. Every investor has different strategies, risk tolerances and time frames. You are advised to perform your own independent checks, research or study; and you should contact a licensed professional before making any investment decisions. The Author make it unequivocally clear that there are no warranties, express or implied, as to the accuracy, completeness, or results obtained from any statement, information and/or data set forth herein. The Author, its related and affiliate companies and/or their directors, executives and employees shall in no event be held liable to any party for any direct, indirect, punitive, special, incidental, or consequential damages arising directly or indirectly from the use of any of this material.

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