Image from 1.bp.blogspot.com

Since the start of the year I’ve read many articles warning about an impending market correction. Those who have been warning about the possibility of a correction generally point to the run-up in assets like gold, stocks, treasuries and oil as well as the troubles in the European Union debt-ridden countries.

Consider the following trends:

* Since January 2009, crude oil has risen by roughly 60% to about $80/barrel
* Since January 2009, gold has risen by roughly 35% to about $1100/troy ounce
* The S&P 500 P/E ratio (20.33) currently stands about 4 points above its historical average (16.35)
* The 10 year treasuries yield (3.61%) is down almost 2 percentage points from the 5.5% average rate from 1993-2007 (treasuries’ yields are inverse to prices)

And more recently:

* This month’s Consumer Confidence Index dropped to 46 from 53 last month
* Initial jobless claims rose by 22,000 last week to 496,000
* New home sales dropped 11% in January to a seasonally adjusted annual rate of 309,000 (lowest since U.S. Commerce Department started keeping records in 1963)

So given the big run-up in assets like stocks, gold, oil and treasuries plus the uncertainty over the U.S. economy improving and the unresolved issues with the EU your first line of reasoning may be to take short positions via puts, short selling stocks or purchasing inverse ETFs.

Be careful!

In my humble opinion, shorting the markets for the average investor is a difficult proposition because the individual investor does not have the leverage in capital to sustain an extended duration in seeing a correction come to fruition. Unlike banks like Goldman Government Sachs, the individual investor cannot borrow money from the government at 0%.

S&P 500 P/E Ratio

Image from standardandpoors.com

Now while I do think that historical averages will prevail and that the S&P 500′s P/E ratio will eventually move back towards 16-17, I have doubts about whether either will occur in the upcoming months. Instead, what I expect is more volatility as has been the case of the past few weeks. This volatility will make timing options difficult and subject inverse ETFs to more decay (2% up, 2% down, 2%up, 2% down repeated a dozen times on $1000 for example does not take you back to $1000). I’m reminded of the phrase, “eat like a chicken and poop like an elephant”, where a two-day drop in the markets yields you a 5+% gain, but a 2-week rally could easily cause losses of -30% or more on your short positions.

The Federal Reserve has basically promised it will continue printing money to keep interest rates low so as to bolster the economy. The typical savings and money market yields will remain pitiful giving people all the more incentive to invest in other asset classes.

I also think politicians and the business media outlets like CNBC have a bias to fudge numbers to make things seem more positive than they appear. Take for example, these charts pulled up from shadowstats.com.

Image from shadowstats.com

The real inflation is the blue line and it shows that inflation has been running about 7% this past decade. It’s denoted as Pre-Clinton Era CPI because the CPI measurements were tweaked during the Clinton administration (and actually even during the Reagan administration) to lower Social Security payments and hide the mess going on there.

Image from shadowstats.com

And here is the unemployment rate comparing the “official” reported version versus the SGS Alternate which takes into account underemployed and discouraged workers. On a side note, I read the other day that according to the Economic Policy Institute and Quintcareers.com, around 30 million workers in America between the ages of 18-64 were minimum wage earners or low income earners (earn less than $9/hour) in a 2003 study. My guess is that this 30 million figure has since remained the same or even increased. I’m not sure what percentage of low-wage income earners are factored into the SGS alternate figure, but I would imagine that the official government number completely discounts this group.

I’m of the opinion that government officials find creative ways to fudge numbers in order to keep their jobs by giving the appearance that the economy is improving under their guidance. It’s also a way to mask our country’s debt so that we may borrow more from other countries. And this creative accounting also happens in the State level as well with States like California withholding a small percentage of paychecks to reduce the deficit gap in its budget.

Media outlets also have a bias to discount negative readings and give a positive spin on things because their livelihood depends on the advertisement revenues from the financial services and institutions they do business with.  If they were to tell you that the next five years in the markets would be stagnant you would probably not bother trading and move your portfolio to some low cost index fund or other conservative investments instead.

And while I do believe the news we have heard from the EU about the problems in Greece are only the tip of the iceberg and that China now has an even bigger real estate bubble than America did, I think those countries also have governments that fudge numbers and a media bias to promote a bull market.

So my opinion is to not wager heavily on a market correction. If you insist that you must short the markets, do so with a very small percentage of your trading portfolio. Forget Ultrashort ETFs altogether because of the volatility and decay factors. If you have the money to invest in real estate then that may actually be a viable alternative right now with the government extending the $8000 tax credit for those who qualify.

Image from seekingalpha.com

Take a look at the chart above. If you look at the Case Shiller 20-city composite, which is used to calculate the rising value of home prices in the 20 largest metropolitan areas, you’ll see that the index is back to where it was in the fall of 2003 (roughly 150). In other words, there has been no home appreciation in home values during the past seven years. Yet, if you take a longer-term approach (say the 125 value from January 2000) you’ll get 150-125 or a gain of 25 for a 1.84% CAGR. But remember you also get the tax breaks from owning a home plus the ability to borrow on the home investment. So going further, if we assumed the home purchased in January 2000 was done with a responsible 20% down payment then this gives a 4-x leverage (20% down payment + 80% loan). Now:

Actual Cost: 125/5 = 25

Return: 150 – (125 x .8) = 50

Return with borrowing: 50/25 = 100% or 7.18% CAGR

Now while 7.18% is roughly inline with the 7% real inflation number this decade, it is better than the government’s bogus 2-3% number and certainly what most banks pay in interest.

The bottom line is that I think that the global economy faces significant headwinds, but attempting to short the markets as an individual investor will prove difficult.

Tweet This Post

3 Comments

Other Links to this Post

1. Mr. Nice Geek » Stagflation on the Horizon? — April 4, 2010 @ 12:13 PM

2. Mr. Nice Geek » Thoughts on “The Big Short” and CNBC Cheat Sheet — April 9, 2010 @ 8:55 PM

3. Mr. Nice Geek » Haha! The Ben Bernank — November 12, 2010 @ 2:28 PM

RSS feed for comments on this post. TrackBack URI

Leave a comment