Chicken Little
by Tom Temple
Feb 8, 11:11 AM
This year, I think I’m going to put my IRA contribution into bonds. At the least, I don’t think I’m going to keep my 90/10 spread. “Why,” you might ask, “when Vangaurd target 2045 is so safe and consistent?” The answer is because my brother-in-law, Brian, told me to.
He’s a trader. I don’t really understand the specifics but he buys and sells (leveraged?) derivatives of backed securities (e.g. real estate) in such a way as to allow hedging. He has a reputation for being a “chicken little” because he sells his risk early and can arrange himself to make money when other people have to dump their risk1. In 2006, he made the most money in his sector. This year, he is the only person he knows to have made any money at all and he made a lot. This gives him a fair bit of credibility. Don’t tell the internet but, right now, he is betting against Sallie Mae and Freddy Mac — two of the central pillars of our credit system.
1 To clarify: “Selling risk” means to selling risky investments at a loss relative to some notion of their expected return (e.g. their current price). When you want someone to buy your risk, you have to pay them to do so. It is totally rational for people with different planning horizons to make such a trade and find it mutually beneficial.
Here’s the problem as he described it.
- There is a lot of bad debt. Primarily I’m referring to mortgages, but also to the “credit crunch” in general.
- All the big players (e.g. SM and FM) are holding more risk than they want to.
- Baby boomers (ages 44-62), about to retire, have a huge fraction of their net worth in their houses and too much of their investments in stocks. Keep in mind that they own like %80 of the stock market.
- The housing bubble has burst.
Because of (1,4) Brian thinks that it is inevitable that SM and FM will have to write off a bunch more debt and/or get a government bailout. This plus the risk averse environment (2) will very likely lead to a (potentially major) market “correction”. This is the “recession” that the government is pretending to be worried about right now as they try to buy back our love. Being young, we can wait this kind of thing out and VTIXV would be a good vehicle for that.
The problem though is the baby boomers’ risk has not been accounted for. Because of point (3-4), they can ill afford such a down-turn at this moment. Brian believes that should this “recession” occur, the baby boomers are going to start selling off their stocks, driving the market down, perhaps dramatically. Worried 45-55yr olds are not guaranteed to take this kind of thing rationally; there could be an irrational sell off in which the stock market could be hurt very badly.
The good news is that the smart young people like us will be ready to buy those stocks from them. It would be nice to be holding those bonds when the old farts come crawling with garbage bags of stock. Capital won’t dry up and we won’t have another great depression.
The question is whether, how much and how long to hedge against this scenario. Brian, 35, has sold all of his stock holdings. He thinks 20:1 the market will go down this year. Stephen, do you still read this blog? Do you have an opinion?
Feb 8, 12:28 PM
Checking the ticker, we haven’t actually been doing very well recently.
Feb 8, 05:16 PM
Condition 4 above is debatable. While the market has collapsed in locales where bad credit risks could “afford” to buy homes, many other communities (Weston, Sudbury, Lincoln, all of Berkshire County, and even Somerville, to name a few) have seen continued price increases.
If the bubble is to pop completely, the economic ripples from the subprime crisis need to resonate to the point that people with good credit and fixed rate mortgages start to lose their homes/not be able to afford homes.
That won’t happen until these homeowners lose their income, and that won’t happen on a large scale unless companies make massive payroll cuts, and that won’t happen unless the market is struggling under the weight of a Great Depression-sized economic crisis.
So sayeth Econ Cat.
Feb 9, 03:01 PM
Your risk averse, “chicken little”, brother in-law is doing well when risk is doing badly in the market. You think that makes him a genius? Sounds to me like he’s just risk averse.
Feb 9, 08:13 PM
Cosmo, I largely agree with you, but I don’t think that has a large bearing on the main argument. It only matters insofar as Fannie and Freddie are going to have to eat some more bad debt and the middle class can’t count on moving into a smaller house and retiring on it. I almost didn’t include it in the main factors.
Don’t be a jackass, Jon. Did I say he was a genius? He may not be as smart as you but at least he has some credibility.
Whatever. Let’s suppose that he is only doing well by pure coincidence because, as you say, risk is doing poorly right now. Even then, your comment addresses nothing in the post. Do you think it is completely random that risk is doing badly right now? Risk has been doing badly for two years. Do you think that there is no correlation with risk doing badly now and risk doing badly in the future? Do you think that all of the middle aged prospectors should be ignored when considering market risk?
Feb 10, 12:14 PM
If the market is badly overvalued, it must be that other traders aren’t able to accurately assess the phenomenon you describe.
If you’re not saying that your brother in law is smarter than them, why can’t they accurately price the market?
Not to push a blind faith in the efficient market hypothesis, but 20:1 certainty in any large market’s direction is quite a claim.
Feb 10, 03:48 PM
Doubtlessly, lots of people are going to be onto the right track. I just wonder if they can counteract the people who are not.
Part of the problem is that most traders aren’t free to act in the way that they might like to. They take their clients’ money and invest it but they can only do so in some kind of predefined way. Brian is outperforming his peers by taking professional risks and going outside of the company’s stated domain.
Suppose Vanguard is super smart and knows that they should shift the bond/stock spread on that fund. Will they? I’m not sure. How much professional risk does doing so put them in? I’m supposing that most brokers will offer all the risk that their clients ask for. My concern is that their clients are asking for too much.
I’m not supposing that the market is improperly valued by long range investors. I’m saying its improperly valued by 55yr olds. Since they own a shit ton of the market, my concern is that a sudden revaluation might be dramatic.
I shouldn’t have quoted the 20:1 figure since it was obviously hyperbolic. He is very confident that at some point, this revaluation will actually happen. He also thinks that it is more likely to happen sooner rather than later.
Feb 11, 05:18 PM
Dan stole my follow-up.
Feb 11, 07:09 PM
Just to be clear, are you suggesting all of the following:
1)baby boomers will behave irrationally if the stock market loses value
2) they are being irrational about recognizing they will be irrational if there’s a downturn
3) institutional investors feel constrained from using buying put options (or some more sophisticated hedging device)
4)there will be insufficient liquidity in the world’s financial markets to capitalize on this irrationality in the stock market at true asset values?
Feb 12, 09:19 AM
Dan, that’s about right. Despite flaming Jon, I don’t mean to pretend that I know anything about this.
2) Yes if I understand you correctly. They are being irrational by holding too much risk for their planning horizon. This would be the cause of (1).
3—4) What fraction of the market is held by what types of investors? I’m concerned that (4) might be true. If the majority of the money that the institutional investors are using come from the irrational baby boomers then I suppose that both (3) and (4) can hold.
Feb 12, 07:19 PM
Tom,
I don’t know much about finance, but I’m skeptical of this line of reasoning.
1) There may be a miscommunication about the nature of the investors irrationality. Why will boomers sell when the stocks lose value. Irrational overexposure to risk, in and of itself, does not imply that.
My (extremely minimal) understanding of behavioral finance is that, if anything, the opposite type of irrationality exists. Supposedly people hold onto stocks too long once they’ve gone down, more or less waiting for it to “break even.”
3 seems unlikely to me too. The derivatives market is by some standards larger than the equities market. Who is trading all that volume if not institutional investors?
4) Perhaps there would be insufficient liquidity in the US, but international financial markets are larger than the US equities market (the foreign exchange market alone does 20 times the volume of NYSE). I could believe a large group behaving foolishly could temporarily change asset prices, but I think there’s plenty of liquidity internationally ready to buy good deals before the market gets severely undervalued.
Those are my hunches… but really that’s just reflecting a deeper belief in the efficient market hypothesis.