Stock trading March 19 2009

In my March 7 update I concluded.

"So large falls in the short term probably depend on the market coming to believe that:
a. Commercial real estate is some sort of repeat of residential real estate (hope Geithners stress test include defaults from builders on owners in this area - 25% of banks loans)
b. Insurance becoming part 2 of the banking crisis (again based on asset purchases with money that they need to pay back in the future - in this case to policy holders).
c. More panic in credit markets.

If not we could have a bounce despite continuing deterioration in economic conditions. "

Well we certainly had the bounce in stock markets! I closed down about half my short positions after the bounce lasted 2 days and other than that not much change. I am currently short the Spanish market and a small short on the French market. The European markets have generally only advanced in response to the US market jumping each day so clearly European markets do not have an upward momentum of their own at this point.

The so called good news that commentators have ascribed the bounce to has been hardly convincing.
1. Bernake saying the recession may end this year if everything goes right. Hardly news he's been saying the recession "may end in 6 months" for the last year.
2. Banks saying they are profitable (as long as they don't have to take count the losses).
3. Housing starts increased from virtually nothing to slightly above virtually nothing.

Basically I am waiting for a blow off top to put more shorts on. I will sell my shorts if there are real signs of a sustainable turnaround or if the market has a low volatilty gentle trend upwards (as occurs in bull markets).

US housing starts - unexpected jump

The blue line is all housing starts.

The figures graphed above show a jump in US housing starts and this jump is due almost entirely in a jump in multi-family housing starts (apartments, condos etc). The stock market liked this and jumped.

Three points stand out for me on this.

1. This seems to have caught people by surprise and resulted in a significant jump in the stock market. Should it be surprising if you understand housing markets?

No! Why - because there's not one housing market so we don't need to wait till all the inventory is run down in say Californian single family homes before we start building condos in Denver. For more details see my blog from January. IT is worth noting the jump in multi family housing starts was mostly in the north east of the country - an area with smaller boom and bust in housing. http://reflexivityfinance.blogspot.com/2009/01/misconception-2-housing-market.html

2. Is this indicative of a broad turnaround in housing starts?

Maybe in some segments but little change in main markets for the foreseeable future. In this vast majority of markets: housing prices are still decreasing, there is still too much inventory for sale (though this is gradually decreasing), foreclosures continue, rental vacancy rates are increasing and rental prices decreasing.

3. If there is s turnaround in housing starts over the next 3 months will it make a big difference to the real economy over the next 3-6 months?

Probably not. Housing starts have fallen to lowest on record. Even worse than the graph suggests if you factor in population growth. They need to increase 100% from this point to get back to a position where they would be considered terrible in any other postwar recession. So even if we get a turnaround it isn't going have a big dollar impact because it will still mean not a lot of dollars going into building. In addition dollars spent are related more to completions then starts and obviously housing completions lag housing starts considerably. Housing completions are still going to be going down for the next 3 months or more and then increase back to the level where we are now for the next few months. This is because housing starts have been going down rapidly for the last 3 months.

So in summary any rebound isn't going to start to translate into dollar impacts for at least 3-6 months and even then the rebound in dollar terms is going to be small because we are starting from an extremely low base and because many markets have significant inventory, low prices etc that will stop the rebound being a broad based one.

For more detail on the figures graphed above see http://www.calculatedriskblog.com/2009/03/housing-starts-rebound.html

What chance a US depression - update

A couple of weeeks ago I did some back of the envelop calculations on what the likelihood of a depression (as defined by a > 10% drop in real GDP) is in the US. I concluded:


"Based on all that I'd guess a 50-80% chance of depression. Let's say a 2 out of 3 chance. Certainly even being optimistic I'd find it hard to argue for a less than 50% chance. That's a scenario worth taking seriously"


Since then I've gone back and looked at various current figures on real GDP and found to my surprise that real GDP has only dropped about 1% since the start of this recession. It has just flat lined for about 15 months. Given this, I now believe it is less likely we're going to suddenly fall off the edge of a cliff and have a 10% plus GDP fall from here. So I'd say that given the impact of simultaneous crashes in stock and housing markets along with a financial crisis the powers that be have done a pretty good job at avoiding a real crash in real GDP (though a real bad job in piling up problems for the future and bailing out the undeserving and increasing the likelihood of 10 bad years ahead).

So what's my new guess on the probability of a US depression? Probably 50% maximum maybe a little lower.

On a more practical level I also suggested various actions that may help protect people from the consequences of economic deterioration ahead. Whether we have a depression or a long drawn out period of low growth these actions remain sensible steps in my view.

"1. Save money by finding things you enjoy that don't cost money rather than things that cost a significant amount of money.

2. Give some thought to what you would do if things go wrong for you or your family. e.g. you loose your job and can't find another one, can't get credit, house prices stay down or go lower, stocks stay down or go lower etc.

3. Give some thought to how you might help others if things turn out badly for them. It feels good to help others - here's our chance.
4. Don't go rushing out to buy houses, stocks etc unless you can afford to risk loosing a fair bit of that money in the next few years. Of course even in a depression they may go higher than current prices within 5 years, but who knows, things will be clearer later.

5. Reduce debt.

6. If you're a trader like me be prepared to continue to short the market unless there are some clear early signs of recovery. Given the size and nature of current government interventions be prepared for signs that a recovery stalls and we have a double dip recession like in 1981 then 1982/3 and 1929-33 then 1937/8."

Stock trading update - March 7

In late Feb I summarised my strategy as:

"1. Short SP500
2. Continue to short term trade Australian market with small positions.
3. Watch gold and treasuries markets especially around gold at US$1000 resistance. "

Since then I have:
1. Decreased the size of my size of my short position on US market and opened short positions on the following market indexes Spanish (largest position), French and UK. Basically the eastern European credit problem looks like it might be an issue and that on top of the hosing market related issues and economic contraction there was fast or faster than the US. In addition the European Central Bank has much less power than US Federal Reserve to aggressively take supporting action so they are in a more difficult situation if things continue to deteriorate.

This has worked well as the Spanish market is down 9.5% this month while US market only down 5.8% and The UK and French markets down around 6.5%.

2. Dipped my toe into small gold stocks in the Australian market when it looked like gold was strong. I sold most of the positions as the gold price weakened and manged to get out even through some reasonably good short term trading. Gold has now bounced off 900 and if it can hold above 920 there maybe another attempt to break strong resistance at $US1000. I am poised to jump back in if $920 support holds.

3. Doing a little less of my day trading in small cap stocks and managing to make a tiny bit of money in a steadily falling market which is good.

4. Concluded that there is little commercial property going to be built in the US in the next 2-3 years (in contract to the past year which has been fairly normal due to lags in planning/building etc). so looked for suppliers to the commercial property market in the US to short. Couldn't find any that looked ideal so gave up for now. Need to get back to that.

The economic news is basically still more of the same. Insurance stocks now being hit hard. Certainly there is potential for them to be forced to raise a lot of capital given that they invest premiums in the market before they need to pay them back and asset values have dropped across the board.

There is clearly a possibility of a significant bounce at this part if only because markets have dropped so far so fast. In addition residential real estate and banking stocks have dropped so far that more drops from this point probably won't have much impact on the stock market indexes.

So large falls in the short term probably depend on the market coming to believe that:
a. Commercial real estate is some sort of repeat of residential real estate (hope Geithners stress test include defaults from builders on owners in this area - 25% of banks loans)
b. Insurance becoming part 2 of the banking crisis (again based on asset purchases with money that they need to pay back in the future - in this case to policy holders).
c. More panic in credit markets.

If not we could have a bounce despite continuing deterioration in economic conditions.

What odds a depression in the US?

Economist Robert Barro looked at international data on stock market crashes of greater than 25% to see whether they were associated with depressions. He defined a depression as a fall in real GDP of greater than 10%. These depressions lasted on average 4 years. He came up with a 20% probability of a depression based on this data. For more detail see
http://online.wsj.com/article/SB123612575524423967.html

I thought it was an interesting but fairly simplistic approach. Let's do some quick guesstimates based on a wider and more relevant range of data.

1. He just looked at stock prices data and looked at declines of over 25%. Would have been more interested if he looked at declines over say 40% or 50% as we know the current decline is at least that large adn possibly much larger . Presumably you'd get much higher odds of a depression in situations with larger stock price declines. I'd guess he'd get maybe 30-40% odds of depression based on a stock market crash of over 50% - which is where we are now.

2. Also would have been convincing if he'd looked at real estate prices as well. My understanding is that real estate price declines of current levels haven't occured since the great depression in the US so on that basis you'd probably have to give the odds a lot higher than 20%. Given that you're batting 1 for 1 on the impact of large real estate creashes you'd have to say 50%-100% chance of depression but obviously a sample of 1 isn't much of sample.

3. A few months ago I looked at sharp (>30% in real terms) declines in real estate prices over the past 25 years in many countries. What I found was interesting (I haven't got the figures here but from what I remember):

- Finland - depression
- Sweden - avoided depression with prompt action and also no other countries around in trouble
- Asian crisis - data for 6 countries - 5 out of 6 countries depression
- Japan 1990's - 10 years of extremely low growth so don't know if it qualifies as a technical depression but it counts for me
- 6-8 countries just had severe recessions associated with their house price slumps.

On that basis you'd have to say 8/16 equals 50% chance of depression.

It would also seem sensible to add in what we already know about the current situation, as summarised in points 4-6 below.

4. The world wide nature of the current situation means the usual method of exporting your way out of a credit related problem does not exist. If you restricted your data to the periods of worldwide contraction for your large stock market and real estate market situations you're almost certainly going to get much higher odds but it's obviously going to make your data set smaller. On this basis maybe 60-80% chance of depression.

5. We have a simultaneous large fall in the stock market and the resident ail real estate market - having both together rather than just one is going to increase the chance of depression. On this basis maybe 60-80% chance of depression.

6. What do we know currently about this recession:

- it's already had the longest postwar recession
- the banks are still in trouble
- rapid economic contraction at this point in the US and worldwide
- no sign of any turnaround in any major industry
- massive oversupply in residential and commercial property
- the first negative quarter of earnings since 1936
None of this suggests GDP is going to do anything apart from decline fairly rapidly in the next 6 months and that is then getting us pretty close to but probably not quite in depression territory. On that basis say 50-60% chance of depression on the basis of the current situation as we could still turn around before we reach that point.

So, to summarise the above 6 points, my guesses for the chance of a depression (defined by 10% minimum drop in real GDP over an average 4 year period) are:

1. Large stock market crashes - suggests 30-40% chance of depression

2. US large real estate market crashes - suggests 50-100% chance of depression

3. World wide data on large real estate market crashes - suggests 50% chance of depression

4. Worldwide data on large stock market and real estate market crashes that are synchronized with each other around the world - suggests 60-80% chance of depression.

5. Simultaneous large drops in real estate and stock market - suggests 60-80% chance of depression.

6. Looking at the current length, depth and trajectory of the recession so far - suggests 50-60% chance of depression.

Based on all that I'd guess a 50-80% chance of depression. Let's say a 2 out of 3 chance. Certainly even being optimistic I'd find it hard to argue for a less than 50% chance. That's a scenario worth taking seriously.

What are the implications of this.

1. Save money by finding things you enjoy that don't cost money rather than things that cost a significant amount of money.

2. Give some thought to what you would do if things go wrong for you or your family. e.g. you loose your job and can't find another one, can't get credit, house prices stay down or go lower, stocks stay down or go lower etc.

3. Give some thought to how you might help others if things turn out badly for them. It feels good to help others - here's our chance.

4. Don't go rushing out to buy houses, stocks etc unless you can afford to risk loosing a fair bit of that money in the next few years. Of course even in a depression they may go higher than current prices within 5 years, but who knows, things will be clearer later.

5. Reduce debt.

6. If you're a trader like me be prepared to continue to short the market unless there are some clear early signs of recovery. Given the size and nature of current government interventions be prepared for signs that a recovery stalls and we have a double dip recession like in 1981 then 1982/3 and 1929-33 then 1937/8.

If there's no depression what have you lost by taking these actions - very little. Maybe you are a little less wealthy then you would have been but presumably the economy will be OK so you'll be OK as far as making a wage etc.

However, if you choose to assume the best and fail to plan for trouble, you could find yourself in a difficult situation in an economy in which there are few opportunities for improving your financial, job and debt situations.

If China recovers who benefits?

Stocks worldwide had a one day bounce after 2 weeks of strong and consistent losses in most markets. The reason for the bounce – speculation re more China stimulus and on past China stimulus working.

How is China doing economically right now?

China growth last quarter of 2008 was 0%.
1. Indications from other countries about the fist 2 months of this year gives little hope there will be a bounce in economic growth in China this quarter.
2. China has large overcapacity in capital goods at the moment due to a huge buildup on the assumption that economic growth would stay strong worldwide. E.g. in Shanghai at normal yearly leasing rates there are 14 years of supply standing vacant.

So in summary as far as we know China is not growing and has no need for more capital goods – apart from what the government may pump in.

Who will benefit from the Chinese governments stimulus?
1. People with the Chinese government connections – i.e. the Chinese.
2. Suppliers of raw materials – Brazil, Australia.
3. Suppliers of low end goods – other SE Asian countries.

Who will not benefit?

Countries that supply capital goods and high end consumer goods to China – Europe, US etc. China doesn’t need more robots (they have plenty that are standing idle); they don’t want a lot more high end consumer goods (they are seeing contracting rather than growing wealth at this point, same as everywhere else).

What action does this suggest?

If there’s going to be a significant rally in equity prices (say greater than 10%) on the “China will save us” idea then I will
1. Short Europe and US stocks – as the economic data that follows will show the hope was misplaced.
2. To the extent that oil and commodity prices look to be rising in a sustained way and there are signs of growth in China’s economy; I will go long Australian mining and oil stocks.