How To Survive The Coming Market Crash
If we have an atom that is in an excited state and so is going to emit a photon, we cannot say when it will emit the photon. It has a certain amplitude to emit the photon at any time, and we can predict only a probability for emission; we cannot predict the future exactly. —Richard Feynman This week, the S&P 500 finally broke through its 2,100 level, despite a huge influx of negative earnings reports . Though it failed to hold, the resistance has been tested. We ask whether the fundamentals of the stocks in this index could justify a true breakthrough of this resistance level. Much of this 7-year rally has been bolstered by central bank stimuli and stock buybacks. Both of these catalysts are coming to their ends. Most notably, as pointed out by Seeking Alpha contributor Gary Gordon, corporations are abandoning their buyback programs as a result of debt concerns. The next market crash will inevitably be labeled a “debt” or “balance sheet” market crash – allow me to explain: The Japanese market crash of the 1990s was caused by companies selling their assets to pay off debt. Individually, each company was doing the logical thing: Cleaning its balance sheets. However, when the majority of corporations engage in this action at once, you have a situation in which no companies are borrowing – despite ZIRP. The quiet liquidation of assets to pay off debt leads to a market crash that is stealthy at first but quickly turns into a landslide. The problem in the current market is investors’ ignorance of such an activity in favor of the go-to data, such as strong nonfarm payroll reports and interest rates. When we see such positive data, we feel the equity prices are justified. The problem is that if the economy really does look good, the Federal Reserve (the Fed) will have no choice but to “slow things down” by raising interest rates; and we all know what happened last time the Fed raised rates. That is, we are in trouble either way. On the one hand, if the fundamentals as per company activities and earnings look bad, the market should react negatively. On the other hand, if economy data supports a strong economy, the “data-driven” Fed must raise rates, which will cause a market correction. It seems that in either case, the 2,100 level of the S&P 500 should not hold for long. From a technical standpoint, the S&P 500 is stuck between 1,810 and 2,134. If this condition holds, we have much more downside at the 2,100 level than upside; i.e., a downward movement can bring us down 300 points but an upward movement is unlikely to bring us up more than 30 points. One problem with earnings being so poor is that the drop in earnings necessarily raises the P/E of stocks in the S&P 500. We are looking at an average P/E of 25. Falling earnings should be seen as a warning sign that the P/E is on the rise – that stocks are becoming increasingly expensive. The natural – logical – reaction would be to sell stocks and instead short stocks or buy bonds and other non-correlated investments, such as gold . Still, the market could continue to rise, as a result of short squeezes and algorithmic trading, which makes up 50% of the market’s trades. A new all-time high could be on the horizon, but it would be historical: The first all-time high created by a short squeeze, not by fundamentals. The question we must ask now is whether a reversal is also on the horizon. Thesis Corporate debt will be the catalyst for the next market crash. This market crash will be the result of balance sheet recession, which was the same type of recession that caused the Japanese market crash. This type of crash is fueled by debt: Corporate debt reaches all-time highs Companies begin to default Other companies begin paying off their debt out of fear To pay off this debt, assets are sold (this is where the crash begins) Borrowing slows The government lowers interest rates to attract borrowers Monetary policy fails because it relies on the assumption that borrowers always exist The economy grinds to a halt Investors move their capital into savings and precious metals, as bonds and equities no longer pay off Food for Thought Balance sheet recessions are basically invisible because only two groups of people look at balance sheets: fundamental investors and creditors (banks). The latter group only wants to know the probability that a company will default. The former group only sees the trees – not the forest. To put it more clearly, think of it this way. If you’re an investor looking at company ABC and you notice ABC paying off debt, you’ll think of this as a bullish indicator. After all, paying off debt is the responsible thing, especially when the company’s debt is at record-high levels. However, the point of a company is to invest your money better than you can. If that company is not investing but paying off debt, it is ignoring its main duty. In addition, paying off debt is not part of the growth cycle of a business, and a company spending its money to reduce debt is therefore not a worthwhile investment. As for how this relates to a market crash, investors look at companies individually. Rarely would an investor note that the result of a massive number of companies engaging in debt reduction equates to a lack of borrowing, which equates to the government engaging in new fiscal and monetary policies – the latter of which fails during the beginning stages of a balance sheet recession, and the former only softens the blow, delaying the inevitable. When we step back and look at company behavior as a whole, we begin to see the forest: Paying debt when interest rates are near-zero is the sign of a recession. What spurs debt reduction? Defaults, exposure to debtors at risk of default, and heightened overall default risk. Food for thought: Click to enlarge The Contrarian Strategy We should always be hedged against a Japan-like market crash. But going short on the S&P 500, such as via the SPDR ETF (NYSEARCA: SPY ) could be dangerous during a phase in which government intervention and short squeezes could bring us to new highs. Instead, I recommend a ratio back spread: Click to enlarge Here, we short an out of the money (OTM) put option with a near strike price and buy two OTM put options with a far strike price and long expiration date. This position is taken when we think a large downward movement will happen in the future for SPY but simply cannot pinpoint when. Here, we are delta neutral and theta positive, which means that the small, daily fluctuations of the SPY will only help us profit via time decay. However, once a large downward move takes place, we will see the profit of the above option strategy skyrocket, as the delta for the bought put will increase much more quickly than that of the sold put (note how gamma is negative). Vega is high, implying that any volatility change in the SPY will lead to an increase in the above spread. With market volatility at a relative low, now is a good time to open such a spread. We only need to do one thing to manage the spread: Roll over the front-end put every month. That is, every month, sell a monthly put option that is roughly $10 out of the money. In this way, we keep the strategy delta-neutral and theta positive. Happy trading. Learn More about Earnings My Exploiting Earnings premium subscription is now live, here on Seeking Alpha. In this newsletter, we will be employing both fundamental and pattern analyses to predict price movements of specific companies after specific earnings. I will also be offering specific strategies for playing those earnings reports. In our last four newsletters, have accurately predicted earnings beats 100% of the time. In the most recent newsletter, we predicting how Microsoft (NASDAQ: MSFT ) will react after its upcoming earnings report. Request an Article Because my articles occasionally get 500+ comments, if you have a request for an analysis on a specific stock, ETF, or commodity, please use @damon in the comments section below to leave your request. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.