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Posted 1/10/2005
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What Mr. Market can learn from Mother Nature
Financial insanity is gripping the country. Were speculating on everything from stocks and bonds to houses. When a dislocation comes -- and it will -- watch out.
By Bill Fleckenstein
The murderous, devastating, epochal tsunami was not a financial event. But -- to those of us who make our living in markets -- it could not help but provoke thoughts about financial risk.
Richard A. Posner, a judge of the U.S. Court of Appeals for the Seventh Circuit, in a fine op-ed piece in The Wall Street Journal last Tuesday, put his finger on what the new year may hold for our overextended markets: "A disaster that has a very low probability of occurring, but that if it does occur, creates enormous losses."
The judge was alluding to geological events, but he might as well have been talking about financial ones.
The insanity is everywhere
Financial insanity is rampant. Folks are speculating in houses, with many having more than one real estate investment due to the financing thats available and the belief that real estate is now bulletproof. Insanity pervades the stock market generally, and Internuts/single-digit midgets (with no real businesses) specifically. The fact that Google (GOOG, news, msgs) could have a $50 billion valuation is one sign of the times.
If one looks at credit spreads, they are also at record lows. And then I see Fannie Mae (FNM, news, msgs) trading at around $70, barely flinching despite the discovery that the company manipulated its earnings. Whatever people think of the mortgage giants business prospectively, it wont be the same as its been in the past. So, I just shake my head and say, theres not one pocket of insanity -- its everywhere.
Coming back to the earthquake/tsunami analogy, I continue to believe that our stock market is the financial equivalent of an 8.0-plus earthquake waiting to happen. The fact that it has not happened doesnt mean it wont, any more than the fact that the Indian Ocean was earthquake-free for so long meant it was immune to this enormous tragedy. Furthermore, I also believe that the speculation I have been detailing over the course of the last couple of years has only guaranteed that whatever damage is slated to befall the stock market has only gotten bigger by the month.
So, the question you have to ask yourself is: If I knew that a place was vulnerable in the not-too-distant future to an earthquake and tsunami, would I go there? Most likely, the answer would be: Of course not. Similarly: If I knew that a financial market was prone to epic dislocation, would I aggressively allocate money to that market? My guess would be No.
However, the timing of such events is very hard to predict. The longer markets do well (especially in the face of bad news), the more people believe that nothing bad can ever happen. (Of course, sometimes markets defying bad news means the news is going to get better. However, when the news doesnt improve after a market has gone up, the stage is set for disaster.)
All risk, all the time
That is where we find ourselves today with our stock market and, by extension, our real estate market and the economy. I dont believe that there has been a moment in time in the last 50 years where the stock market has been more lopsidedly tilted toward all risk and no reward. And I believe this is the most attractive period to be a short-seller that I have witnessed in my career.
Most folks probably think that the first quarter of 2000 was the greatest moment to be a short seller. But though valuations were insane and the misallocation of capital rampant, problems were just theories." Now we have real problems, including monster budget and trade deficits, a seriously weak currency, rising short rates, a weakening economy and wildly bullish sentiment measures. Combine that with 8,000 hedge funds and 6,000 mutual funds all leaning to the long side, and you have a recipe for a big dislocation in the stock market.
So, when problems start, they are liable to get out of control very quickly. Given that I believe the stock market is a dislocation waiting to happen, the knock-on effect (i.e., the tsunami that comes after it) will be enormous and far-reaching.
It occurs to me that as long as Im talking about analogies, a potential analogy for our stock market in 2005 might be the Nikkei in 1990. I remember that, in the last quarter of 1989 (a year when I was short Japan), the fundamentals started to deteriorate markedly, but the market kept going up. It closed on the high tick in 1989 and opened up 1990 by going straight down -- an unusual occurrence for that market, and something we saw here in America early last week.
Obviously, a few days don't guarantee a trend, but it is a parallel worth considering. With all due respect to everyone whose life was affected by the tsunami in the Indian Ocean, I judiciously submit that that is the appropriate stock market analogy for folks to try to get their minds around for 2005.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money. At the time of publication, Bill Fleckenstein was short Google and held Fannie Mae puts.
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