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The metric used to calculate market overvaluation is interesting but it has little value for predicting a stock market crash. Let's take he last 3 major US crashes:

1987: this crash was caused by automated trading systems which could run wild in the absence of any prevention regulations such as circuit breakers

2000: the collapse of the dotcom bubble

2008: start of the financial crisis caused mainly by opaque credit default swaps and packaged subprime loans

Of those 3, only the dotcom bubble seems to be a bit related to the market overvaluation metric. And even right before the dotcom bubble crash there were plenty of economic guru's who argued that classic overvaluation metrics were not valid anymore because we were now in a 'new economy'.

The other two crashes were caused by black swans; occurrences that nobody was aware of and that were only understood afterwards. Most likely the next crash will be a black swan as well.

No, the 2008 crash wasn't a black swan. It just came from the debt side, rather than the equity side. It was clear this was coming. In 2004, I wrote this, on my "downside.com": [1]

The next crash looks to be housing-related. Fannie Mae is in trouble. But not because of their accounting irregularities. The problem is more fundamental. They borrow short, lend long, and paper over the resulting interest rate risk with derivatives. In a credit crunch, the counterparties will be squeezed hard. The numbers are huge. And there's no public record of who those counterparties are.

Derivatives allow the creation of securities with a low probability of loss coupled with a very high but unlikely loss. When unlikely events are uncorrected (I meant uncorrelated), as with domestic fire insurance, this is a viable model. When unlikely events are correlated, as with interest rate risk, everything breaks at once. Remember "portfolio insurance"? Same problem.

Mortgage financing is so tied to public policy that predictions based on fundamentals are not possible. All we can do is to point out that huge stresses are accumulating in that sector. At some point, as interest rates increase, something will break in a big way. The result may look like the 1980s S&L debacle.

It took longer than I expected for that to kick in, but it happened.

[1] http://downside.com/news.html#comingmortgagecrunch

The Economist had strings of articles on this, about how the models used to price vast sums in derivatives were fundamentally flawed, the risks to the financial system, lack of regulatory tools to address possible issues. Warren Buffet famously called CDS/CDOs weapons of financial mass destruction. But when people are making money and everything looks sunny side up, warnings like yours are rarely heeded.

so "black swan" is a paradox. a black swan is when something that happens outside of the models. it being in YOUR models means it wasn't a black swan for YOU.

as such there are probably no such things as black swan events. I mean, until there is. Its more like Schrödinger's swan.

For this kind of event, you can see the pressure building up well in advance. Often, it's not clear what's going to break, but at some point, something has to give. A real "black swan" event was Hurricane Sandy. Flooding of Lower Manhattan was not expected.

What looks risky now?

> 2009-05-31 - Conventional wisdom

>The future is now in the hands of political forces. We can't predict that from fundamentals. So we have no further predictions at this time.

So diversifying ones portfolio based on ones portfolio exposure to "political risks"? Usually you see people trade on that in currency markets? If most of ones portfolio is dominated by a single currency (and hard to liquidate to another asset?) one will have the most exposure to the political risks in that particular locale?

That reflects the TARP bailout and the Fed's policy on interest rates. The Fed bailed out the banking system by lending money to banks at very low rates, which they could then profitably re-lend at much higher rates, allowing banks to pay back the TARP loans. My point was that this was a political decision, one not predictable by financial analysis.

Through all that neither the dollar nor the Euro moved all that much compared to other markets. Housing, oil, stocks, and gold all moved more.

student loans.

The government owns student loans.

> The government owns student loans.

To back up your point, the US federal government guarantees the vast majority of the student loan market: https://fred.stlouisfed.org/series/FGCCSAQ027S

I believe the total student debt market is estimated somewhere between $1.3-1.4 trillion these days, so at least 77.5% backed by US taxpayers. I don't know what TARP topped out at, but I doubt it was 75% of banking assets.

A) not all of them.

B) the government owned the mortgage debt, given that they paid it.

I think the main question is how to get access to capitalize on the downside risks of A).

- Find out who has exposure to student loans portfolios and what percent is non performing?

- Find out what other assets A) is holding that will have liquidation pressure if *-swan occurs?

- What extent is B) tied to A)?

- What pressures B) would face long term due to non performance of student loans that would influence A) and the larger market of assets under the jurisdiction of B)?

- How much could be made from theoretically capitalizing on the downside risks of A) vs other assets in the mean time?

Subprime auto loans.

I see this as fundamentally different, mostly because it is far easier to repo a car and auction it off than it is to foreclose on a house and sell it to someone else.

Another thing is that no one is wildly pricing cars; the fact that lots of subprime people are buying cars does not drive up the price of cars for everyone else. Thus, if a whole bunch of subprime borrowers default, the rest of us aren't sitting there with a car that's actually worth a quarter of what we thought it would be worth.

We also don't keep an enormous share of our equity in cars the way that we do in housing.

True. Except it may be able to be used as a proxy for larger economic issues. If borrowers are defaulting on their car loans at a higher rate than usual, it begs the questions: "why" and "why now"?

Everything based on crypto currency.

It only counts if it's something that's riskier than it seems. Everyone knows cryptocurrency is extremely risky, the problem in 2008 was that these packaged mortgage products were far riskier than they appeared, far riskier than they were rated by Moody's, S&P, etc.

Maybe you only meant your comment as snark, but if not it's important to understand the difference between simple risky investments and potential structural flaws in the finance system, like the ones we saw in the financial crisis.

Do you think there's another housing bubble now?

To answer that, look at the ratio between median house price and median income. Historically, that's around 2.2. Freddy Mac says 3.5 is the new normal. It got up to around 4.7 before the 2008 crash, and peaked around 10 for California.

This is a measure of whether people can make their mortgage payments. When that ratio gets too high, foreclosures rise.

The Economist has an interactive chart, but, annoyingly, they don't let you see the absolute ratio number, just its trend.[2]

[1] http://www.freddiemac.com/research/insight/20160531_how_to_w... [2] https://www.economist.com/blogs/graphicdetail/2016/08/daily-...

I don't see it.

"occurrences that nobody was aware of and that were only understood afterwards"

Umm, I'm no genius but I was managing my mother's money at the time of the 2008 crash. It was very obvious to me that there was going to be a crash, I pulled out of the market in late 2006 and didn't lose a dime in the crash.

I think the better statement is "The 2008 crash was obvious but many people were in denial".

Again, I'm not a financial wizard, I could just see the writing on the wall on that one, everyone was getting approved for houses they couldn't afford, you just knew that was not going to end well.

You can see the writing on the wall now, with stocks being pumped up around the world by central banks and with margin debt at an all time high.

The problem is, it could be years before there is a collapse, or it could be tomorrow. That's a lot of yield you might be losing out on. A near similar argument could be made in 2014. You probably could have doubled or tripled your money in that period.

And even if there is a correction, not all equities will decline significantly (some will stagnate, or just decline a few percentage points, some will still double), whereas others will lose 80% of their value.

> The problem is, it could be years before there is a collapse, or it could be tomorrow. That's a lot of yield you might be losing out on. A near similar argument could be made in 2014. You probably could have doubled or tripled your money in that period.

All true. I think what makes sense then is not to get out of the market entirely, but depending on your risk tolerance, simply re-balance so that you own less stocks at a time like this, while holding more cash or alternative investments.

Look into structured notes. You can get some gains with sort of an insurance policy.

I just started reading about structured notes.

How does one go about actually purchasing them? It doesn't seem they're available through typical online brokers like Etrade or Scottrade.

Predicting a crash is easy but timing it with accuracy is extremely difficult. In fact you were two years too early and lost out on a lot of potential return.

There will always be a crash/correction. Easy. But when?

Completely agree. Yeah luckydude I can say with 100% certainty that if you took all of your money out right at this moment, you won't lose any money in the next crash. Give me the nobel prize in economics guys.

unless the 'next crash' is runaway hyper inflation.

Great point! Important to look at crash in real, not nominal, terms.

More: https://en.wikipedia.org/wiki/Money_illusion

The correction will happen immediately following the moment the tape prints it. It always has, it currently is, and will continue to do so in the future.

The problem is people aren't watching the tape. It's thought of "too hard"(by those who fail), which is another way of saying their net ability is inadequate for a career in trading.

The market has always told us what it is going to do, seconds before it happens. You have to be willing to watch those seconds though, and capable of interpreting the tape during them... 1 day candles? too late. 30m candles? too late. 1m candles? maybe, but overall too late. The timeframe you are looking for is "real time", which is present in time and sales(and nowhere else). Anything else is inadequate for consistent profitability, but there is no shortage of people failing to be the exception.

You did well (you are a lucky dude), but I'm sure there was someone else who pulled out in 2003 and looked foolish.

If it was obvious, more people would have pulled out.

A crash is simply the result of it becoming obvious that the market is overvalued, is it not? Everyone heads for the exit at the same time.

Not really, it can be obvious the market is overvalued, to the point where almost everyone agrees this is true, but there is still money to be made and the momentum is still upwards so it keeps getting even more overvalued. A trader doesn't care how overvalued a share is compared to fundamental economics, he cares whether it's overvalued compared to it's likely price tomorrow or in 10 minutes, or in a few milliseconds. Then something happens that makes it real, like Lehmans being unable to meet its obligations.

Yeah, there were a huge number of articles in 2006 with a theme of market doom and housing debt and CDOs being the culprit.

So you pulled out in 2006... When did you get back in? Timing the market is hard...

Like I said, I'm not a financial wizard, so I'm mostly in cash and I've missed some upside. Not completely, have a pile of Apple stock that's done well, but I'm not the right guy to be managing money. So I've moved most of it to a guy at Morgan Stanley that a friend has been using for a long time.

What are you paying, out of curiosity? 1% of AUM?

It varies based on what gets traded. And I don't really know because I stopped thinking about what I was paying and started thinking about what I'm earning. I really don't care what his cut is if I'm netting 3.75-4.0% on average.

If that works for you, that's fine... It's your money. You're probably paying this guy 1% in fees and expenses, minimum.

To be frank, 4% is not good. For comparison, my Vanguard account, which is mainly low cost ETFs and index funds, has had a 11.8% average annual return over the past 5 years.

Enjoying those fees?

Are you in the market presently or have you pulled out again?

Mostly in cash but I would not base decisions off of where I am. Investing is complicated, I've decided I suck at it and have handed it off to someone with a good track record.

There's a proximate vs. root cause argument going on here. In 87 and '00, the stock market was absolutely overvalued relative to historical metrics like the ones linked (and in '08 the real estate market was). It is today too. Now, the proximate causes were not "overvalued" because ultimately something has to "happen" to push an unstable system into a correction.

But realistically the corrections were inbound regardless of the specifics about automated trading, the startup economy, or bank solvency.

There's one coming "soon" now, too. Eventually.

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