Boom Bust Boom, Protect Yourself from the Next Crash

Recently I had a chance to watch Boom Bust Boom (streaming now on Netflix). The movie’s aim is to explain the never ending economic cycle of massive speculative increases (booms or bubbles) and then equally as massive decreases (busts or crashes). It’s an entertaining way to digest an economics lesson with songs and puppets and does a very good job of explaining some historic economic crises including the Dutch tulip crash, the British South Sea Bubble, and the stock market crash of 1929.

It then examines the developments surrounding each bubble, what similar characteristics they share, why it seems like they can’t they be prevented. The general gist is under-regulated speculation combined with massive group-think leads to most asset bubbles.

Several economists presented their opinions with the most but the one that seemed to be most responsible for their hypothesis was the economist Hyman Minsky who felt financial and economic regulation go in opposing cycles. When an asset bubble is popped, a crisis ensues and regulation is tightened. The regulations are generally effective and provide a stable economic environment but the new stable environment is soon taken for granted (prior lessons forgotten) and regulations are gradually loosened. This opens the door for the next crises. Since reaction is based on human nature, all economic systems are inherently unstable. The only way to protect ourselves from “ourselves” are to enact regulations which are harder for us undo.

At this becomes the point, the movie loses steam. Other than the great history lesson, it lacks very much on the solutions front since it does not suggest what regulations should be put in place (other than one economist talking about separating banking functions) nor how any regulation can be made more permanent. I’m not going to offer much steam either and instead propose ignoring solutions, instead let’s focus on identifying asset bubbles and protecting yourself.

This should be topic priority since several economists including Professor Robert J. Shiller (who is featured in Boom Bust Boom), feel we could currently be heading for another stock market crash. Here in his 2015 presentation explains his view: Robert J. Shiller: Anxious about the Next Bubble (I also am fascinated by his idea there is a robot fear hanging over the market but since he can not support it with any data it’s kind of moot thus far). If you have less of an attention span but still want to hear Professor Shiller’s views, here is the more edited-for-TV version from CNBC.

It’s hard to argue with him since the data is scarey.

To provide some highlights: At one point in his career Shiller developed a modified price-earnings ratio called the Cyclically Adjusted Price Earnings ratio (CAPE). High levels of CAPE tend to be followed by poor stock market performance over long intervals of time. Here is a graph showing the CAPE from 1965 to 2015:

CAPEAs you can see the United States average over that time frame is roughly 17. In July 2015 however, it reached 27. The only other times in recent history it reached those levels where right before the crash in 2000 and the crash in 2007. We know what happened.

Looking at this information in a different way, we can look at Warren Buffett’s favorite metric, market cap to Gross Domestic Product (GDP):

Buffett Indicator

 

Again you can see the same pattern. The Buffett Indicator has not been as high as it is right now since right before the crash in 2000 and 2007.

Lastly, we can also look at the investor confidence data from Yale’s School of Business:

Investor Confidence

This information was also cited in Shiller’s presentation as the index has not been as low as it is right now since the period leading up to the crash of 2000. It is well below the levels before the 2007 crash as well. Confidence is important because as it weakens it makes investors susceptible to negative news stories about investing and opens them up the possibility of retreat.

Retreat in this analogy equals crash if you’re not following along.

Now comes the tricky part. What do you do?

One quote comes to mind:

“The market can stay irrational longer than you can stay solvent.”

-John Maynard Keynes

And there lies the problem with even the economists that predict these market crashes. Timing is a bitch.

In the CNBC interview with Professor Shiller linked above, he is even asked if he has pulled his money from the stock market and he replies that he has not. The reason has so be that he understands that as long as the momentum keeps moving up, everyone is making money.

In the movie The Big Short, Michael Burry (played by Christian Bale) has all the data and has committed everything he has to shorting the housing market. But as the market is moving as he predicted, his shorts still aren’t paying and he is confronted by nervous investors. He responds, “I may have been early, but I’m not wrong,” to which the skeptical investor responds “It’s the same thing.”

Although Burry ends up making a fortune on the bets, the investor is right. Being wrong about timing can be just as costly, if not more so, than being wrong. But there are also lost returns to consider associated with not being part of the market and you can’t stay on the sidelines earning 1% forever.

I’m also too aggressive and not really that risk averse (although this article is focused on how to not lose a ton of money in the next crash). I could still sleep at night losing 50% so I’m going to keep playing and risk losing. I would of course prefer not to.

So what to do?

The Plan

First I’m going consolidate some of my smaller holdings and then purchase Trailing Stop Orders on each of my positions above $10K.

For those who have not used Trailing Stop Orders before, here is E*Trade’s explanation:

Trailing stop orders are designed to help you protect any gains and limit losses automatically. The order follows the stock’s movement tick by tick so you don’t have to.

With a trailing stop order, you set the stop as a distance in either points or percent from the stock’s current bid or ask price (the bid price for sell orders and the ask price for buys). This is in contrast to a regular stop on quote order, where the stop is set as a fixed price.

After you submit your trailing stop order, the stop price adjusts itself automatically, following (or “trailing”) the stock’s bid or ask price, but moving only in a direction favorable to you, in accordance to the parameters you defined for your order.

As a hypothetical example, let’s say you own shares of stock XYZ (currently trading at $15), and you decide to place a trailing stop order with a trailing stop value of $1. (You can also set this value as a percent.) This means that you want to sell the shares when the bid price falls $1 from the highest point it reaches after order placement. In other words, $1 is the maximum you want your trailing stop level to be away from the prevailing bid price. Your initial trailing stop level, then, gets set at $14 – or $1 below the current bid – and the trailing stop will ratchet up if the stock price rises. If XYZ climbs to $18 without falling $1 at any point along the way, your trailing stop level will rise to $17, moving up in lock step with the bid price. If XYZ then dips below $17, your order will then be triggered and sent to the market center for execution as a market order. In the same way, if the stock had immediately fallen from $15 to $14, your order would have been triggered for execution at that time.

The cost for each of these gems is $9.99 per position and you’re only charged that if the order is actually executed! Otherwise this peace of mind is absolutely free! That’s pretty amazing!