Tag Archives: housing bubble

The Big Short: Market Genius or Luck?

There are a lot of finance articles lately due to the hype over the film adaptation of Michael Lewis’ book The Big Short.

Interview with Michael Burry, Real-Life Market Genius From The Big Short

Is he a market genius or did he just get lucky? There is evidence of genius, in that between 2000-2008 Michael Burry returned 500% to his investors vs. a flat market, quite possibly the highest return of any fund that decade. Even more impressive, he did not get wiped out in the 2008 bear market, capturing both the bull market and the bear with perfect timing. That kinda throws water on the whole leftist belief that the market is rigged or a scam, or that the only way people make money in the market is with luck, cronyism, or deception instead of skill or talent. Obviously, he had no connections with Washington. He didn’t engage in insider trading. Using his superior intellect, he was able to find slivers of opportunities in a market that is otherwise impenetrably efficient.

But back to the original article, is there a crisis coming? The odds of another crisis are slim.

From a discussion, someone list some possibilities:

1) Some kind of dollar, global reserve crisis that rocks the global economy for a while. Spurred on by the US debt and projected near future large budget deficits due to welfare and entitlement spending.

2) Broader bond market. I think this is a well understood threat, and doesn’t require much elaboration.

3) A specific junk corporate debt crisis. About half of the major corporate defaults in 2015 were US companies, which have levered up significantly on the back of the Fed’s super easy money policies.

4) Another significant drop backwards in the asset bubbles the Fed just got done re-inflating. If the Fed’s policies fail to provide enough to sustain those huge asset classes (real estate and equities primarily), then when they tip over it’ll pull the US economy down into a protracted recession. The global economy is practically in a rolling recession as it is, if the US goes next it would cause a lot more global pain (including amplifying the problems in China and Japan, both big exporters to the US). There’s a real debate to be had about whether the Fed can ever actually create a scenario in which the intentionally inflated assets can sustain (stand alone without Fed props), or if they have to always deflate backwards with a hefty penalty for the market manipulation / forced capital misallocation (which then prompts even more dramatic action at each turn, to try to re-inflate).

Dollar collapse & hyperinflation seems unlikely, for reasons I give here and here. Despite all of the debt, the data suggests America is not at risk of defaulting from a genuine inability to pay; however, a technical default due to gridlock is possible.

The fed balance sheet is big, but interest rates are very low. The fed has posted a large profit, a 30% gain in 2015 for a profit over over $100 billion, which is sent back to the treasury.

Due to the mathematics of the yield curve and the composition of the fed’s holdings, the the odds of the fed losing money on its holdings are low.

“Short-term interest rates would have to rise rapidly to quite high levels — in the neighborhood of 7% — for the Fed’s interest expenses to surpass its interest income. Such an outcome appears very unlikely,” the paper said. In the event that the Fed did face a loss, it could simply hand no money back to the Treasury and, “in the most extreme case, future remittances would also be reduced (and recorded as a change in deferred credit), but the Fed’s capital base and financial position still would remain completely secure.”

Japan has a much bigger debt, they seem to be doing fine. Low interest and strong dollar is due to reserve currency status, flight to safety, emerging market weakness, commodity weakness, petrodollar, the large size of the US economy, and other factors.

Corporate profits are at record highs. A crisis in the corporate debt market would require either a major decline in profits (from a deep recession, for example) or a spike in interest rates, neither of which show any signs of occurring.

Overall though, a bet against the US stock market is probably doomed to fail, unless your lucky or skilled like Michael Burry was. Here’s why:

1. Nowadays, options are priced in such a manner that the expected value of buying out-of-money hedges is almost always negative. This is due to the inflated volatility for out-of-money put options and other factors.

2. It just so happened that the subprime mortgage meltdown coincided with Michael’s career; for the period between 1935-2007, his strategy would have failed. It also would have failed between 2008-present. Maybe it would have worked in 1987, so we’re talking three instances out of a century.* Right now, the evidence suggests banks have reformed their lending practices, with higher credit scores for new homeowners, so the odds of another banking meltdown in America are slim.

3. Then you have the constant stock buybacks, tame inflation and modest valuations, record high profits & earnings that keep growing, consumers that won’t quit consuming, and so on. A totally different landscape than before 2008 when Taleb, Michael, and other bears made their fortunes. I just don’t see a compelling reason for stocks to fall much.

4. A bet against the stock market (especially tech) is a bet against capitalism, technology, high-IQ, and the best and the brightest. Do you really want to bet against Amazon, Facebook, Microsoft, and Google? Do you want to bet against the fed and a billion consumers from all over the world, along with all wealthy consumers from China? I sure as hell don’t. Just because bears made money in 2000 and 2008 doesn’t mean it will work again. It may be years or even decades before there is another a big selloff. For every success story of someone who bets against the market, there are a dozen losers, although no one makes movies or writes books about them.

5. Perpetually low interest rates makes stocks more attractive at a higher valuation than usual. The price part of the P/E ratio is reduced when inflation is very low. When inflation is high, cash is more attractive.

Profitably betting on the collapse of the financial system is obviously much harder than merely betting on a decline. When you restrict the payoff to near default (>80 or greater loss of price of the underling security), the math shows that only 1929 (around that period) and 2008 would have yielded a positive return.

Of course, leftism is to be expected in anything even tangentially related to Michael Lewis, from the article:

The zero interest-rate policy broke the social
contract for generations of hardworking Americans
who saved for retirement, only to find their
savings are not nearly enough.

There isn’t really a ‘social contract’ in the Constitution, Declaration of Independence, or anywhere. There is no document that stipulates that the government owes anyone anything beyond ‘life, liberty, and the pursuit of happiness’, which are intentionally vague. The expanded ‘social contract’, which includes housing, jobs, guaranteed income, welfare, education, healthcare, high interest rates,…etc, is a construct by the left to justify more wasteful entitlement spending, to make the rich feel guilty for not spreading their wealth more than the high income taxes they already pay.

The evidence actually shows that a better returns can be had with stocks than cash (bills). Even with rates at 4%, stocks way outperform cash:

Putting cash into a bank is a poor way to save for retirement, if past performance is any clue.

The ‘hardworking person’ saving for retirement by stashing all his money in the bank may more myth than reality.

The majority of Americans have little to no savings, so the difference between 0% rates and 4% is immaterial if your expenses exceed your income.

The problem is not that interest rates are too low, but rather people suck at personal fiance. But on the other hand, the Paradox of Thrift suggests that it’s ‘good’ for the economy that people don’t save too much.

Those who have more wealth put it in bonds, collectibles, real estate, or index funds. They seldom just keep it in cash.

Another thing that’s kinda annoying are all these people who think their predicting of the housing market bust in 2006 is attributable to some sort of profundity on their part, rather than just broken clock theory.

Contrary to popular belief, many pundits were actually bearish on housing in 2004-2007. Given the enormity of the crash, it makes these predictions seem more prescient than they really were, but such predictions were hardly unique. Of these pundits, very few actually made money betting against the housing market. A Google news search from 2004 to 2006 shows many pronouncements of a bubble or crash in housing, as well as much skepticism of the housing market.

About half of the entries are pessimistic about housing (articles by CNN, NY Times and Bloomberg, Mises Institute, Robert Shiller), and the other half are bullish, dismissive of a bubble, or neutral (Cato Institute, WSJ).

By late 2006, being bullish on housing actually made you more of a contrarian than being bearish. As a rational realist, I’m not too impressed that someone predicted something that hundreds of other people also predicted in that same time period, and then didn’t even act on it by shorting the market. Also, the vast majority of pundit predictions are wrong (like all those failed predictions between 2009-2014 for the stock market to crash and or for a double dip recession), so being right once out of dozens of incorrect calls is hardly a sign of innate skill or prescience at forecasting.

* Restricted only to American financial institutions. Foreign ones have had many more crisis.