Financial Implosion? We Think Not

Includes: DBU, DVD, LVL, SEA, SPY
by: Todd Feldman

Do we think there will be a financial implosion in the global financial markets? We do not. Of course, the financial implosion would come out of Europe. However, we do not analyze the details of what is going on in Europe. We analyze behavioral indicators. One of the main components of our indicators is the ability to model memory. The market has a short-term memory and forgets crises and bubbles in the past. For example, at the beginning of 2007 the market had no memory of a large financial crisis. The thought of Lehman Brothers falling was impossible based on our assessment of the sentiment of the U.S. market in 2007. Just a small shake up in our indicators would create a strong sell. This is what happened in March of 2007, and then again in the summer of 2007. At that point our indicators were screaming to sell.

Today, we have the Lehman event still in our rear view mirror. The memory of the financial crisis is still strong. Therefore, market participants are putting a strong weight on the probability of a financial meltdown in Europe, which would bring down the global financial markets. That large weight is a function of what happened in the recent past.

We try to use our behavioral indicators to measure the irrational fear in the market versus the rational. There still exists a lot of irrational fear which is driving volatility. However, we find that the actual risk of a financial implosion is less than what the market believes. In these type of events where the spread between rational and irrational risk is wide, we typically see lots of volatility for several months, then a stabilization period. Let us take a look at the periods where we saw a large spread between rational and irrational fear. These periods include 1978, 1986, and 1994. An increase in the measure signifies an increase in risk.

Figure 1: Behavioral Indicator Comparison 78, 86, 94 compared to 11

The x axis is the number of weeks. It can be seen that in all periods there was a significant increase in the indicator, indicating increased worry. However, afterwards the indicators stabilized over the following year.

How does the current measure compare to the year 1999 and 2007-- the years before major financial market crashes?

Figure 2: Behavioral Indicator Comparison 99, 07 to 11

As you can see, at the beginning of 2007 and 1999 our measures were far more elevated than at the beginning of August 2011. In addition, the indicators increased quickly in 2011, whereas the indicators slowly increased in 2007 and 1999. This is the typical pattern for a financial crisis, not what we see today. We also explain graphs and indicators in our newsletter.

What do we suggest? First, we predict there will not be a financial market implosion. We predict the global markets will trade sideways or increase over the next year. Therefore, we suggest investing in high dividend paying stocks. If the market trades sideways you get your dividend. If it increases you get your dividend plus stock market appreciation. Some of the recommended ETFs include LVL, DVD, DBU, SEA.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.