Can the Market Go to Zero?

Theoretically, the answer is yes – any six sigma event can occur. But if you believe you can lose “everything” as the market goes to zero, you must also believe that the current assets and future earnings of Microsoft (MSFT) and Apple (AAPL) are worth exactly zero. That Dow Chemical (DOW), DuPont (DD), 3M (MMM), Exxon (XOM) and every other S&P 500 (SPY) company has no value today and no prospects of ever earning another cent.

I don’t believe that. We manage the life savings and future security for a large number of clients. They are not calling in a panic asking us to “sell everything” as I believe “market professional” Jim Cramer did on national TV. So if the markets aren’t going to zero, then they must logically halt their decline somewhere between the 8,451 the Dow (DIA), as the most widely-followed benchmark, closed Friday night and zero-point-one. Where might that be?

A reasonable person might conclude it is – somewhere right around here. PEs have dropped to the 10-12 range, yields on quality dividend-paying firms that will continue in business have increased to the 5-12% range. This is the time a rational person might think of as a pretty good time to consider buying, not selling. And that’s exactly what most people are doing. If the average investor is taking this slide with an equal mixture of befuddlement and equanimity, even in the face of that befuddlement, then who’s driving the market lower?

In 1950, 94% of all securities investing was done by individual investors. 6% was mutual funds and other institutions. Today, 24% is individuals – most now on the sidelines, uninterested in selling into such a dangerous milieu – and 76% is institutional. And therein lies one-half the problem. It isn’t these institutions’ money – it’s yours. They have no skin in the game. They are paid whether or not they “beat the market.” They are typically paid a big bonus if they do even incrementally better than the market.

So if the Dow Industrials are off 40%, and they are only down 38%, they get a bonus. Their motivation is different than yours and mine. We lose our future if we panic – they lose their bonus if they don’t try to beat every other pension fund, mutual fund or hedge fund manager out the door. This creates massive volatility as 800-pound gorillas try to crash through the door at the same time. And why shouldn’t they? It’s not their money. To them, it’s just pieces of paper they have to flail around in order to “win” the “game.”

What to do about it?

1. If you are an individual investor, sit tight. Sooner or later the gorillas will stop flailing. Don’t lock in a guaranteed loss and then miss the first 3,000 points of an upturn.
2. Reinstate the uptick rule for short-selling. It served us well for 70+ years.
3. Level the playing field. Ban naked short-selling for everyone. Currently you and I can’t sell short without borrowing the security. “Prime dealers” however – including brokers, banks, and hedge funds whose primary business it is – can short more shares than there are shares outstanding of a company! (And thus destroy a going concern.)
4. Place collars on institutional trading. If the Dow 30 gain or lose more than 250 points in a session, allow individuals to trade to their heart’s content. It’s our money. Restrict institutions to trading blocks of 9999 shares or less and then only via voice or single-order-entry. No computer-to-computer program trading of millions of shares allowed until we are back within the collar.
5. Change the game. Why should some 25-year-old quant testing a new algorithm for day-trading be allowed to manage your 401k or your IRA you’ve entrusted to a mutual fund?
6. As an example, I read on the internet a rational proposal that individuals be allowed to take their 401k and IRA money – which currently must be held by a “custodian” – read institution that may or may not view it as play money – and pay off their mortgages with it. I’m sorry I can’t now find that site to give the individual who came up with the idea credit for it. Why should you and I not be trusted with our own money? Why are we forced to give it to someone who doesn’t respect it nearly as much as we do? This gentleman’s proposal would allow millions of us to own our homes free and clear, thus ensuring no one could take it from us and, without a dime of other taxpayers’ money for a bank-brokerage bailout, would give trillions back to the banks and, via securitization, individual bond-holders who now hold our mortgages. Instant credit fix and instant security for us. To that benefit I would add: it would also vastly reduce the amount of money held by institutions. Restoring a balance of market participants to something like 50/50 rather than 76/24 would be far more beneficial than any bailout, G-8 meeting, or other top-down, “we’re in charge, you can’t be trusted with your own money” plan.

I said therein lay half the problem. The other half is our relationship with the media. Every hurricane has to be the biggest, the worst, the most virulent. Every auto accident has to be the most grisly, every car chase the most dangerous ever. Give it a rest, folks. We’ve had market declines before. We will again. Turn off the TV and don’t bother reading any financial headline colored in red or set in type larger than ¾ inch. Do you think Benjamin Graham would have cared about screaming headlines? Do you think John Templeton used them as anything but a contrary indicator? That Warren Buffett cares that a bunch of institutions are acting stupidly, or gives it greater credence simply because they are in unison?

Value will out. As Ben Graham said, “In the short run the market is a voting machine. In the long run it is a weighing machine.”

Let’s just not miss this opportunity to stop the madness emanating from past wrong-headed decisions to wrest our financial future away from our responsibility and place it in the hands of institutions. Let’s take back our markets.

We’re doing our part at Stanford Wealth Management – on Friday we closed our short ETF positions that we disclosed ownership of in our 2 April 2008 Seeking Alpha article, “A Bear Market By Any Other Name.” (Those short ETFs were UltraShort S&P (SDS), UltraShort QQQ (QID), Short Emerging Markets (EUM), UltraShort Emerging Markets (EEV), and Short SmallCap600 (SBB).) Tuesday morning, win, lose or draw, we will be buying ETFs for the Dow (DIA), Nasdaq (QQQQ), and S&P 500 (SPY). It’s time to rebuild.

Disclosure: Long DIA, QQQQ, and SPY

Comments

[moonbat1775:]

"Theoretically, the answer is yes – any six sigma event can occur."

Except the Austrian Economists would call this a "cluster of errors" produced by a systemic fault. This event was predicted don't you know? Or haven't you read mises.org or LewRockwell.com?

A few patches won't solve this problem for long. We want REAL change. And I'm not talking Obama kind of change.

2008 Oct 12 04:18 AM

[flatsixdude:]

I fear for your clients

2008 Oct 12 07:56 AM

[usmctpdog:]

Best real world article I have read in the last month.

2008 Oct 12 10:42 AM

[Joseph L. S...:]

Thank you for your comment, but please don't fear for our clients! We are on record at Seeking Alpha recommending short ETFs in April. In our full disclosure in the last paragraph above, we closed them Friday. That's been a pretty good ride... (I can't typically reply to individual posts because I need to get back to our clients' portfolios, but this one did make us wonder what flatsixdude might have been refering to!)
JS

2008 Oct 12 01:12 PM

[aby1366:]

If a zero state does occur then one could bet no market would exist due to a panic environment. Who could trust anyone in that climate?

2008 Oct 12 06:28 PM

[Moon Kil Woong:]

Well the SEC allowing banks to value all illiquid assets at anything they want like they did this weekend is a good start to making the market completely irrelevant. A 0 value is a completely unknown value the same way the $61 trillion in CDS contracts could make the $71 trillion in US assets - the $15 trillion in known debt add up to less than 0. I suppose it would be about correct give or take a few trillion.

2008 Oct 13 12:28 AM

[Smarty_Pants:]

Two comments:

1) Banning short selling for market makers will result in great increases in spreads on options, which is the equity equivalent of increasing the cost of insuring debts. Prices on put options would be especially impacted as the market makers offset any short put positions with delta neutral short equity positions until they can buy those puts back on the other side of the spread. This may not affect your portfolio, but it introduces extra costs/risks in the market for a great many. Next time you wanted to use puts to 'insure' your long positions you would find out it costs a lot more than you expected.

2) Why do people always insist that driving a stock's price down is injurious to the company? If IBM were suddenly repriced to $1/share does the company suddenly earn less? Is their property worth less? Do their sales plummet? NO! They have already received the money from selling those shares and the price after that has zero impact on their operations other than to provide a wonderful opportunity to buy stock back and improve returns to shareholders. Don't blame poor company performance on falling share prices. To do so is to put the cart before the horse.

2008 Oct 14 10:38 AM

[User 283135:]

So, after you told us the bottom was in in Oct. and to sit tight, not we're supposed to believe you when you say it's in now? Sorry guy; but you are just as vested in the continuation of the status quo (read: not your money to lose), as the "money managers" you mock.


On Oct 12 01:12 PM Joseph L Shaefer wrote:

> Thank you for your comment, but please don't fear for our clients!
> We are on record at Seeking Alpha recommending short ETFs in April.
> In our full disclosure in the last paragraph above, we closed them
> Friday. That's been a pretty good ride... (I can't typically reply
> to individual posts because I need to get back to our clients' portfolios,
> but this one did make us wonder what flatsixdude might have been
> refering to!)
> JS

Mar 03 08:51 AM