What Happens If Stocks Crash?

by: Convex Strategies

I recently wrote yet another bearish piece on gold prices, and as usual the comment stream generated some very interesting discussions. Gold bulls are generally extremely confident in their predictions for the future, and (note I mean generally) tend to believe the global economy is facing dire consequences.

So exactly what negative catalysts do these investors believe we're bound to deal with?

A "Triggering Event"

I've seen this mentioned several times as the potential catalyst for a market crash and/or soaring gold prices.

This is perhaps my favorite rationale for a crash as it exemplifies textbook recency bias. I've been guilty of falling prey to this cognitive bias as well, but we are four years removed from the collapse of Lehman Brothers; some of these market participants would have you believe these events happen once every few months.

U.S. - Check

The failure of another major financial institution or sovereign government is always possible, but is it likely today? U.S. banks are in excellent shape, and essentially all of them passed the doomsday scenario simulated in the recent Fed stress tests (I know, "but how can you possibly believe the evil Fed?").

A common criticism of the stress tests is that they don't account for a collapse in the U.S. bond market. Of course they don't -- the collapse of the U.S. treasury market is nearly impossible. A severely deflationary environment like the one simulated in the tests would likely force a tidal wave of capital into risk-free securities like treasuries (stick with me -- I know how crazy this sounds).

Banks like Wells Fargo (NYSE:WFC), JP Morgan (NYSE:JPM), and even the hated Citigroup (NYSE:C) and BofA (NYSE:BAC) have the best capital ratios they've had in years, and are benefiting immensely from improved credit trends and the rebound underway in housing.

How about Europe?

Europe's banks aren't doing too well, but they're starting to draw upon their massive reserves at the ECB, reflective of a less risky environment; reserves are down 19% since 2010. This money largely seems to finding its way into sovereign debt, evidenced by the strength seen in PIIGS bonds. Earnings have picked up at UBS (NYSE:UBS) and Deutsche Bank (NYSE:DB), and European capital markets are showing signs of life.

What you don't hear about is the transfer of toxic assets to public balance sheets and the large-scale asset impairments that took place as the economic picture in the EU deteriorated. Construction of the ESM and EFSF, and intervention on the part of the ECB and IMF have forced painful writedowns and kept enough liquidity in the system. Funny thing about liquidity: it doesn't cause inflation, especially in the context of an underlying economy that is suffering from deflation. In reality, the expansion of credit on behalf of major financial institutions drives prices higher. That's the key distinction between liquidity and credit.

Much to the dismay of the doomsdayers, even Greece is doing better. The huge writedown they got on their public debt last year has made their burden manageable (at least for now), and the EU seems committed to reinvigorating their economy. Guess Dan Loeb had it right. It's quite profitable to be able to find the good in bad situations.


Honestly, I have no idea, and neither does anyone else. They had to try something, but my feeling has always been that their major issues stem from a rapidly aging demographic and a strict immigration policy. Their companies earn weak returns on equity and they just can't seem to get out of their deflationary spiral.

The federal government can't do that much more in terms of stimulus given its present debt load, and thus it's difficult to align fiscal and monetary policies so that they work together.

Don't forget, Japan had a brief economic expansion under Koizumi, and that didn't last either.

All that said, shorting Japan, particularly JGBs, has been called the widow maker for a reason. My guess is that given the fact that this thing has moved in slow motion for more than 20 years now, and considering how publicized their issues are, the apocalyptic scenario won't play out.

Say I'm Wrong And Stocks Crash

Let's say I've got a poor read on the situation (I'm sure many of you will think I do) and stocks crash. After all, margin debt is at all time highs and we all know what happens when leverage is involved.

We've seen crashes before and we'll see one again. Maybe tomorrow, maybe next week, and probably in the next four or five years. What should we do? Nothing. Except maybe buy on the crashes.

1932 - The Dow drops almost 90% from the peak to 41. 41. Pretty solid entry point.

What happened in 1987, when the Dow (NYSEARCA:DIA) dropped 22.6% to 1,738? Stocks climbed 780% to 15,267.

How about in May,2010, otherwise known as the flash crash? Hell, it only took a few minutes to recover the majority of the gains. We've done quite well since then.

Listen: do your best to own companies that will stick around for the long haul, and if you don't trust your judgment, buy an index fund.

You're not smart enough to call an end to the 237 bull market that is the U.S., but you can certainly be a part of it.


So what's left? Things are moving in the right direction, but we're still dealing with subpar growth in developed economies and most of the emerging markets still seem to be cutting rates.

Stocks (NYSEARCA:SPY) seem to be closer to the end of their abnormally strong bull run than they are to the beginning. Just one year ago, news of a weak GDP print or poor unemployment numbers in the EU would have sent us down 100 points on the Dow. We seem to shrug off more bad news with increasing ferocity, and the "greed" cycle may be underway now that some very public bears have crossed over and funds start to chase returns.

That doesn't mean stocks are fully valued, but we're closer. The mega-caps like Johnson & Johnson (NYSE:JNJ) and P&G (NYSE:PG) may have seen some gains pulled forward as a result of their dividends and safe-haven status, but a lot of the cyclicals and financials are trading at attractive valuations with plenty of upside.

As longer-term interest rates move up, banks like WFC will enjoy expanding NIMs, or net-interest margins, especially since short-term rates are pretty capped. Insurers like Aflac (NYSE:AFL) will finally earn some decent returns on their fixed income portfolios. American corporations, which have locked in extremely attractive long-term financing, will also see the outlook of their pension plans improve substantially. Auto makers like Ford (NYSE:F) and GM (NYSE:GM) are restructuring in Europe and benefiting from pent-up demand here in the States.

It's a good time to be invested. Not as good as 1929, 1987, or 2010, but good. Enjoy the ride.

Disclosure: I am long WFC, F, AFL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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