John Taylor: Is Our Version Of The 1987 "Can't Lose" Paradigm Melting Down?

Tyler Durden's picture

From John Taylor, Chairman of FX Concepts,

Questions

Over the past few days Bill Gross at PIMCO made some noise within the financial community comparing the “Bernanke Put”/QE-infinity currently propping the markets to the mid-1980’s concept of ‘portfolio insurance’. Of course, we all know the end result of this failed attempt at investment utopia as portfolio insurance was a primary cause of the 1987 stock market crash for both psychological and practical reasons. We agree in principle with Mr. Gross, and actually made a similar argument last year ahead of the summer meltdown in pro-risk assets. We find it funny and a little sad that so many professional investors now scoff at the notion. Is this time really that different? Is it really that far fetched to believe that the “can’t lose” aura that propelled equities higher over the first half of 1987 is precisely the exact same one that has seen pro-risk markets levitate ever higher since David Tepper made his infamous “win-win” speech on CNBC way back in September of 2010? However, here we are more than two years later and only one of Mr. Tepper’s “wins” has actually come to fruition as despite policymakers best efforts their impact is clearly having less and less impact. How long will free market forces allow this to go on? How long did institutional equity investors give firms like LOR (Leland O'Brian Rubinstein Associates, Inc) in those dark days of October 25 years ago before throwing in the towel in their trust of portfolio insurance and admitting they were not invulnerable investors? Are the markets today heading towards a similar revelation?

The price action over the past few weeks in the wake of the markets getting more from the Fed than they could have ever expected heading into an election is a clue that the times indeed could be a changing. The 1987 paradigm underwent a similar period of choppy trade before melting down. Of course, crashes by their nature are a rare breed and the probability of one occurring is astronomically low. That said, should the S&P 500 fail to hold the 1400 level over the next few days (especially on a closing basis) we wouldn’t wait around too long in anticipation that the modern day version of LOR will save the day. The chart makes it clear that quantitative easing has diminishing returns. Soon they could be negative.

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mrktwtch2's picture

we are going under 1200 by mid march..no matter who wins..

BigJim's picture

 Of course, crashes by their nature are a rare breed and the probability of one occurring is astronomically low.

LOL, what?  Astronomically low? What astronomy is this? Ptolemaic?

SheepDog-One's picture

I guess its along the same lines as 'Dont worry, the unicorns will never stop jumping over the sparkle rainbows...we know that can't happen since they fart gold dust'.

pan-the-ist's picture

He means that things on atronomical scales are generally LARGE not small, unless you're talking about ptolemy who proposed a much smaller universe...

MrPoopypants's picture

Ptolemys system still predicts eclipses with the best of them.

Shizzmoney's picture

Markets down, taxes up.....no matter who wins? 

Time to buy me a house with a loan!

dick cheneys ghost's picture

We should at least test the 666 bottom. Has there ever been a depression where the bottom has not been tested?

swissaustrian's picture

A hyperinflationary depression in Weimar Germany.

ihedgemyhedges's picture

My sex life has been depressed for years and my wife has made damned sure that there's no testing of the bottom......

Obaminator's picture

That last post just made my Day!!! ROFLMAO! god I love ZH's comments!

twh99's picture

If you are testing her bottom, you're doing it wrong.  ;-D

Thisson's picture

Maybe you should test another market? ;-)

Solon the Destroyer's picture

Have you considered using swaps to inflate your -- um -- portfolio?

ToNYC's picture

Lose the wife; Save the Life.

LooseLee's picture

Maybe in local and national currencies, but NOT in the senior reserve currency. Sorry. Won't happen...

Jlmadyson's picture

Negative return on QE.....the end is nigh.

swissaustrian's picture

1987 won't even be visible on long term charts once the crack up boom gets going.

gjp's picture

you mean it hasn't started yet?

swissaustrian's picture

No. This is just the warm up.

DeadFred's picture

I've been watching those rising support lines for some time and we're close. I put my end-of-world levels at about 1380 for the S&P, 13000 for the Dow, 800 for the Russell. We're currently right on it for the Comp and already below for the Nasdaq100. Maybe they can turn it around on support but if you look back on the charts almost all the big drops come from breaking supports like these with nothing below but air. The next few days will be crucial.

reload's picture

FTSE chart 100 is as follows: weekly right on resistance and been there 4+ weeks. A break out = new all time highs by christmas. Daily - top of horizontal wedge formation - support 300 points below at roughly 5500. Hourly - on support and been there since yesterdays sell off. 

Still a lot of complacency, the recent falls are tiny in the big picture.

Of the Humans I know trading for institutions many have missed this summers rally completely or have underperformed by being in defensive stocks. A lot of London Hedge funds are well below their high water marks, so no performance fees or bonuses for a lot this year. Add the increasing regulatory burden, constant threat of redemptions plus less accomodative relationships with prime brokers  and you have a recipe for a lot of fund closures imminently (as widely predicted by `the Tylers`)

A lot of successful managers are going to lay off the juniors and shut the doors for good in the next couple of months. Does it matter? probably not, but any non algo volume is good volume in my book and the market is going to loose some players.

Personaly I think we go full Zimbabwe pretty fast from here.

PUD's picture

Meanwhile..ADP is refiguring how it lies about job data! lol http://www.marketwatch.com/story/adp-alters-method-for-counting-job-grow...

Bold Eagle's picture

Lol indeed. Good luck trying to match fake numbers.

fuu's picture

We have a pair of dimes? REHYPOTHICATE THEM NOW!

Cognitive Dissonance's picture

1987 - ‘portfolio insurance’

2012 - BTFD

JustObserving's picture

It is not a market anymore - the Fed can print up any amount of money.  It is printing $85 billion a month officially (or will be soon).  That is a lot of money to prop up markets.  And if that is not enough, the Fed will print more.

So watch the ramp in the markets when the Fed decision comes out at 2:15 pm EST today.   

You can count on the Fed to print our way to a Zimbabwean prosperity.

JustObserving's picture

Never short a manipulated market.  Besides, homeland security will label you a terrorist.

If the market falls a bit more, the Fed will start buying stocks like in Japan.  

JPM Hater001's picture

I predicted QE would eventually reach negative results 6 months ago.  Dollars in the front door going right out the back door with no economic value.

Duke of Con Dao's picture

I worked for a top IB back in '87. forecasts are like the prophesies of the Oracle at Delphi.

they were only remembered when they were right... the Oracle made thousands of wrong ones...

Rip van Wrinkle's picture

Are you telling me the schmucks in charge get the fact that printing is having little to no effect on your average Joe? In fact it's been having a negative effcet since 2009?

 

They'll print....and print again....and again.....and again. NO politician has the backbone to take the heat. Not even Romney, the closet Democrat.

ekm's picture

Whoever knows something about Pyramid Schemes will easily conclude that 1987 multiplied by at least 3 times is inevitable.

 

sunny's picture

QEternity not working!?!?  A brilliant observation, only  4 weeks late. WAKE UP AND SMELL THE COFFEE!  Nothing like calling a trend a month after it starts and many other called it earlier, brave beyond measure.

sunny

Two dogs's picture

I can see the correlation between QE and the index - but what exactly is the link?

Is it because the Fed has bought crap from financials that are then blowing this windfall on stocks? ie: bidding up prices by actually buying stuff.

Is it because people believe that the above will happen - ie confidence/optimism?

Or is it some other wierd reason?

rosiescenario's picture

It would be interesting to overlay the chart with another one where the medium is either silver or gold.....

adr's picture

Up, Down, Sideways, Leftways, Longways

But I thought Bernankemarkets could only go up and down.

No this is a Bernankevator, it can go anywhere he chooses.

DowTheorist's picture

Truth be said, the fundametals are frightening.

However, I tend to favor sheer market action. As per Dow Theory, the stock market is in a primary bull market. Such primary bull markets have long legs. They aren't just a "tradable" rally. The average gain of a primary bull market averages ca. 40%.

Furthermore, 70% of the primary bull market signals end up in profits.

Even if the current bull signal was a "failed" bull signal resulting in losses (30% probability), this wouldn't be the end of the world, since we would see a bear market signal if markets are to go substantially low. Since the Dow Theory tends to be more responsive than moving averages, sell signals are flashed at ca. 10% from the top. Not so bad and in the meantime it allows the investor to participate in the trend until exhausted. Even right now, if the current correction went straight down, the loss incurred would be of 6.25% (for those holding the SPY).

Thus, the Dow Theory complies with the basic rule of investment: “Cut your losses short, let your profits run”. This is accomplished thanks to the Dow Theory trailing stops. More on them here:

http://bit.ly/OAhUXt

Under Dow Theory, we always know how much we stand to lose whereas the profits are open ended.

Good forecasts, like the one of this article, may be useful in determining the risk/reward ratio of the prospective stock investment. If we believe the forecast is likely to be proven right in the future, we may moderate our profit’s expectations. Thus, not all Dow Theory bull markets are created equal. Some return 80% whilst others return a meager 25%. The macro view may help us determine the odds.

JustObserving's picture

Dow Theory applies to a free market.  It does not apply to a manipulated market where the Fed is interfering and propping up markets at every turn.

Sorry, you will lose your shirt if you apply such theories now.  Gold and silver should be skyrocketing with massive printing all over the world.  Yet they are falling fast.  All free market theories are inapplicable now.

GoldbugVariation's picture

Some opposite points:

+ Corporate profits are at or near all-time highs.

+ Interest rates are close to zero, so it is very cheap for large corporations to borrow new capital.

+ Historic P/E measures need to be evaluated differently when bond yields are this low, as the ability of equities to produce earnings (and dividend yields) is now more valuable

+ The Fed will be doing QE-infinity for at least the next 2 years, that's $1 trillion or so of new money entering the markets each year - the Fed buys MBS, but the people who sold the MBS to the Fed (mostly hedge funds, no doubt) then have cash with which to buy other assets

+ Central banks all over the world are committed to a policy of producing inflation (Draghi's speech in Germany today)

+ The world has changed.  There is a growing consumerist middle class, numbering hundreds of millions if not billions of people, in Latin America, India, China, other large Asian countries like Malaysia, Thailand, Philippines, Indonesia, Pakistan, also in the Middle East, Kazakhstan, Russia etc.  These consumers have assets and income, and little debt.  The market for large corporations is no longer Joe-six pack and his EU counterpart, look beyond your own front door.

I think talk of a colossal crash is misplaced.  I am not ruling out a 10%-20% correction at some point.  Current market weakness is mainly caused by US election uncertainty, no other reason - markets hate uncertainty and the candidates are now running neck and neck.

gamera9's picture

Are pragmatist views welcome at ZH? Maybe it's time to find another dour blogosphere. :(

Clowns on Acid's picture

GoldBug - You left out the variable of Shadow Banking in your analysis above.

I generally agree w/ your analysis / outcomes, however the only reason I see a potential 10 to 20 % "retreat" is that the CB's will step in and begin owning equities outright (instead of just the Indices) if necessary.

The immoral (or is it amoral ?) Fed is creating a huge disequilibrium in the market that has only bad consequences ...at some point going forward.

Of course in trading...timing is everything.

AldoHux_IV's picture

without any real change in the hold central planners have and no real event causing concern (as every other risk event is essentially controlled in this HFT speaker driven "market" by a central planner) then odds of a crash are unlikely unless needed for the central planners to pursue a plan B and by the looks of today's action, look for the markets to grind slowly higher until politicians need a push off the fiscal cliff.

everything else is scripted and unoriginal until real change occurs

LooseLee's picture

David Tepper is a POS Moron....

narmbs's picture

I agree that this is a valid concern, love this blog and read it every day. But to say that you "made a similar argument last year ahead of the summer meltdown in pro-risk assets" is a lot like a broken clock being right twice a day. Yes there is a lot of risk out there, yes this is an overlooked risk, but I am willing to bet if a blog reader shorted the market everytime you "made a similar argument" about risk assets, he'd have lost more than his shirt by now.

hyper-critical's picture

I run a > $1B macro hedge fund. Before you write "good for you, douchebag," check these out:

http://screencast.com/t/LBH5gtbe

http://screencast.com/t/2tK6Wmnj3nzZ

and do a little google research session on VIX Commitment of Traders data. You'll notice the difference in difference in positioning between what are known as commercial traders vs that of speculators has gone parabolic in opposite directions, at 10+ standard deviation record highs for commercials, 10+ record standard deviation lows for speculators.

This unprecedented amount of 'volatility selling' by speculators (undoubtedly leveraged, as investors try to squeeze yield out of anything) and purchasing by commercials, who think their books are 'hedged' because they own correlated cheap d/side protection on their long books is almost EXACTLY like the portfolio insurance fiasco that was the real catalyst for the '87 crash.

The fundamental market making/institutional hedging mechanism acutely broke when Google went offline last Thursday, and you can see its effects in the whippy action both in the market and individual names. (COF, LL flash crashed UP). This results from market makers being short gamma...which is technical and for another day.

Just sayin, even though the market's down 4 out of the last 5 days, implied volatilities are still stupid cheap, so betting on the downside provides a ridiulous risk/reward. Black-Scholes notoriously mis-prices tail risk at cyclical and secular inflection points.