Some time ago one of our readers (nick: Hoplita10) asked for an article describing one matter: What should be one’s steps when the crisis will hit and the economy will nose dive?

First and foremost I would like to point out that there is no such thing as ‘doomsday’. Yes, there are days when headlines are full of words ‘black’, ‘tragic’, ‘massacre’ and those when stock exchange may lose double digits (Daw Jones lost 22% during Black Monday ’87 but situation stabilized quickly after), but the crux lies somewhere else.

The most important for us is to see the bigger picture and draw the right conclusions. One-day losses during the slump of 2007-2008 did not go over 10% and still after 18 months indexes around the globe lost from 50-80%. Rapid, one-day losses are easy to be stopped by temporarily suspending trades. On the other hand, once the fear is installed among investors – this is unstoppable.

To take the right position is not going shopping after the market lost double digits one day, but instead after stocks become cheap enough that possible potential of further falls will be limited.

How to point out the moment of market comeback? There are number of cues:

1. Economic Cycle

Cycles of stock markets take approximately 7 years. The bull market lasts for 4-5 years after which indexes are just too expensive. “Smart money” escapes from the market initiating the slump lasting about 18-24 months. Fear and panic are the keywords here and this is why falls are much more intensive and take shorter. Greed and reason rules times of the climb.

Three months ago stock exchanges in most countries reached their peaks. After that falls begin. Recap (and keep that in mind): slump lasts for 18-24 months!

S&P lost 8% since its May peak, but the biggest sale recorded on one day was 11%. Bigger losses were found in London – 15%. German DAX lost 22% and Polish WIG lost 16%.

Last two periods of plummet meant loss in total of 60-70%.

2.When stocks are cheap enough?

To state that we have number of factors to look at:

a) Price/Equity – gives you the worth of the enterprise as a ratio of their profits generated by the company. P/E has seasonal fluctuations therefore, better to use Shiller’s P/E. Shiller’s P/E averages profits for the last 10 years. Looking at the US stock exchange (which pioneers global trends) as of today we are just a little bit better than in 2008 when the economic meltdown started and 46% above the slump of 2009. In other words, stocks in the US from today’s levels should drop by at least 30% for us to start thinking about opening our wallet.

Comparison. For the market to be as cheap as after the biggest tumble in 1980 we should wait for another 70% rebate (assuming that companies will still generate profits on their levels until now).

Source: gurufocus.com

b) Margin Debt – the debt taken to buy shares. Relationship of debt to buy shares is simple. If investors think that the stock prices are low enough and the chances are high that they will climb – then they are willing to use debt for further purchases. Money from this loans flow to the market increasing the price of bought stocks. The higher level of the debt secured by shares the higher the prices and the closer we are to the final peak.

Using analogy, the lower the margin debt the closer we are to the slump.

Source: inflation.us

Can you see the analogy? Blue mimics the NYSE index’s performance. Red states the amount of margin debt used to buy shares. Correlation is plain and clear.

Basing on the debt in USD may skew the picture. USD systematically loses due to inflation.

Let’s see then how margin debt looks when we compare it with the USA GDP.

Source: inflation.us

In April this year we saw minimum of marginal debt/GDP which was slightly higher than its evident levels of peaks during 2000 and 2008. It falls for 3-4 months now just like stocks on American exchange.

In case of the 2003 slump – and the one from March 2009 – level of margin debt in relation to GDP equals 1.2%. If the fall which started few months ago will persist for at laest a year then with high dose of confidence we can say that this ration will come closer to 1.2% suggesting the end of the slump in the stock market.

3. There are more analogous factors helping us to evaluate whether shares are expensive or cheap. I could show you only few of them otherwise the article would take tens of pages. The most important here is to understand that your comeback to the market should not happen just after 3-4 rough months. Right now we can read factors telling us the fall period began. This period generally lasts for 18-24 months. If this time it will be the case we should look forward to 2017 as then the real opportunities shall manifest themselves.

By the real opportunities I mean stocks bought for 40-60% of their book price, paying 6-8% dividend with serious potential for growth. Today it is very hard to spot such a chance and even if you can spot one or two – with this market they can be even cheaper!

 

Summary

When market are losing it does not happen in one day or two. It is a process lasting for 18-24 months. Moreover, global falls are correlated with NYSE falls. When serious losses hit the US you can bet that other markets will feel them.

Crises have a tendency to last for some time and simultaneously are very fertile ground for great opportunities. This requires patience, capital and knowledge. Lack of the last component will result in lack of courage to use capital in the right time. Consider going back to investing in stocks when it will not be associated with being totally mad.

 

Trader 21