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As If! Whatever! Party Like It's 1995

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Thursday, 29 November 2018 06:04 PM Current | Bio | Archive

Human memory is fickle. When we tend to look back on the past and reflect, we tend to filter out the small and the mundane. What’s left? The things that left a big impression, good or bad.

Take the stock market of the 1990s, for instance. We see it as an end of history, a Goldilocks economy, the internet boom. While we remember the big bust, that didn’t happen until 2000. So it’s easy to look back on the stock market of the 1990s with rose-colored glasses.

But when you wear rose-colored glasses, all the red flags just look like flags. And there were plenty of warning signs that trouble was brewing while stocks were enjoying huge, bull-market returns.

While the United States was enjoying the end of the Cold War and the peace dividend that followed, other countries faced some major crises. This included countries like Mexico, Thailand — and most of developing Asia in general — and even the emerging Russian economy.

These international crises flared up and mostly out quickly. If you were investing at the time, however, it may have looked a bit scarier.

While this was happening, financial institutions were just starting to get into trouble for being overly leveraged. Although the Glass-Steagall legislation that separated traditional banking from investment banking wouldn’t be overturned until 1999, other financial actors were able to get into trouble.

The worst of the lot was Long Term Capital Management, or LTCM. Using a pricing and risk model developed by Nobel-prize winning economists, the company managed to make market-beating returns in illiquid assets like Russian bonds. Those steady returns were coupled with a high degree of leverage to make the whole thing work.

Until it didn’t. Facing a ruble crisis in 1998, LTCM’s business model showed that what works on paper will stop working at some point — indeed start working against investors in a very big way. Trying to base the future on the past makes sense in mathematics, but not in a dynamic economy that’s built around continually building a better mousetrap.

LTCM would be an incubator for government action. In the interest of keeping the company’s highly leveraged positions from spiraling out of control all throughout the financial system, the Fed brought together the biggest banks, as they would a decade later, to unwind the troubled firm and avoid a market shock.

It worked, although not all the banks called in to buy up part of the troubled company wanted a part. Bear Stearns not only decided not to pitch in, but was a counterparty and triggered the firm’s margin calls in the first place. This likely played a role in allowing Bear to collapse over a decade later.

So am I just being nostalgic for the 1990s or something when a $4.5 billion buyout was a big deal? Maybe in part.

But it’s also because we’re starting to see similar blowups along the way. That tells us the party isn’t over yet, but that investors do need to think seriously about their risks going forward.

So far in 2018, we’ve seen two similar blowups this year. First, in February, investors who were shorting market volatility as a long-term strategy (instead of a short-term one), managed to get themselves in serious trouble, with some even going bankrupt as volatility surged from a near-record-low of 11 to 30 in just the span of a few days.

Most of the damage here was done to individual investors who thought they found a goose that laid a golden egg, providing seemingly safe and steady returns that could be leveraged into big bucks. And while I’m a fan of shorting volatility, I only want to do so after it’s spiked well above its historic average. Shorting volatility at 30 generally makes sense, given its average over time between 17 and 20. But it doesn’t make sense at 12.

Next, in November, a fund that sold naked calls on natural gas contracts, called OptionSellers.com, imploded as natural gas prices spiked in the middle of the month. While selling naked calls on natural gas made sense while prices were falling, it was easy to leverage and build a position that would be difficult to unwind or hedge quickly if things changed. And they changed big, as volatility in that space went from 20 to 67 in the span of a fortnight.

That fund isn’t just underwater. Because naked calls were sold, investors were not only wiped out, they’re still on the hook for more money than they invested due to this huge market move.

I get it, some market moves are unpredictable. But a good investor expects the unexpected and protects themselves accordingly. If you want to sell calls, use covered ones, as we do in our Financial Braintrust Alliance service. That’s not as sexy as levering up on naked calls, but it consistently brings in income and lets us get more money out of a trade than the market may want to give us at the moment.

So am I worried about this market? Not yet. We’re seeing a lot of folks with very leveraged ideas and poor risk management blow up. It’s not a pleasant sight to see, but it’s also the events the market needs to get people to think about — and actually act on — their risk.

So how can you de-risk your portfolio?

You can raise cash. You can take profits on companies that are showing a huge profit but whose future prospect looks more uncertain. You can hedge a long position by selling covered (not naked) calls against it. You can reduce your exposure on the options market to just bought positions, not sold ones. I’ve moved from selling naked puts on stocks to buying calls when I see an opportunity instead. It makes little sense to get caught holding shares of a company at a loss when a company tanks.

But while you’re doing all those things, don’t give up on the market yet. There’s a lot of fear out there, and markets don’t end long-running bull markets like these ones on fear. They run out on greed, which has been in short supply this year. Hang in there, but take some risk off the table.

Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.

© 2019 Newsmax Finance. All rights reserved.

   
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AndrewPacker
So am I worried about this market? Not yet. We’re seeing a lot of folks with very leveraged ideas and poor risk management blow up. It’s not a pleasant sight to see, but it’s also the events the market needs to get people to think about—and actually act on—their risk.
party, 1995, invest, market, risk
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2018-04-29
Thursday, 29 November 2018 06:04 PM
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