How to interpret my friend's analysis of systemic risk in stock market?
March 18, 2020 4:45 PM Subscribe
My good friend "Deet" made a lot of money in the past month by betting that coronavirus would cause the stock market to go down. He is now cautioning me that there's systemic risk of major parts of the financial sector collapsing. He says I should reconsider my strategy of holding my index funds long-term. Can you recommend some reading to help me understand how to interpret his view?
Long ago, I read that passive index funds are the best long-term strategy, and that active management over a 10-year period will nearly always do worse. I have found that to be the case in my own investing. (Sources: Warren Buffet, Jack Bogle, and "Random Walk Down Wall Street" )
Last month, when I saw coronavirus escape from China and begin expanding across the world, I figured that the stock market would suffer, but I also wanted to stick to my investment strategy. So I didn't touch my portfolio.
My good friend "Deet" has been invested in passive index funds for 15 years. However, this time, he sold all of his stock index funds last month. He moved the vast majority of it into bonds, and used a small part to buy sophisticated financial instruments (international call and put options, which I don't understand). He has made a ton of money so far, in the past few weeks.
He has become increasingly confident and is now making predictions that the market will continue to crash. He says recent actions by the Fed and Goldman Sachs show that there's significant systemic risk. He compares it to 2008-9 when Lehman Brothers fell, and the Reserve broke the buck. He says 2008 was almost the downfall of the entire financial sector, which could've decimated everyone's stock portfolio.
He says we're at a similar juncture now based on leverage and Fed actions, and the system is rigged in favor of bankers who have already exited the market. He says it's risky for me to continue my strategy of holding mainly stock index funds.
I am confused. What he says about systemic risk makes sense. The book "Random Walk Down Wall Street" does mention that various stock exchanges never recovered, e.g. Japan's market crashed 30 years ago, the Holland tulip craze, and other historical stock exchanges. So perhaps this is the time when the US market crashes and never recovers.
I'm not a financial buff, and now I'm conflicted. Part of me thinks that he's fallen prey to the mentality that he has the winning insights to beat the market, and I should dismiss it as irrationality. Another part of me thinks that his analysis of the Fed's actions seem reasonable, so maybe he's right that I should be cautious.
Can you provide any links to reading that would help me understand how to interpret his mentality? I'd like either "here's a well-respected guide on why it's foolish to analyze systemic risk and Fed actions" or "here's how to know that this time we are truly facing the potential sunset-years of the US stock exchange".
Long ago, I read that passive index funds are the best long-term strategy, and that active management over a 10-year period will nearly always do worse. I have found that to be the case in my own investing. (Sources: Warren Buffet, Jack Bogle, and "Random Walk Down Wall Street" )
Last month, when I saw coronavirus escape from China and begin expanding across the world, I figured that the stock market would suffer, but I also wanted to stick to my investment strategy. So I didn't touch my portfolio.
My good friend "Deet" has been invested in passive index funds for 15 years. However, this time, he sold all of his stock index funds last month. He moved the vast majority of it into bonds, and used a small part to buy sophisticated financial instruments (international call and put options, which I don't understand). He has made a ton of money so far, in the past few weeks.
He has become increasingly confident and is now making predictions that the market will continue to crash. He says recent actions by the Fed and Goldman Sachs show that there's significant systemic risk. He compares it to 2008-9 when Lehman Brothers fell, and the Reserve broke the buck. He says 2008 was almost the downfall of the entire financial sector, which could've decimated everyone's stock portfolio.
He says we're at a similar juncture now based on leverage and Fed actions, and the system is rigged in favor of bankers who have already exited the market. He says it's risky for me to continue my strategy of holding mainly stock index funds.
I am confused. What he says about systemic risk makes sense. The book "Random Walk Down Wall Street" does mention that various stock exchanges never recovered, e.g. Japan's market crashed 30 years ago, the Holland tulip craze, and other historical stock exchanges. So perhaps this is the time when the US market crashes and never recovers.
I'm not a financial buff, and now I'm conflicted. Part of me thinks that he's fallen prey to the mentality that he has the winning insights to beat the market, and I should dismiss it as irrationality. Another part of me thinks that his analysis of the Fed's actions seem reasonable, so maybe he's right that I should be cautious.
Can you provide any links to reading that would help me understand how to interpret his mentality? I'd like either "here's a well-respected guide on why it's foolish to analyze systemic risk and Fed actions" or "here's how to know that this time we are truly facing the potential sunset-years of the US stock exchange".
Systemic risk is the risk which you cannot avoid by hedging or diversification. Financial collapse is one of those.
At this moment it appears that there are many companies that have been largely overvalued. They used the money Trump's tax cut afforded them to do stock buybacks. Unfortunately it seems that they got in crazy debt due to the Fed's low interest rates.
When you see companies like airlines asking for bailouts it's because this crisis has caught them with their pants down. Their prices have gone down the wazoo, and they can no longer make the necessary profits to pay their obligations.
Additionally the disruption in China's supply chains, the world's major manufacturing hub, and people having to stay at home have completely destroyed the market.
Your friend probably made a lot of money because he started short selling, which is to borrow stock from someone else sell it at the current price, then buy it again when its value has decreased so that it can be returned to the original owner.
He is possibly buying options to hedge his stocks. That's a big topic however. If you want to know more about how that works, PM me.
I would trust him if I were you. Sell your assets now, markets are in freefall. They've nearly lost all the "value" Trump's administration gave them. He's probably making money because he's a financial expert and knows how to navigate markets pretty well.
posted by Tarsonis10 at 5:35 PM on March 18, 2020 [3 favorites]
At this moment it appears that there are many companies that have been largely overvalued. They used the money Trump's tax cut afforded them to do stock buybacks. Unfortunately it seems that they got in crazy debt due to the Fed's low interest rates.
When you see companies like airlines asking for bailouts it's because this crisis has caught them with their pants down. Their prices have gone down the wazoo, and they can no longer make the necessary profits to pay their obligations.
Additionally the disruption in China's supply chains, the world's major manufacturing hub, and people having to stay at home have completely destroyed the market.
Your friend probably made a lot of money because he started short selling, which is to borrow stock from someone else sell it at the current price, then buy it again when its value has decreased so that it can be returned to the original owner.
He is possibly buying options to hedge his stocks. That's a big topic however. If you want to know more about how that works, PM me.
I would trust him if I were you. Sell your assets now, markets are in freefall. They've nearly lost all the "value" Trump's administration gave them. He's probably making money because he's a financial expert and knows how to navigate markets pretty well.
posted by Tarsonis10 at 5:35 PM on March 18, 2020 [3 favorites]
Don't sell now. Yes its probably going to crash, the US stock market has been way overvalued for a long time and has far too few controls on the kinds of gambling your friend is doing. BUT selling now just solidifies your losses to date. Hang on to your indexes and ride it out. And by ride it out I mean 3-7 years out because this is a big correction and if we are very, very lucky the Feds will crack down of wild speculation so this type of thing will be leas dramatic in the future which will lead to smaller peaks as well as smaller falls. Hopefully anyway.
We're only down to where we were when Trump took office, for perspective. Less than 4 years ago. A lot of individual companies will go bankrupt but your index funds should smooth that out for you.
I also moved almost two thirds of my investments to bonds and cash but I did it a year ago+. This fall has been a long time coming. I have quite a bit left in stocks and I'm leaving it there for now. No point to sell now, you just give a gift to someone else in 10 years when those stocks are worth a lot again.
posted by fshgrl at 5:42 PM on March 18, 2020 [20 favorites]
We're only down to where we were when Trump took office, for perspective. Less than 4 years ago. A lot of individual companies will go bankrupt but your index funds should smooth that out for you.
I also moved almost two thirds of my investments to bonds and cash but I did it a year ago+. This fall has been a long time coming. I have quite a bit left in stocks and I'm leaving it there for now. No point to sell now, you just give a gift to someone else in 10 years when those stocks are worth a lot again.
posted by fshgrl at 5:42 PM on March 18, 2020 [20 favorites]
Ever hear the expression “it’s dangerous to catch a falling knife”?
Just a word of caution regarding “market timing”. This is a thing that is nearly impossible to do intentionally. Some, like your friend, get lucky. But beware of what he is telling you. The sad fact is that no one can predict accurately which market segments may collapse at a given time. Yes, travel and airlines stocks would be a pretty bad bet right now, but for how long?
If you don’t need the money in the next ten years, just ride it out. Warren Buffet is famous for saying “Buy when everyone else is panicking”, with the understanding that you’ve done your research.
posted by dbmcd at 5:44 PM on March 18, 2020 [13 favorites]
Just a word of caution regarding “market timing”. This is a thing that is nearly impossible to do intentionally. Some, like your friend, get lucky. But beware of what he is telling you. The sad fact is that no one can predict accurately which market segments may collapse at a given time. Yes, travel and airlines stocks would be a pretty bad bet right now, but for how long?
If you don’t need the money in the next ten years, just ride it out. Warren Buffet is famous for saying “Buy when everyone else is panicking”, with the understanding that you’ve done your research.
posted by dbmcd at 5:44 PM on March 18, 2020 [13 favorites]
This is an outside context problem, essentially without precedent. You are indexed, if you are properly adjusted for risk in the market across your retirement horizon you should be fine. If you are concerned talk to a certified financial planner who has fiduciary responsibility. Do not listen to randos on the internet.
posted by iamabot at 5:45 PM on March 18, 2020 [9 favorites]
posted by iamabot at 5:45 PM on March 18, 2020 [9 favorites]
The difference between this crisis and the tulip craze is that the market is going down this time because real businesses are reducing their output. This is different than everyone realizing that tulips are, actually worthless!
This is bad in one very real sense (i.e. businesses going under) but good in another (our financial systems are still functional, prices are reflecting real business outcomes).
There are some risks for runaway declines, however. If many businesses default on corporate debt, for example, or if many small businesses go bankrupt or supply chains get disrupted beyond repair.
But, at some point these real business outcomes will stabilize and reverse as the pandemic resolves itself! Noone knows when that will happen or how quickly the reversal will occur.
I think your friend got lucky. She made an accurate call on the extent of the coronavirus pandemic. Before following her advice this time, however, I would spend time deeply understanding her reasoning behind the connections between the pandemic and the broader systemic declines she's forecasting. The alternative is to just follow the (average) advice of literally every other investor on the planet and follow a passive investing strategy :)
posted by The Ted at 5:50 PM on March 18, 2020 [4 favorites]
This is bad in one very real sense (i.e. businesses going under) but good in another (our financial systems are still functional, prices are reflecting real business outcomes).
There are some risks for runaway declines, however. If many businesses default on corporate debt, for example, or if many small businesses go bankrupt or supply chains get disrupted beyond repair.
But, at some point these real business outcomes will stabilize and reverse as the pandemic resolves itself! Noone knows when that will happen or how quickly the reversal will occur.
I think your friend got lucky. She made an accurate call on the extent of the coronavirus pandemic. Before following her advice this time, however, I would spend time deeply understanding her reasoning behind the connections between the pandemic and the broader systemic declines she's forecasting. The alternative is to just follow the (average) advice of literally every other investor on the planet and follow a passive investing strategy :)
posted by The Ted at 5:50 PM on March 18, 2020 [4 favorites]
Best answer: The best book I've read on this is The Myth of the Rational Market. It is primarily a history of ideas and definitely not investment strategy, but it's really good at understanding why the market is clearly wrong sometimes but also why it's hard to make money off of knowing that. (Krugman review of the book if you want an IMO imperfect summary before you read).
The short version is there is literally no way to know. This is a problem caused primarily by real world issues (production and trade will be impacted by the virus) rather than anything people doing purely financial analysis can figure out, but then of course impacted by the way the financial sector works which could amplify the downturn or the recovery. Things may bounce back like crazy in a few years or not recover in our life times. The only thing I can say is your friend doesn't know either.
posted by mark k at 5:58 PM on March 18, 2020 [2 favorites]
The short version is there is literally no way to know. This is a problem caused primarily by real world issues (production and trade will be impacted by the virus) rather than anything people doing purely financial analysis can figure out, but then of course impacted by the way the financial sector works which could amplify the downturn or the recovery. Things may bounce back like crazy in a few years or not recover in our life times. The only thing I can say is your friend doesn't know either.
posted by mark k at 5:58 PM on March 18, 2020 [2 favorites]
I think your friend got lucky. She made an accurate call on the extent of the coronavirus pandemic. Before following her advice this time, however, I would spend time deeply understanding her reasoning behind the connections between the pandemic and the broader systemic declines she's forecasting
If these reasons should happen to involve Reddit, particularly Wall Street Bets, make sure to put both fingers in your ears, chant lalalalala loudly, and run away as fast as possible.
Talk to an advisor or just sit tight with the diversified plan you have: that's the best advice you'll get on the internet
posted by fshgrl at 6:00 PM on March 18, 2020 [3 favorites]
If these reasons should happen to involve Reddit, particularly Wall Street Bets, make sure to put both fingers in your ears, chant lalalalala loudly, and run away as fast as possible.
Talk to an advisor or just sit tight with the diversified plan you have: that's the best advice you'll get on the internet
posted by fshgrl at 6:00 PM on March 18, 2020 [3 favorites]
Best answer: I'm sorry, but your friend is a fool likely to blow his own fingers off, financially speaking. Market timers are simply gamblers, nothing more.
Leave your money where it is. In the event of societal collapse, your volatility plays or 3x-leveraged calls on the Nissei index aren't going to do you any good, either.
posted by praemunire at 6:01 PM on March 18, 2020 [8 favorites]
Leave your money where it is. In the event of societal collapse, your volatility plays or 3x-leveraged calls on the Nissei index aren't going to do you any good, either.
posted by praemunire at 6:01 PM on March 18, 2020 [8 favorites]
The game may be rigged for the bankers, but how long do you think anyone will last in office after letting the Boomer’s retirement savings get wiped out?
posted by Tell Me No Lies at 6:38 PM on March 18, 2020 [1 favorite]
posted by Tell Me No Lies at 6:38 PM on March 18, 2020 [1 favorite]
The best book I've read on this is The Myth of the Rational Market. It is primarily a history of ideas and definitely not investment strategy, but it's really good at understanding why the market is clearly wrong sometimes but also why it's hard to make money off of knowing that
Very little classic economical theory applies to the US markets anymore after 30 years of mandatory investments via 401k and retirements funds. It's too much money looking for a home, basically, and has been for a few decades and that always causes problems. God knows what will happen to the IS markets in the end but free market economics will have fuck all to do with it.
posted by fshgrl at 6:58 PM on March 18, 2020 [3 favorites]
Very little classic economical theory applies to the US markets anymore after 30 years of mandatory investments via 401k and retirements funds. It's too much money looking for a home, basically, and has been for a few decades and that always causes problems. God knows what will happen to the IS markets in the end but free market economics will have fuck all to do with it.
posted by fshgrl at 6:58 PM on March 18, 2020 [3 favorites]
Very little classic economical theory applies to the US markets
I'm not 100% sure which direction you're going here, but since you posted this in response to me I should make clear the book I recommended has nothing to do with classic economic theory and "free market economics" doesn't really apply either.
posted by mark k at 7:30 PM on March 18, 2020 [1 favorite]
I'm not 100% sure which direction you're going here, but since you posted this in response to me I should make clear the book I recommended has nothing to do with classic economic theory and "free market economics" doesn't really apply either.
posted by mark k at 7:30 PM on March 18, 2020 [1 favorite]
The market is significantly down now. It will probably go down further. It will eventually go back up. Smart advice is to buy low and sell high. I would avoid panic selling unless you desperately need the cash.
posted by Slinga at 7:36 PM on March 18, 2020 [7 favorites]
posted by Slinga at 7:36 PM on March 18, 2020 [7 favorites]
I'm going to go against the grain here. Basically no US company has had an earnings call that reflects this pandemic yet. The impact of this crisis is still in the logarithmic growth phase. You can't time markets, and yes, catching falling knives is dangerous, but selling partway down, missing some of the additional drop, and then buying back in - even a month later! - will still net you more than just staying in the market.
That said, if you're going to try to market time, you should do it when you're still 99%+ sure that there's significantly more bottom to drop out. And then more importantly, and this is why people advise you do not market time, you need to put your money back into the market after it falls some more, but before it starts going back up. Psychologically, most people have an aversion to doing this. I came around to it in 2008 - we sold in November, which was late, but even though the S&P had already dropped 35%, we missed the last -12% or so and thus had more $ to put back into the market at the beginning of 2009. But if you at all think that you will wait for things to start trending back up to reinvest, you should not sell now.
posted by deludingmyself at 7:53 PM on March 18, 2020
That said, if you're going to try to market time, you should do it when you're still 99%+ sure that there's significantly more bottom to drop out. And then more importantly, and this is why people advise you do not market time, you need to put your money back into the market after it falls some more, but before it starts going back up. Psychologically, most people have an aversion to doing this. I came around to it in 2008 - we sold in November, which was late, but even though the S&P had already dropped 35%, we missed the last -12% or so and thus had more $ to put back into the market at the beginning of 2009. But if you at all think that you will wait for things to start trending back up to reinvest, you should not sell now.
posted by deludingmyself at 7:53 PM on March 18, 2020
I'm not 100% sure which direction you're going here, but since this in response to me I should make clear the book I recommended has nothing to do with classic economic theory and "free market economics" doesn't really apply either.
Totally agree. There is almost no point in trying to logic the market in the US. Its far too complicated Nd uncontrolled as well as wildly out of whack with actual company worth.
posted by fshgrl at 8:13 PM on March 18, 2020
Totally agree. There is almost no point in trying to logic the market in the US. Its far too complicated Nd uncontrolled as well as wildly out of whack with actual company worth.
posted by fshgrl at 8:13 PM on March 18, 2020
i have about 20% of my savings in stocks that i'd been trying to sell off a little at a time while the market was good, but now i'm just gonna let it do its thing, i.e. crash and burn, and hope it recovers some time in the future. i won't offer advice, but i'm committed to let the value of my own investments plummet to zero. i can't take personal responsibility for the entire system collapsing.
posted by mammal at 8:29 PM on March 18, 2020
posted by mammal at 8:29 PM on March 18, 2020
Best answer: This question is impossible to answer without knowing how old you are.
If you are not within 10 years of your planned retirement (if you own enough equities to refer to it as a portfolio I assume you are planning to retire) I would leave it as is. I didn't touch a thing through 2008-2010 and have never regretted that for a second.
If the collapse is drastically worse than that one and instead of a recession we get a depression, all of us are going to have problems bigger than our 401k's. Including "Deet."
posted by escabeche at 9:23 PM on March 18, 2020 [4 favorites]
If you are not within 10 years of your planned retirement (if you own enough equities to refer to it as a portfolio I assume you are planning to retire) I would leave it as is. I didn't touch a thing through 2008-2010 and have never regretted that for a second.
If the collapse is drastically worse than that one and instead of a recession we get a depression, all of us are going to have problems bigger than our 401k's. Including "Deet."
posted by escabeche at 9:23 PM on March 18, 2020 [4 favorites]
Best answer: In many ways the Covid-19 pandemic is like a forest fire in terms of its impact on the economy. Lots of damage and panic right now, a short period where people look at the ashes - and then recovery. It can be hard to predict which areas would be damaged by the blaze - and it can be equally hard to predict which companies will flourish in the "new shoots" phase: all we know is that some big trees will fall and make clearings for saplings.
Index funds will suffer in the downturn - but they will also be good at automatically getting you invested in the fast growing companies afterwards.
posted by rongorongo at 12:22 AM on March 19, 2020 [2 favorites]
Index funds will suffer in the downturn - but they will also be good at automatically getting you invested in the fast growing companies afterwards.
posted by rongorongo at 12:22 AM on March 19, 2020 [2 favorites]
There is some concern that some ETFs might fail for internal reasons that I don’t entirely understand.
I can’t imagine that the Fed/ECB/BoE will permit any bank to fail outright - they will be bailed out. We might not like the inflationary consequences of that, but I don’t think bank failure should be high on the list of concerns.
posted by pharm at 3:05 AM on March 19, 2020
I can’t imagine that the Fed/ECB/BoE will permit any bank to fail outright - they will be bailed out. We might not like the inflationary consequences of that, but I don’t think bank failure should be high on the list of concerns.
posted by pharm at 3:05 AM on March 19, 2020
I guess it comes down to - what ELSE would you do? Shorting stocks is incredibly risky as a small individual investor. Do you want to invest in real estate at a time when people are likely to be defaulting on rent left and right? Or put your money under the mattress (and run a very real risk of locking in your losses)? This is going to be a huge crash, and I’m sure it’s not over yet, but I don’t know that you have a lot of better options.
posted by mskyle at 6:13 AM on March 19, 2020
posted by mskyle at 6:13 AM on March 19, 2020
How old/far from retirement are you? That’s the key question.
Some of us are/will continue to be putting money *into* the market this spring.
posted by amaire at 8:19 AM on March 19, 2020
Some of us are/will continue to be putting money *into* the market this spring.
posted by amaire at 8:19 AM on March 19, 2020
The market is significantly down now. It will probably go down further.
Yes. Right now 'significantly down' for me means that I lost everything for 2019. It may go down and therefore go back farther than that, but you have to think "would I have pulled all my money out and invested like crazy at the beginning of say, 2017?" If the answer is 'no', then just keep doing what you are doing.
Also, about the best you can do with safe investments is 2%-3%, so if I had pulled all my money out for 2019 with the prescient knowledge, I would have 2019+ 3%. Which is not that much different over such a short period of time.
posted by The_Vegetables at 8:30 AM on March 19, 2020 [1 favorite]
Yes. Right now 'significantly down' for me means that I lost everything for 2019. It may go down and therefore go back farther than that, but you have to think "would I have pulled all my money out and invested like crazy at the beginning of say, 2017?" If the answer is 'no', then just keep doing what you are doing.
Also, about the best you can do with safe investments is 2%-3%, so if I had pulled all my money out for 2019 with the prescient knowledge, I would have 2019+ 3%. Which is not that much different over such a short period of time.
posted by The_Vegetables at 8:30 AM on March 19, 2020 [1 favorite]
Also short term strategies like shorting have significant tax impacts for most of us, so you friends short term big gains are going to come with a tax bill, where as doing nothing has no tax impacts.
But it really depends on your timeline on when you need the money.
posted by The_Vegetables at 8:31 AM on March 19, 2020 [1 favorite]
But it really depends on your timeline on when you need the money.
posted by The_Vegetables at 8:31 AM on March 19, 2020 [1 favorite]
There is some concern that some ETFs might fail for internal reasons that I don’t entirely understand.
ETFs are very low margin and therefore they become unprofitable and liquidate pretty often even in normal times.
posted by fshgrl at 11:48 AM on March 19, 2020
ETFs are very low margin and therefore they become unprofitable and liquidate pretty often even in normal times.
posted by fshgrl at 11:48 AM on March 19, 2020
What's your investment horizon?
If you're looking to retire within the next 5 years, then it's too late - you should have moved out of stocks and into bonds (or a mix depending on your plans).
If your retirement is >10 years out, don't worry about it. Keep your statements unopened and don't look at them for a few years.
Your friend is very lucky in what he did but that does not make him an expert on the stock market or on systemic risk (unless he works in the industry, that is). But if he's a day-trader who got lucky, I would ignore his confidence - that's comes from the money he's made and not from any deep understanding or knowledge of the future.
posted by Arthur Dent at 3:16 PM on March 19, 2020 [1 favorite]
If you're looking to retire within the next 5 years, then it's too late - you should have moved out of stocks and into bonds (or a mix depending on your plans).
If your retirement is >10 years out, don't worry about it. Keep your statements unopened and don't look at them for a few years.
Your friend is very lucky in what he did but that does not make him an expert on the stock market or on systemic risk (unless he works in the industry, that is). But if he's a day-trader who got lucky, I would ignore his confidence - that's comes from the money he's made and not from any deep understanding or knowledge of the future.
posted by Arthur Dent at 3:16 PM on March 19, 2020 [1 favorite]
This thread is closed to new comments.
posted by sandwich at 5:06 PM on March 18, 2020