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“What Are the Odds On An 80% Stock Market Correction?

Tuesday, February 28, 2017 13:54
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(Before It's News)

“What Are the Odds On An 80%
Stock Market Correction?
by Vern Gowdie
“Another night, another high for
the Dow Jones. Are you excited, nervous or mystified by the US
stock market’s seemingly relentless march higher? If you take the
investor and adviser sentiment polls at face value, it’s ‘game on’.
Bullish sentiment is reaching record levels.
Institutional money-managers are
holding the least amount of cash in their portfolios…it’s ‘all in’.
The Volatility Index (VIX) is showing the heart rate of traders is
far from elevated. It’s flat-lining around the same level it was in
early 2007. Ah, nothing like a little complacency to steady the
nerves, is there? Bets are being taken on how soon the world’s most
famous index will hit 30,000 points.
History (and a certain oracle
from Omaha- Warren Buffett) tells us we should be fearful when
others are greedy. But in the minds of market participants, there’s
really been nothing to fear since Greenspan made this statement in
response to the crash of 1987: ‘The Federal Reserve, consistent
with its responsibilities as the Nation’s central bank, affirmed
today its readiness to serve as a source of liquidity to support
the economic and financial system.’
Everyone knows the Fed has the
market’s back with its quantitative easing and href=
target="_blank">zero interest rate policy.
Why worry? Join the
party. But is the Fed as omnipotent as people think? Or are they
just a gaggle of clueless PhD serial bubble-blowers who masquerade
as serious, know-it-all banker types?
My money- secure in a dull,
boring, unexciting, low-interest bank account- is on the latter.
That’s my bet. The considered wisdom is: Don’t bet against the
Not all bets are
Hillary Clinton was such a sure bet for the
White House, Newsweek didn’t even wait for the official results
before going to print. It was, as they say, a ‘fait
Brexit. It was not going to
happen. The Brits will never vote to leave the EU. Wanna bet on
What about that 2017 Super Bowl
result? The New England Patriots were down for the count going into
the fourth quarter…behind 28 to nine on the scoreboard. No team in
modern NFL history has ever come back from a 19-point deficit going
into the fourth quarter. What were the odds on the Patriots
winning? But win, they did, tying up the game at full time and
scoring the winning points in extra time. Who’da thunk that at the
start of the fourth quarter?
Leicester City were rank
outsiders to win the 2015–16 English Premier League. The team was
so far off the bookies radar they started the season at the
less-than-flattering odds of 5,000–1. Guess what? They won. Beating
high-profile teams like Manchester United and Arsenal for the
coveted trophy.
What are the odds of winning
Lotto? Millions to one. Yet, every week, someone becomes an instant
millionaire. Long odds mean that, on the balance of probabilities,
it’s unlikely to happen…but it can, and sometimes does,
Since 1987 we’ve seen three
substantial market corrections (1987, 2000–2002 and 2008–09)- give
or take. Each downturn resulted in roughly a 50% correction across
the major indices. However, the tech-heavy NASDAQ index took a hit
of nearly 80% after the dotcom bubble burst.
Judging by the latest VIX
reading, the odds on a ‘garden variety’ correction of 50% are
pretty low. Therefore, a correction of 80% is up there with
Leicester City winning the title. No one is expecting it. Which is
precisely why you should be worried. Mr Market loves it when
everyone is looking the other way. That’s when the surprise is at
its greatest. An 80% correction is the market’s Hannibal Lecter
moment…a nice Chianti to go with his liver and fava beans.
Danielle DiMartino Booth- former
Wall Street trader, financial columnist and adviser to the Governor
of Federal Reserve Bank of Dallas for nine years- has written an
excellent book, titled: “Fed Up- An Insider’s Take on Why the
Federal Reserve Is Bad for America.” By way of background, in 2006,
her Dallas Morning News financial column regularly warned readers
of the impending disaster in subprime lending. She’s one smart
Here’s an extract from page 50 of
‘Fed Up’ (emphasis mine): ‘At the top of the [Fed] pyramid now sits
Janet Yellen. Under her leadership, the Fed has struggled to
extricate itself and the American economy from years of policy
blunders that have positioned our economy on the precipice of
another financial crisis that could dwarf that of 2008.’
Got that? Dwarf
This is a former Fed insider. Not some
shock-jock newsletter writer looking for a headline. She was there
when Janet Yellen said in January 2007: ‘While the decline in
housing activity has been significant and will probably continue
for a while longer, I think the concerns we used to hear about the
possibility of a devastating collapse- one that might be big enough
to cause a recession in the U.S economy- have been largely
allayed.’ And when Bernanke proclaimed to Congress in March 2007:
‘…problems in the subprime market seem likely to be
She has seen these bozos up close
and personal. They are theorists. Academics that have never been in
a real job…straight from university to the cloistered, secretive
and unaccountable world of central banking. They’re completely
removed from the impact of the decisions they make- guaranteed
pensions for life, heavily-subsidized in-house cafeterias and
dining rooms. They socialize with other pontificating PhD dreamers
and schemers. These are the people market participants are trusting
to have their back. I wouldn’t bet on it.
How could the next financial
crisis dwarf 2008? Follow the maths.
Stock prices (I’m careful not to
say values, because there is no value at this stage) are a function
of earnings multiplied by a PE (price/earnings) ratio.
A company earning $1 billion X a
PE of 15 = $15 billion.
If there are 15 billion shares on
offer, each share is worth $1.
Not rocket science.
At present, the
cyclically-adjusted PE (CAPE) is around 28x.
In 1982, at the start of the
greatest bull market — and not so coincidentally, greatest credit
expansion in history — the CAPE was 7x.
A fourfold expansion in the
multiple applied to earnings.
Physics tells us that expansion
is followed by contraction.
A company earning $1 billion on
today’s CAPE of 28x = $28 billion.
Should the CAPE contract to its
1982 level of 7x, the company would be worth $7 billion…a 75%
reduction in value, even though the company is still producing the
same earnings.
But what happens if the market
correction also causes a contraction in economic activity and
earnings fall by 20%, to $800 million?
Earnings of $800 million
multiplied by a CAPE of 7 = $5.6 billion…an 80% fall from $28
If PEs and earnings can rise,
then logic says they can also fall. Nothing in markets is ever
A CAPE of 7x (or less), while not
common, is not without precedent — 1921, 1933 and 1982.
Earnings falling by 20% are also
not an everyday event. But in times of financial upheaval,
consumers tend to retreat…so it can happen. When you work through
the numbers, it is possible to construct a feasible scenario where
an outlier event can occur. The market bookies are completely
discounting the prospect of a fall of this magnitude and, for that
matter, of the market correcting at all, which is why the odds of a
substantial correction are not as long as you think.
And remember, long-shots do
Think of Wall Street as the
world’s biggest casino…which it is. If you adopt this mindset, the
only chips you should have on the table are the ones you are
prepared to lose heavily on. If you cannot afford to suffer a
significant loss of capital, cash in your winnings and wait for the
odds to improve in your favour. When is that? When no one can
afford to go to the casino because they have no money left to play
“Be afraid. Be very

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