“I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [“hard-core pornography”], and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.”
Justice Potter Stewart
The famous quote above is a favorite of mine when attempting to explain what is a bear market. Its a very hard thing to define and most people will disagree with you on any number of points, but after a few years in this industry “I know it when i see it” is all i can really offer.
Given recent events in two notable markets both equities and Oil I thought it might be good to discuss the notion of what many may have heard the term a bear market squeeze. If that term leaves you confused never fear I am here to shed a little light.
A bear market squeeze can be as grizzly as it sounds – especially if you are short. It is the process whereby prices rise at a ferocious rate AFTER a large sell off. Just when you least expect it and things look like Armageddon is really happening they often pop up as if from nowhere leading many to scratch their head in raw utter confusion.
As I aim this blog at those not in the financial industry, chances are many of you have never bought a share in your life consciously ( they have probably been bought on your behalf without you knowing if you contribute to any sort of collective pension plan but let’s keep this simple).
If you have never bought a share in your life it’s highly likely you certainly have not shorted any shares either. Shorting is a foreign concept to many – I personally remember being explained the process on one of my first days in a back office of a large investment bank and assumed my manager was lying to me.
How can you sell something you don’t own? Is usually the first question that arises. In brief here is the process.
- A Large investment vehicle Investor A will purchase shares for indefinite periods of time with a long term horizon for investments. They wish to make it a little more attractive to just buying shares and staying long. Therefore they “lend” the shares to an investment bank or some kind of agent for a fee.
- That agent now has inventory (say VODAFONE SHARES ) that they can “lend” out to customers who wish to go short the stock. i.e. profit from a movement lower in the price.
- Investor B “borrows” the shares from the Agent bank and pays a fee for that privilege (usually 20-50bps of the notional amount annualized). They can now “deliver” shares to whoever bought them from her and not be held accountable for a settlement failure.
- When Investor B decides that they have made enough profit/loss on their short sale they go back into the market and buy back the required amount of shares to flatten off their position and deliver them back to the agent bank whom they borrowed from in the first place and hey presto Investor A still has the original amount of shares in the first place.
Seems pretty easy right – wrong. The market as a whole especially in equities is often geared to being long shares not short them. It’s fair to say that more POWER exists on the long side, i.e. more institutions are geared towards buying shares than selling them. A lot are even explicitly mandated that they cannot sell short shares. Its also more expensive to short shares, as discussed above there are fees to pay just for the privilege to short and these are subject to demand/supply also therefore the worse the stock the more likely you will pay a higher cost to short therefore reducing your return on the trade. This creates a process whereby it can be very dangerous to short shares and it should really be left to the professionals.
So back to the original thoughts on what is a bear market squeeze? Its easier to explain it in terms of something more familiar. Many of you may have bought a house, tried to, thought about it or at least engaged in the process in some shape or another all too varying different outcomes.
In this case if you are a first time buyer you can consider yourself “short” the property market and anyone looking to sell is “long” the property market. Think of what you see around you and what you experience.
Property market is definitely a market whereby the longs have the power as the shorts need to get a house or a place to live and there are plenty of extraneous factors that can go into squeezing the price of a house higher. When you are short the housing the market here are a number of factors that are squeezing you.
- Lack of new supply
- Lack of available credit
- Poor wages that do not enable saving for a deposit
- Cash rich investor’s ability to move much quicker than you
- Sellers of property have time on their side and can drag out the process often for a long time while you burn cash renting
- Potentially aggressive selling tricks from estate agents
- A motivated competing bidder
- And the worst one is information asymmetries – whereby you are dealing on very little information, usually only what you can see in front of your face. Competing bids or offers are all done in anonymous fashion therefore you have no way to know where you stand.
These are just a few factors that I am sure you have experienced at some point and I have not even talked about macro factors in the overall economy that may affect decisions. Either way when you think about these things and what drives prices higher its not all that different from financial markets – its just happens a lot quicker.
Recently, in last two weeks we have experienced a very strong squeeze in both oil and equities – lets have a think why.
In the oil market the producers of Oil are “Long” and the customers are “Short” by design. Producers make it and customers need it. Oil has been trading lower now for some time witnessing prices not seen for 12-13 years. If you are short by design then it’s not the worst place for you to step in and buy some, especially lets say if you are an industrial producer, airline etc who buys in bulk. Also there is a recency bias that affects your decisions. This time one year ago oil was trading +80% higher than it is now – this time two years ago oil was trading roughly 220% higher than it is now- talk about a bargain !! When you put these things in context and look at the design of the market its easy to see why someone would want to try and lock in low prices and therefore the market will squeeze. The best explanation for this is one of my favorite quotes
“the cure for low oil prices , is low oil prices “
Im not saying that we have seen the lows in the oil price, on the contrary I believe in the power of trends and therefore expect to see pressure on oil prices again relatively soon but nothing goes down in a straight line in financial markets.
In equities it’s a little more complicated – the recent squeeze of circa 10% off the recent lows left many scratching their head including me. There are pros and cons to owning equity in this current market environment and on a very basic level here are some of them. A little obvious as to my thoughts on the situation here!
In a bear market squeeze the below list will be weighed up amongst other things and investors will get comfortable with some things while struggling with others but the result is that after a hefty drop in prices ( the cons ) more people were focusing on the pros for a period of time, and if volume of selling drops then the result can be a rapid rise in prices that leaves everyone wrong-footed.
- Equities produce cash yields in the form of dividends- if the price of a stock that used to offer a 5% dividend yield reduces in value then its potential dividend yield gets more attractive ( assuming you hold everything constant i.e. the ability of the company to pay a divi in the first place)
- Following on from this point bond yields, often considered the “safer” investments are rapidly losing attractiveness all around the world due to very low and sometimes negative yields- i.e. you receive almost NO return or In some cases you are actually paying for the privilege to lend someone money!!
- If (and this is a BIG IF) the overall market returns to growth the value of the equity will rise at a rapid pace providing a very good return and there.
- The overall market is dangerously geared to monetary policy from the respective central banks – think about this for a second – investors all over the world are making huge investment decisions based on what a handful of economists who have had some but very little luck in “fixing” the global economy since the GFC.
- The diminishing returns from the seemingly forever stimulus plans are becoming apparent and certainly worrying.
- Politically around the globe things are changing – i.e. regime changes bring about instability – the US presidential election is looking like the biggest circus to date.
- The world is almost certainly oversupplied with oil which has curtailed official inflation figures
- Rapid changes In technology are breaking previous industries and having an impact on incumbents margins in a real way.
- These changes in technology are also leading to an increasingly marginalised workforce who either need to adapt or die – adapting is a very difficult thing for the majority.
- The current trend would suggest that lower prices are inevitable for now ( not a prediction just an observation)
- China the once mighty growth engine of the world “appears” to be slowing down and there are strong concerns over their banking systems leverage both visible and in the “shadows.”
- Concern over European banks capital buffers has flared up again – also the ability for them to grow their business models is highly curtailed in the new regulatory limelight
- Oil companies are obviously suffering
- Commodity markets often a signal for growth around the world are still languishing around the lows with no real visible natural buyer in sight – metals, energies particularly.
- Two regime changes of enormous importance to be witnessed this year in the US- the presidential cycle and monetary policy cycle (recent fed hike to be continued or not?
Bear markets are a weird and wonderful thing- they are without a doubt the most interesting periods of time to be involved in financial markets, the sell offs are devastating to investors but the resulting bear market squeezes can be just as devastating if you have over played your hand on the short side and leads to some very tricky decisions.