"The Riskiest Market I've Ever Seen"

That's what Charles Biderman, CEO of TrimTabs Investment Research, said not long ago in a video post. Here's his reasoning:

I first started working in Wall Street in 1970 … and this is the riskiest market I've ever seen. The reason is simple: There's no money going into the market by investors. Mutual fund investors have had consistent outflows for the last several years. Hedge fund investors have not put any money into the market this year, or in the last year and a half. Pension fund investors have not put money in. And companies have been net sellers for most of last year and this year.

So there's no new money from traditional investors, yet the market is up $7 trillion … from the March 2009 low. How can that be, if no new money has gone in? We've never seen a market where no new money has gone in and the market has gone up like this. The only logical conclusion is that it's the carry traders … people who can borrow at virtually no interest rate, and take that free money and go long.

As you can see in the full video, Biderman goes on to conclude that if these carry traders "back away," the market's toast. He gives the May 6 flash crash as a precursor of what may lie ahead -- only worse. Thus, the riskiest market he's ever seen.


But not convincing. I suppose it depends on whether you're a trader or an investor, but I think this kind of logic -- which, to be fair to Biderman, is rife -- is perfectly backwards.    

First, you don't need a lot of new money coming in for markets to make big moves, as they have since last March. Prices are set at the margin. All you need is one buyer and one seller trading one share to set a market price. And that price can be much higher (or lower) than the previous quote. This is why market technicians (I think that's what they call themselves) urge caution when stocks surge on low-volume days. 

Also, plenty of carry traders are hedge funds, so the notion that hedge funds are sitting on the sidelines while carry traders run wild contradicts itself. Lastly, individual investors may be pulling money out of mutual funds, but as I've shown, a lot of that money is simply being transferred into stock ETFs. It's a shuffling, not an exodus.

More importantly, though, the idea that markets gain risk as new money dwindles strikes me as not only as false, but also amazingly dangerous. If you follow this logic to the extreme, does a market become riskiest when you're the only buyer left, and you can practically name your own price? Conversely, does it become the safest when everyone and their cousin is buying, like tech stocks in 1999? Of course not. If you're an investor -- not a trader -- it's exactly the other way around.

Investment risk doesn't come from a lack of buyers. It comes from high valuations. It comes from buying stocks for more than the business is worth. Ram that into your skull: Risk doesn't come from market swings, but from buying a company at the wrong valuation. If you equate volatility with risk, you probably shouldn't be investing. At all.

Take a real example from Biderman's reference to the May 6 flash crash. On that insane day, Procter & Gamble (NYSE; PG) briefly dipped to $39.37 per share, its lowest price in some eight years. Did that drop make the company riskier? Did people suddenly stop buying Crest toothpaste? Of course not. The price may have blipped, but the value of P&G didn't change one iota during that 10-minute meltdown. The flash crash allowed you to buy one of the world's strongest consumer companies at perhaps the best valuation ever seen. And it didn't force anyone to sell -- you were at its mercy only to the extent you allowed yourself to be. Ditto for Philip Morris International (NYSE: PM  ) , ADP (NYSE: ADP  ) , and Verizon (NYSE: VZ  ) . The flash crash created some of the safest prices these companies have ever traded at. Permanent downside risk was minimal, while upside potential was huge.

The flash crash was the opposite of risk. It was deep safety from valuations.

If you start viewing markets that way, a chart like this is probably the most valuable in measuring risk:

Source: Standard & Poor's, Yahoo! Finance, author's calculations. 2010: Q1 & Q2 actual; Q3 & Q4 S&P estimates.

Source: Standard & Poor's, Yahoo! Finance, author's calculations. 2010: Q1 & Q2 actual; Q3 & Q4 S&P estimates.

To revisit Biderman's point: Was the market really safer in 2000, when there was an utter dislocation between stocks and earnings? Safer than today, when earnings have rebounded so ferociously that the dislocation is almost as strong in the other direction? If you believe the estimates, the S&P currently trades at 12 times 2011's earnings (not shown in this chart). Those estimates could be off by as much as 25%, and the index would still trade at a rather reasonable 16 times earnings.

So you can call today's market a lot of things. Uncertain. Gut-wrenching. Confusing. Annoying. I just don't know if "the riskiest ever" truly applies.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Procter & Gamble, Philip Morris International, and Verizon. Philip Morris International is a Motley Fool Global Gains recommendation. Automatic Data Processing and Procter & Gamble are Motley Fool Income Investor picks. The Fool owns shares of and has written covered calls on Procter & Gamble. The Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (63)

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  • Report this Comment On October 08, 2010, at 12:55 PM, AlphaCenturion wrote:

    I think you nailed it right on the head when you talk about valuations being the true measure of risk. In fact, this is exactly what the great Michael Burry preaches when he says that the biggest risk in selecting stocks isn't variance but simply buying at the wrong price. I can buy a stock at a 15 P/E or a 30 P/E and the variance may be the same but one entails significantly more risk. When I see hugely profitable companies who have been around for years trading at 10-12 P/E it's hard for me to look at that and say they're overvalued regardless of what's happening with the economy. To borrow another great Michael Burry line, when it comes to the market right now, "the most prudent view is no view."

  • Report this Comment On October 08, 2010, at 5:50 PM, goalie37 wrote:

    Thank you so much for this article. I am so fed up with the well dressed morons flooding across the tv every day. A guy on CNBC just said that an 8% move on Google is bigger than it seems because 8% of a $500 stock is $40. Really?? 8% is bigger than 8% somewhere else? Grrrrrr. Now you find this Biderman guy. Ugh!

  • Report this Comment On October 08, 2010, at 9:11 PM, TMFTypeoh wrote:

    Your articles are the best of all of fooldom. Considering your competition, take that as a HUGE compliment.

    As usual, well said, well writen, well argued......i agree 100%!

  • Report this Comment On October 09, 2010, at 3:27 AM, Friendlysurfer wrote:

    Agree to the fullest

  • Report this Comment On October 09, 2010, at 4:47 PM, georacer wrote:

    Well if you go purely off price/earnings and the earning are inflated (home builder/banks in the mid 2000's) and due to drop off you are still buying an over valued stock just not one as obviously overvalued as one with a high p/e. In a low interest rate environment like we have currently company's can finance growth at a cheaper rate but that can have a negative effect on earnings in the future when rates go up.

  • Report this Comment On October 09, 2010, at 4:59 PM, ScottRichard wrote:


    In your comment you allude to a Micheal Burry line, "the most prudent view is no view." Can you give me the source?

  • Report this Comment On October 09, 2010, at 5:09 PM, aleax wrote:

    Yep -- the "risk" in events such as the flash crash is in having stop-loss orders out, a "strategy" (HA!) which Peter Lynch put paid to already in his "One Up on Wall Street" best-seller for example (hardly a bright new tome, but, like all real classics, still immortal;-).

    If you found yourself selling stock for 20% or more less than it was trading 30 minutes later, blame it on having placed a stop-loss order, NOT on the "flash crash" -- and, stop placing stop loss orders, or, if you're a day-trader adrenalin junkie who can't live without them, at least stop reading sites meant for INVESTORS, not GAMBLERS;-).

  • Report this Comment On October 10, 2010, at 7:00 PM, thisislabor wrote:

    Ram that into your skull: Risk doesn't come from market swings, but from buying a company at the wrong valuation. If you equate volatility with risk, you probably shouldn't be investing. At all.

    Thankyou! that's what I said. now why does my finance text book say I am wrong! i just dont get it... .no. seriously. I don't get it.

  • Report this Comment On October 11, 2010, at 10:17 AM, lazytype wrote:

    Didn't he mean that risk comes from derivates? 'stop loss' tirggered one after another.

    Like cars on a highway riding 100mph with one inch gap

    Too high leverage means 10% drop - game over, chain reaction.

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