|We wrote last
time that, ".....history has shown that bear markets do not end until most
investors believe they will never end, far from the attitude displayed
by most professionals." If there is one salient fact about the current
bear market, it is that the attitude of professionals has not changed its
course from the very beginning of the stock market mania. The premise
of a stock asset bubble was never accepted. The premise that a bubble
could burst was never accepted. The premise that a new bear market
had commenced was never accepted.
certify this bear market as unique in all of history. Thus, we are
probably correct in assuming the mania was and still is the biggest mania
of all time. If so, it may be entirely logical to assume that the
biggest stock market mania of all time should be followed by the worst
bear market of all time. However, the notion of "worst" is dependent
upon three factors; price or time or both. Thus far, the current
bear market is not in first place in any of the three categories.
But as long as the bear market remains unique in those regards mentioned
above, the greater the odds will be that the bear will eventually
reign as the worst of all time.
With the holidays
closing in, we thought it approriate to offer a reading list of the best
books we have found to illustrate the environment. We believe they
will present perspectives well worth your time.
Despite the loss of $7.5
trillion in wealth, Americans are still fascinated by stocks. Amazingly,
the velocity of trading continues at levels well in excess of the Roaring
Twenties. For every dollar generated in Gross Domestic Product, $1.77
is currently traded in the stock market versus $1.33 in 1929. And
clearly, the 1920's represented a veritable stock market mania. The
stories you have heard are all true. Read for yourself in Once
in Golconda: A True Drama of Wall Street 1920-1938 by John Brooks (ISBN#0471357529).
Brook's treatise is the most comprehensive study of the time and stands
out for its relevance to the present day. In the words of the Saturday
Review, "It's all there......the avarice of an era that favored the rich;
and the later anguish of myriads of speculators doomed by a bloated market,
easy credit and their own cupidity and stupidity," words that could easily
be written again about the current era should a similar fate befall us.
There is one huge difference, of course. In the prior era, the dominant
psychology changed from greed to fear as it always has done before when
prices have collapsed. But not this time. Wall Street's propaganda
mill has accomplished the impossible - a bear market unaccompanied by fear
- only the resolute acceptance that patience alone is all that is required
to bring about a brand new bull market.
What is at risk is
that the circumstances
that have always
ended bear markets before are not present now.
Given the annual changes
in total stock market capitalization versus GDP visible below, it is difficult
to imagine a dénouement any different than what occurred after the
1929 market crash. In fact, in terms of lost wealth, the current
outcome thus far appears worse than it was in the prior era. Despite
the obvious; that $7.5 trillion in wealth had to be created before it was
destroyed, does not place us back at square one. It places us further
back on the path to economic well being than we were before. Consider
that as the perception of potential wealth expanded on paper, those blessed
with such potential spent at least a significant portion of said potential.
Consider that as prices surged to levels that implied the permanence of
rising prices, those blessed with stocks actually spent a significant portion
of their future, as clearly illustrated by the growth of margin loans,
home equity lines of credit, and credit card advances. In the case
of margin loans, their impact versus the entirety of GDP was greater than
anytime since 1929. In the case of IRAs, 401k and other pension accounts,
the assumed assurance that funds would subsequently be there when one retired
became an impetus to spend in the present. And as a result, much
of the 4.8% annualized economic growth generated during the mania from
1995-2002 may have stemmed from assumptions that were way too optimistic.
Unless stock prices can once
again soon reassure the investing masses of the permanence of gains, the
reality of the destruction of so much wealth will eventually take its toll
on the psychology of investors and their approach to savings. The
odds greatly favor that investors will turn to far more conservative approaches
to saving in the future.
Every day without
a new Dow high is bad news
for long term holders
The long term mantra. "Buy and hold."
Who hasn't heard it? Trouble is, Wall Street's old familiar line
and "virtually guaranteed" strategy does not always work, unless you have
the patience of a saint. And even then, your patience could be painfully
tested. And even then, you might wonder what if instead you had sold
out when everyone else was giddy and prices were high? The truth
that Wall St. does not ever want you to hear is that stocks do indeed go
down for protracted periods from from time to time. Proof?
See the last chart of our archived report of April 2002, "Time
Will Tell." One also need look no further than how the "virtually
guaranteed" strategy of Dollar Cost Averaging has worked since January
1997, a period of five years and ten months. Using DCA, one buys
more stock when prices are low and less stock when prices are high, a seemingly
brilliant way of facilitating the logic of "buy low, sell high."
The problem of course, is that using DCA or buy-and-hold, one never
sells! As a result, gains are merely tentative and are only "on paper."
Investing $500 (for example) each and every month in the S&P 500 certainly
did quite well for awhile as the mania unfolded, but it is clear than an
alternative and conservative course of action would have turned out a lot
better to date.
The current mania has been constructed upon the
foundation of mutual fund investments. Funds are the easy way to
play the market, both for individuals and for their IRAs and 401Ks.
Let the professionals do the legwork of investing your money. When
the mania commenced in 1995, there were only 1600 stock mutual funds around.
Today, there are more than 4800 stock funds and believe it or not, September
2002 witnessed a new record in the number of funds! The rate of growth
in funds is an astounding 16.9%, even greater than the growth in the Dow
from where we measure the inception of the madness in January 1995.
In the process, the fund business boomed exponentially, enriching fund
managers and shareholders of the fund companies. To this effect,
it has been more important to keep the illusions of enriching investors
alive, rather than managing their risk.
How else could Fidelity Magellan, the world's largest
mutual fund, have only 0.5% of its assets in cash only three trading sessions
past July 24, 2002, when the traded to a print low of Dow 7532, the lowest
the Dow had traded since October 1998?!
If we are correct in our assessment that the field
has been completely flooded with those whose advice and performance has
been less than profitable (read less than professional), then it stands
to reason that growth will flatten and even turn negative in the next several
years to come. We believe the target offered in our chart (below
right) is conservative.
This conservative target implies prices as
low as Dow 6000.
Although prices did collapse into the September
2001 lows, we still do not believe we have seen anywhere near the kind
of capitulation phase that would mark a definitive end to the mania.
Simply put, history has shown over and over again that the bad times do
not end until participants recognize the environment as horrible and without
the possibility of change; and are prepared to sell stocks at literally
any price. This is what drives prices to attractive long term levels
and what catalyzes the potential for a new bull market. The proof
is in Taming
the Bear by Thomas Saler (ASIN: 1564403688). Head straight
to Chapter 4, "Guessing Games," and read how the conventional wisdom from
Wall St. is bearish at bottoms and bullish at tops. And then consider
that Wall St. strategists have remained overwhelmingly bullish throughout
the current bear market. Even investment advisers, with the exception
of a few very brief weeks, have been overwhelmingly bullish even as prices
tanked. This is so atypical of any past bear market!
Capitulation on a par with 1987 would mean
a lot more to come
in terms of price, time or both.
Our dollar weighted cumulative advance/decline
volume measurement for the New York Stock Exchange is an example of the
most massive head-and-shoulders type pattern we have ever observed.
Although the pictured pattern does not precisely meet the textbook definition,
it nevertheless provides a striking image of a succession of failing
rallies. When the broadening top of higher highs and lower
lows was broken significantly in the fall of 2001, major support was once
again tested. But when the correction from the subsequent rally failure
into early 2002 broke below our zone of "major, major support," the notion
of support became invalid. We then placed our best measurement of
EVENTUAL downside potential well below where the mania commenced in 1995.
Given that the indicator has already broken below where Federal Reserve
Chairman Alan Greenspan posed "irrational exuberance" at Dow 6437 in December
1996, we believe prices will eventually follow.
There is certainly some chance that resistance
levels will be tested. The best case for resistance is the former
zone of major support. But even at current levels, upside potential
is less than downside risk.
If prices do move higher, then downside risks
will increase accordingly.
[a portion of this commentary is
derived from our article in the October 21st issue of Crosscurrents]
Every six months, we look at the seasonal aspects
that have ruled the market for more than five decades. [see our current
on this website] Simply put, since 1950 the stock market has
LOST money for investors during the months of May through October, a period
we have termed the "Dead Zone." These losses have averaged 0.3% per
period. On the other hand, the period November through April has
been responsible for gains of 15.9% per period, virtually every single
penny and more of all stock market profits! Put another way, $10,000
invested in only the months of November through April has grown to $463,636.
$10,000 invested during the Dead Zone is now worth only $8976. Why?
We can only offer a few rationales, which probably account for this rather
strange phenomenon. First and foremost, the evidence shows that cash
inflows are higher during the good six months, most likely influenced by
IRA and pension inflows and possibly, year end bonuses. Statistically,
this is borne out by mutual fund inflows since mid-1990, which have averaged
only $8.2 billion per month from May to October and $13.9 billion per month
from November to April, a resounding 70% higher than during the Dead Zone
Secondly, the seasonal weakness typically felt
in September and October has been documented for years and has now conceivably
become somewhat of a self fulfilling phenomenon all by itself. Although
that notion will certainly be construed as controversial, it is clear that
a vast consensus of observers are now pinning their forecasts on the typical
October bear killing turn, positing at the very least, a 30% to 50% upside
move over the next six to nine months. Given the extent of this consensus
and how rapidly it has formed in recent weeks, we now have second thoughts.
As we have pointed out ad nauseam, there are two important factors working
against stocks at this time; the continued optimism of strategists and
mutual fund cash levels, both absolute and relative. The pyschology
that permits this type of consensus to exist and grow is detailed at length
and the Stock Market by David Dreman (ISBN: 0814454291).
Even if stocks bottom in this time frame, can we
now expect the same six to nine months of decent upside that we thought
might be possible before? Given that even we now appear to be part
of the vast consensus, we must doubt our own judgment! Looking more
closely at the six month phenomenon, if investors are truly on the path
to paring back the percentage of household assets devoted to stocks, perhaps
November to April will not prove to be the wondrous environment all now
seem to expect. In fact, it is quite clear that the good six months
were not up to snuff in the last secular bear market, measuring from the
first over-1000 Dow day in 1966 to the super bull's takeoff in 1982.
As our chart illustrates, seven of the 17 periods were negative and throughout
the periods, gains only averaged 4.5%. Gains during the good six
months at times other than a secular bear market were worth two-and-a-quarter
times as much. And since the bull market ended in 2000, the last
three "good" six month periods have been flat, -2.5% and +9.2%, an average
of +2.2%, not exactly what investors would consider inspirational.
In fact, the consensus is also relying on the 3rd
year of the Presidential Cycle, virtually flawless as far back as the eye
can see and the best year of the cycle by far, averaging 18% gains.
But even here, we see the impact of a secular bear market! Three
of the pictured 13 years within the third year of the cycle stand out for
paucity of gains, 1971, 1979 and 1987. The first two years were within
the framework of a secular bear market. Despite the legitimate concern
that there are no guarantees, a huge consensus now believes the third year
of the cycle will bring about a bull market. That, and the arrival
of the "good" six months have folks all worked up.
The statistics of the 50 years would have you believe
the year ahead, or at least the next six months will be rewarding on the
long side. But even if every one of the past observable periods had
resulted in gains of 30%, there is no proof that this period will also
gain as well. In fact, Fooled
By Randomness: The Hidden Role of Chance in the Markets and in Life
by Nicholas Taleb (ISBN:1587990717) will show you why. The consensus
view is meaningless.
At the very top in 2000,
the consensus was extremely confident that
higher prices were at hand.
We see the same type of consensus
[a portion of this commentary is
derived from our article in the October 7th issue of Crosscurrents]
The statistics measuring the scope of derivatives
are enough to make one's eyes bulge out in disbelief and horror.
Given that we see financial earthquakes as unavoidable as the planetary
kind, there is likely to be an inevitable disaster somewhere on the horizon.
In fact, inevitable disasters have already occurred, and at least one has
threatened the stability of the world's financial markets. For a
glimpse of the first stage of a financial armageddon, read When
Genius Failed: The Rise and Fall of Long-Term Capital Management by
Roger Lowenstein (ISBN: 0375758259).
That said armageddon has not yet taken place
does not mean it never will.
As today's charts clearly illustrate, derivatives
appear larger than life itself. The total notional value of derivatives
for U.S. commercial banks is now $50 trillion, an amount five times the
country's stock market capitalization and five times gross domestic product.
"Notional" does not represent capital at risk, just the total amount covered
by derivative contracts. For the most part, actual capital at risk
is a very small percentage of the total. However, the overall numbers
are so staggering and enormous that only one assumption makes any sense
Systemic risks have grown to
The "wisdom" that has allowed this proliferation
of constructs posits that risks are reduced for individual parties by the
act of selling a portion of the risk for a price. Thus, a blowup
along the lines of an LTCM is shared amongst possibly a dozen or more counter-parties,
assuaging the effect on the market as a whole. We agree.....in theory.
However, as portfolio insurance painfully proved in 1987, when all
adapt the same strategy, a very different outcome may take place.
Simply put, the process works too well (to a point). Derivatives
do spread out risk and the market is better able to absorb the engineering
of financial products and grows accordingly. However, we have reached
a point where so much has been engineered and so many derivatives proliferate,
that overall systemic risks have clearly risen, rather than subsided.
LTCM was the perfect example, the inevitable earthquake that eventually
to happen, an earthquake that impacted a daisy chain $2 trillion long and
an event that came closer than most realize to destroying our financial
system. The problem with derivatives is that whatever risk is posed
by an individual contract or security cannot be removed from the
system - it is simply placed elsewhere within the (closed)
No matter how you slice them,
whatever risks can be extracted
from $50 trillion
in derivative contracts must
remain within the system.
The top seven commercial banks account for 96%
of notional values in derivatives. Credit exposures are significant
and in some cases, are well in excess of the bank's entire risk based capital.
And most importantly, no matter how they share the attendent risks, they
are all still suffering the risks contained within the system. Credit
exposures as a percentage of risk based capital are staggering.
We will continue to update these perspectives at least twice a year.
Mutual funds pounced on the July low as they have
on the September 2001 low and have now pounced on the "obvious" October
low. They are doing their best to create a new bull market out of
the fabric of investor psychology. But that fabric has already been
torn apart by revulsion stemming from the awful travesties that encompassed
companies such as Enron, Worldcom, Adelphia and Tyco. And trust has
evaporated as the emails of Merrill's superstar internet analysts were
read into the public record. Even the matter of what constitutes
corporate earnings was thrown into great confusion and was only recently
settled by Standard & Poors, the keepers of the flame. And as
it turns out, the flame is a only burning ember, a shadow of the great
fire it was once purported to be.
Incredibly, investor psychology could not even
be enhanced by a newly chosen chairman of the Securities & Exchange
Commission. If anything, the actions of Mr. Pitt proved beyond any
continuing doubt that investors are not served, they are served up.
Stock mutual funds watched investors spend
They are apparently intent upon doing the
The bear market has been roundly ignored.
Losses have been dismissed as the only route
to eventual gains.
(the logic of which will forever
We'll say it again....
"history has shown
that bear markets do not end
until most investors
believe they will never end"
The odds for much lower prices
are likely still quite high.
As you have seen above, certain
of the charts and analyses presented here are shown in our newsletter weeks
and even months in advance of their appearance on this site. If you
haven't already, we urge you to take advantage of our FREE 3-issue trial.
We hit all our targets for
2000, 2001 and 2002. We invite you to check out the archives and
all our other features.
Our downside targets
(offered at 2 in 3 odds) for 2002 were achieved.
Dow Industrials 7800-8200
/ SPX 800-890 / Nasdaq Composite 1135-1285
The lower targets offered
in our July update were also met:
Dow 7000-7400 / SPX
720-760 / Nasdaq Composite 1100-1170
actual print lows were:
Dow 7197/ SPX 768/
Nasdaq Composite 1108
The odds for a retest
or downside break below these levels
are still about 10%-20%
by year end.
Our best case scenario
for the remainder of 2002 has been adjusted to:
Dow Industrials 9200
/ SPX 965 / Nasdaq Composite 1480
Alan M. Newman, November 9, 2002
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information on this website is prepared from data obtained from sources
believed reliable, but not guaranteed by us, and is not considered to be
all inclusive. Any stocks, sectors or indexes mentioned on this page
are not to be construed as buy, sell, hold or short recommendations.
This report is for informational and entertainment purposes only.
Longboat Global Advisors, Alan M. Newman and or a member of Mr. Newmanís
family may be long or short the securities or related options or
other derivative securities mentioned in this report. Our perspectives
are subject to change without notice. We assume no responsibility
or liability for the information contained in this report. No investment
or trading advice whatsoever is implied by our commentary, coverage or