The Anatomy of a Bear Market

I'm not going to pretend to know how to pick a bottom for stocks, but if we dissect the anatomy of a bear market we might understand why stocks markets eventually recover.

Anatole Kaletsky, a columnist at The Times, wrote a brilliant piece on bear markets in a recent publication. "When we look back through history - or think about the underlying economics of business cycles - we realize that every financial crisis and bear market in the past has been a buying opportunity because we can see, with hindsight, that the world never did come to an end," he says. Kaletsky makes an important observation: "If everyone in the market knew that previous financial crises and bear markets always created buying opportunities, then a new bear market could never occur." Overly simplistic? Logically correct?

But why do we still go through bear markets when everyone knows past bear markets offered buying opportunities? Another important observation: We can only go into a bear market if potential buyers believe that the latest financial crisis was somehow different - and worse - than any that had gone before. "If people believed that this was just an average sort of crisis, they would now be buying instead of selling, and there would be no crisis," adds Kaletsky.

In other words, a bear market is only possible if there is a consensus that a financial crisis is significantly worse than ever before. And that is why we are currently in a bear market. A few examples of this psychology:

- George Soros, who said that this is "the worst market crisis in 60 years". George Soros also reacted to Black Monday in 1987 with a single chilling sentence: "This is 1929"
- David Rosenberg at Merrill Lynch, who said "we confess that we have been in the business for 25 years and have never - and repeat never - seen a cycle like this one."
- Alan Greenspan described LTCM in 1998 as the worst crisis in his 60-year working lifetime.
- Nouriel Roubini of New York University's Stern School of Business, who said that this is "the worst housing recession in U.S. history"
- Legg Mason's CEO, Chip Mason, said that credit markets are in the "worst state he has seen in his 47 yrs in the business"
- etc.

This psychological trap will probably always be with us. The most experienced investors and bankers have careers that last about 30 years, a blink in economic history. "It is hardly surprising, therefore, that people are constantly amazed by each new cycle that comes along - and find it difficult to see it in historic proportion," says Kaletsky.

The near-term question: If bond insurers are bailed out, will credit markets recover? If credit markets recover, will investors then come to the realization that this is just an average crisis? If that is the case, a bottom for stocks might be around the corner.

The long-term question: If each successive crisis really is worse than the one before, a necessary condition for bear markets to occur, are we involved in a cumulative process that may one day approach an apocalyptic climax? That idea seems a bit far-fetched...

Disclosure: None

Comments

[BxCap:]

Great round-up of bear market quotes.

2008 Feb 26 11:35 AM

[Stevo:]

I find it very interesting that these financial meltdowns typically
occur during business (aka Republican) administrations. Are
they really so stupid as to let the S&L industry melt down,
allow a meltdown in the stock market and mortgages thru the
subprime crisis. I suspect good old fashioned greed and
graft. This is what happens when wealthy capitalists take
control of government. Shades of 1929...they won't be
happy until all the progressive reforms of the great
depression have been taken away. I am sure that
the Republicans can dredge up a Hoover to run!!

2008 Feb 26 11:58 AM

[J. C. Boland_:]

Good questions, intelligently posed. But the argument that bear markets have always proved to be buying opportunities (at some point) is essentially post hoc. Metaphorically: You hurtle toward the edge of a cliff, manage to avoid going over (once again), and become a believer in cliffside driving (or buying). The theory collapses if you allow the possibility that one of the earlier bear markets could have ended apocalyptically, which opens the possibility that this one could: that the perceived risk is real, though there's no certainty that what you fear will come to pass.

2008 Feb 26 01:00 PM

[jbmaria:]

Nice quotes,little substance. Most of us know bear markets end,we need to know when?
But,are you sure it's not different this time? After all,it's the first time in my knowledge for the toxicity engendered by highly leveraged CDOs.

2008 Feb 26 05:09 PM

[James Biringer:]

Good article, Eben. Here's a blurb I sent out kinda along the same thoughts you had. I'm no expert or guru, but I think I'm smart enough to think for myself and make my own decisions.


>>>>
Dear Investors,

Maybe it's me, but I got a nagging thought
rolling around in my head the last few months.
And I heard a quick mention of a similar thought
on Fast Money tonight.

Let me see if I got this right. I'll try my best to put
my thoughts into some type of cohesive essay.


----------------------...


The investment banks are marking down drastically
their assets in the CDO and CMO funds they put together.
Investors bought into these vehicles through bonds and
bond funds made up of all these SIV's.

Alright, let's see now. I got a slice of a bond fund made
up of a mix of prime, alt a, and subprime mortgages.
There's all kinds of hullabaloo going around, and I have
to mark to market my bond fund CMO's.

Wait a minute. There's no market for my bond fund of CMO's
because of a high level of fear by investors. Shoot. I have to
market to a market that barely exists at this point. Alright.
I mark to market my fund of CMO's and find I'm 70% down
right now. This asset, according to the market is worth 70%
less than what it was worth last year, or whenever.

But...is it really worth 70% less?? I would argue no. Because,
if I ride this out, that same market, imho, will give me true value
in a year or two. And not for nuthin', true value, not market value,
is the real worth of the asset I'm holding right now.

For instance, if I put a real negative number on my CMO, I'd have
to say that 20% of my mortgages in the CMO are non performing.
But the market is marking down my bond fund of CMO's by 70%.
And another thing, those NPA's are still worth something. This is
real estate. Okay, let's say it's devalued by, I don't know, 20%
for pete's sake. Well 20% ain't 70%. That's a lot different.

I know, to unscramble the NPA's out of the bond fund of CMO's is
gonna bear some cost for admin, foreclosure, and general nuisance
fees.

But 70%??

I'm not seeing it.


----------------------...


I guess what I'm saying is some of this is getting overblown
in my book. Could be wrong. But I think, that at the margin,
there's definately two sides to this plug nickel. If that makes
any sense.



Thank You,
James Biringer
Co - Moderator - Intelligent Investors Group
finance.groups.yahoo.c.../
Owner - Verizon401k Newsgroup
finance.groups.yahoo.c.../

The opinions expressed in this email are
those of James Biringer. They are not
intended to be recommendations of any
security, only his opinion. As always,
investors should do their own
due diligence and research, and invest with
caution. James Biringer reserves the
right to change orders at the last minute,
cancel the order entirely, and add orders
not advanced to the group, due to time
constraints and changing market conditions.

2008 Feb 26 08:20 PM

[root_thing:]

You can always argue that the stock market will make a new high at some time in the future. But will that be in six months? A year? Five years? A decade? If the stock market is stagnant, you can probably find alternative investments that provide a better return. That's a reason to sell. And if you think the market is going down, why would you willingly take that ride down even if you know it will eventually come up again? Doesn't it make more sense to re-enter at a point closer to the bottom? Yes, it's hard to pick the bottom, but if you're any good at investing, you should have a sense of whether the bottom is very far away or getting close. If you don't have that kind of instinct, then buy index funds and stop wasting your time.

2008 Feb 26 08:50 PM

[johnthebear:]

How can this be a typical crisis if at the end of the downturn, there are no mortgage companies to finance the buyers who want to buy. Think about how much financial capital has been lost in the markets all over the world.... $ 7 trillion Dollars!

This not a game that has clear winners and losers, some will win by shorting the market, but average investors and institutions, pension funds and banks all over the world have less capital. They did not get that capital that made all the lending possible without taking risk and accumulating over many years.

So, if the winners on the down thrust of the markets don't come to the aid of the financial system, who will? I as a tax payer am not ready to step up to the plate and lay down my assets to bailout the banks. So who will? How long will it take? It is certain that no one knows, but the most clear example of what can happen and the time involved is the great depression.

I suggest readers look at the chart of the Dow since 1929 and see how long it took to recover. It also took WWII to pull our economy out of the grave, and if it had not been for American generosity in rebuilding Europe and the rest of the world, there would not be a "global" economy today. Again, if we get down that far and are in WWIII with all the Moslem nations, what then?

2008 Feb 26 11:12 PM

[cynic69:]

Eben
"This time its different." Never before in history has energy been this expensive in relation to the income of consumers. Nerver before in history has the world run out of cheap and easy to get light sweet crude. It may take quite awhile for the economy (built on $30 oil) to adjust to $150 oil. We humans have been greedy and stupid in that we have wasted our one time allocation of light sweet crude by pouring it down the throats of "the world's most dangerous cars" (SUVs). Do you think that the price of oil is going to fall? Dream on!
Gale Whitaker

2008 Feb 27 12:53 PM

[Dawson Lodge:]

Sure there will be a time to recapitalize producers. But not when it takes $4 of debt to generate $1 of production.
What people don't remember is that the US declared bankruptcy in 1971, and the time since has been a tissue paper (FED) fantasy.
This kind of mass delusional hysteria occurs every 60 years or so, when debt-money evaporates faster than it can be created.
The masses remain in denial until stuffing their faces becomes painful to the wallet, and it costs a week's pay to see the superbowl.
There has been no profit for 30 years. The stored wealth of America has been incinerated to build military empires (US & Soviet).
The treasury has been looted, the capital has been squandered, the owners of the US government have
their Swiss chalets well stocked.
When you can invest a buck you have, (not a buck you borrow) and make a buck profit in a few months, that's when the cycle has bottomed.
Sell the gold and buy stocks around 2015.

2008 Feb 28 01:30 AM

[Michael Zhuang:]

Brilliant!

Our study of past bear markets pretty much confirms what you said.

2008 Aug 01 10:23 PM