The Current Bear Market: Death by a Thousand Cuts

The general stock market behavior recently has been painful, to say the least. Now with DJIA broke below March low, any hope of a quick ending on the current bear market diminishes. Even though the S&P 500 Index has not broken below the March low yet, and even though the market is very oversold at the moment and a rebound before the 4th of July Holiday weekend is possible, the damage is already done. January and March lows will not hold for the current on-going bear market, and we should expect a 2nd leg down leading the S&P toward the $1,100 level.

 

Usually, strong rallies happen during a bear market, partially due to short squeeze but more due to false hope that the bear market will end soon and greed will take over, as investors try to pick a "bottom". This kind of bottom picking rarely works, especially during the early phase of a bear market, when sovereign wealth funds [SWF] buy investment banks and other financial institutions in the 1st half of this year. At the same time, SWF's interest might not be totally bottom picking.

Investment banking is a relationship and sales business; SWFs representing their countries were probably returning a favor to Wall St. for issuing all the IPOs of their government-linked enterprises in the US financial market for the last couple of years. But once they realize they are the 1st round of suckers on this rip-off capital raising game, the relationship goes sour and it becomes difficult to squeeze more money out of their pocket in the future.

Two months ago, the banking sector represented by KBW Bank Index (BKX) (or other similar indices) had been range- bound and traded around $75-90, now below $60. From technical point of view, we might see a mini-rebound for BKX from the current oversold condition around $55-60 which could temporarily provide a weak support. In December blog: "My Ten Predictions for 2008", I felt very confident that Citi shares would be at the teens this year, and now they are. I just hope that at the end of this banking bear market, which might have several more years to run, Citi shares will still hold up at double digits instead of falling into the single digit territory, like Bear Stearns.

Overall, for the general stock market, especially the banking sector, the last two months might be qualified as something called "death by a thousand cuts", an ancient form of torture and execution in Imperial China. If you look at the BKX chart, everyday the index has been dropping bit by bit, not drastic enough to have media headlines all over the place like the 1987 crash, but still painful enough for buy and hold investors. And the pain has grown day by day, however so far there is no capitulation (I wouldn't call last Thursday's 6/26 crash a capitulation), which usually signals a relief rally coming soon. So we don't know how long this pain will last.

After the March bottom, I was looking for a strong bear market rally lasting for about half year, or at least getting us through the summer, since it is very normal to see such rally in the bear market after a capitulation like the one that happened in March. For example, we had two very strong rallies in 2001 for several months during the last bear market. However, this was only a one-month mini-rally, bringing us back to only $1,420, then the whole banking sector dragged everything down again. Usually we don't see a big crash in the summertime due to slow trading activity, but maybe this year will be different.

At the peak, financials were over 30% of total profits in the S&P 500 when they only represented 22% of the index's market value. Now with everyone realizing that their trading profits from structured products are phantom, non-repeatable, and likely gone forever, at the same time that their banking advisory fees from M&A, IPO, especially LBO from private equity firms dry up as long as this credit crisis is not over, it is actually very natural to see the banking sector suffer badly. Then S&P 500 is dragged down by it, similar to GE 's being dragged down by its GE Capital division.

Even with absolutely no transparency on the GE Capital portfolio, it is widely speculated that problems and losses have happened in their commercial lending, asset-backed securities, and especially over-the-counter derivatives. The banking sector becomes a large liability on our society's balance sheet.

In a Barron's interview early this year, Jeremy Grantham of GMO predicted the S&P will go down to $1,100 by 2010. When I read his wonderful insights and comments, my gut feeling was that he is too conservative on both the target and the time. I would not be surprised to see his target of $1,100 reached this year, and by 2010, we will see only 3 digits left in S&P 500, which could touch $800, the bottom of last bear market, and possibly also the bottom of the current one.

I mentioned this $800 possibility in one of my blogs in August of 2007, and I don't think there were any believers at that time, but it doesn't seem to be as farfetched now. The current market behavior of slow death by multiple small cuts is not very usual, a nightmare for bottom pickers. We probably won't know the reason behind this until it is much too late. I feel that the market has smelled and figured out that something really bad coming, especially for next year, as smart money is withdrawing capital from stock market gradually.

At the same time, I am also very concerned about baby boomers getting close to retirement. According to Jeremy Siegel, a professor at the University of Pennsylvania's Wharton School, his computer model shows that, putting aside help from overseas investors, the boomers' retirement could cause stock prices to fall 40% to 50%. This becomes more likely with the depreciation of US dollar so that overseas investors will further shy away from US stock market.

There is also more urgency now with real estate, a big nest egg for boomers, falling double digits, something they over which they don't have full control. Who wouldn't want to protect the only other nest egg left, their stock portfolio, while they have some control and still can cash out their capital gain from the bull market of the last 20 years? At the end of the day, if people foresee capital flowing out of the stock market, and their investment horizon shrinking day by day, who would want to be the last one holding the bag?

If you look at the period of 1968-1982, a bear market that lasted 14 years, there a lot of similarities to the current period. If we try to map the two periods, 1968 top is probably like 2000, and 1969 is the 1st crash like our last bear market, then the extremely difficult period of 1973-74 resembles the current one with the same concerns of oil, energy, agricultural commodities, inflation, and falling US dollar.

History never repeats itself exactly and perfectly, so I wouldn't be necessarily counting on another 8 years of bear market from now. But from this historical perspective, at the same time, I wouldn't be surprised either to see that this bear has another 4-5 years to run. This recession will likely last longer than the previous several recessions. The main reason for this is that during last several recessions, the Fed had always aggressively reduced interest rates, then reduced some more.

This may be good or bad, but in economics or the financial market, no single trick will work forever. This one-trick approach most likely won't work this time due to inflation and in addition, Fed is running out of bullets to lower rates. This is why, when Fed held the rate unchanged, the market went into crash mode last week. From the liquidity side, the Fed has used up almost half of its balance sheet on subprime to rescue Wall St banks already. The next crisis of credit default swap will wipe out the remaining balance sheet of the Fed. During the current market turmoil, I have maintained a strong confidence and commitment to gold, silver and precious metal stocks. They provide a good insurance for this period full of uncertainty. Gold and gold stocks have negative correction with equities, if we view their relationship for an extensive period of time. In other words, gold would go up and gold positions would provide some protection and offset to the hit we would take on the equity portfolio.

There will also be many unexpected crisis from outliers, anomalies and black swans in the future. During a bear market and financial turmoil, capital protection and preservation is far more important than taking risk for capital gain. Gold also provides good protection to double digit inflation which we are currently facing (not the government published scale-down figures). When inflation expectation skyrockets, long bonds will suffer heavy losses and TIPS won't provide protection from price increases on energy and food. With equities, bonds, real estate and US dollar all falling to face a slow death by a thousand cuts, only gold can save us now.

Comments

[bluesmoke:]

You sound so dire. I think much will rest on the shoulders of our next President. A sound energy policy will be an important first step. But overall, I think the financial markets got ahead of themselves. Once real estate bottoms out, then real growth can return.

2008 Jul 02 11:25 AM

[bluecat:]

I think you are right on with your predictions. Most people can't believe it could ever get that bad because we've never seen really hard times since the 30's. I think they are about to be proved wrong!
Don't listen to the permabulls who preach buy and hold. They will get you killed!!

2008 Jul 02 02:23 PM

[Old Trader:]

bluesmoke....perhaps you're right...but just where IS that re bottom?

2008 Jul 02 06:59 PM

[BrucePile:]

A good guide to overall market bottoms since the commodity bull market began in earnest in '04 has been the steel capitulation days. You can draw a neat support trend line from about '05 on through a series of sharp two or three day smack downs in the index (DJUSST) or the individual stocks to the support line near the end of nearly every S&P selloff. That seems to have happened, to a large extent, today.

Though I still think we're in a bear market, as I explained months ago, there are many signs that we're probably near the end of this selloff that made June such a historic bad month. Cramer is screaming "Play defense. Sell everything and buy the cereals and medicals." (he usually says that when you should be backing up the truck for the other stuff). Also, the VIX (the fear index) has spiked nearly to a trend line you can fit through the end of each selloff this year. The VIX seems to want to form an upsloping channel going into January '08 and a slightly downsloping channel coming away from that pivotal month.

I don't mean to criticize Cramer - well, OK I do. I enjoy his show, but he can lead you astray. His strong point is scoping out the good and bad areas of the market; but his day-to-day market calls seem to be wrong more often than right. Yesterday he said the oil inventories would be up and oil would be down big. Oil was up big today. And in an article today here at seeking alpha (The Most Bullish Thing), he said of yesterday's market action that the shorts had better cover. The shorts made a mint today. His show would be much better if he ceased the short-term pontification on the random noise and just did the bull and bear market area analysis, which he is pretty good at.

2008 Jul 02 09:42 PM

[Bryanb:]

Great article. I agree with (and fear) most of your predictions.

We have not yet hit a long term bottom, because there is still hope out there. We need complete capitulation and no hope for the better to reach that.

I have been short the past 2 months and this week covered my shorts and went long (hoping for a short term rally), so I am experiencing your slow torture firsthand.

It seems that a sound energy policy is something the US needs long term, but do either of the candidates have this as a priority? Wouldn't a short term fix for the US economy be a lower oil price? How could your authorities shake out the oil speculators to achieve this? So many questions to which I would love an answer.

2008 Jul 03 05:53 AM

[Blair:]

One can ask whether things are sufficiently different in today's market (a kin - black swan) that one should be prepared for Tan's forecast.

If you do a bearish point and figure count for the Dow, S&P 500 and the NASDAQ, the all count down to the 2002-03 low. Of course, once (and if) the market does go down to that level, one can ask whether there is more to come.

The whole profound change in the availability of easy to get and low interest credit is the big issue. Just because the fed rates are low, it doesn't mean that one can borrow money without trouble.

The whole credit market doesn't make any sense. It is desired to get the housing market off of the floor. However, with the low interest rates that a retail customer can get, which doesn't even cover inflation let alone taxes, means that it will be very difficult to get new retail buyers into buying the homes -- unless the prices drop to unimaginable low prices.

2008 Jul 04 02:35 AM

[Kunst:]

"Gold and gold stocks have negative correction with equities"

correlation?

2008 Jul 04 08:52 PM

[thomast2:]

Thanks everyone for all your great comments. As I said, the bottom of this bear market is expected to be around $800 for S&P, similar to Blair's analysis. Kunst, you are right, it is negative "correlation", sorry about the mis-spelling. Thanks again.

2008 Jul 05 02:08 PM

[SW Richmond:]

Stock market runs on easy money. There is no more easy money. Guess which way the stock market is going?

2008 Jul 06 09:52 AM