Believe It or Not, It's Still a Normal Bear

A long-time reader left a comment over the weekend expressing concerns about current events and what they mean. He is either starting to think, or already does think, that this bear market will be worse than normal. He cites many reasons to worry, says he is less confident about things and wonders how I can "cling to my faith" that this is a normal bear.

I responded with some numbers but wanted to reply in writing too with some of my thinking about the current situation, and also my thought process in general.

One way to break this down is into two categories: facts, and the things that people are afraid will become facts. As of Friday's close the S&P 500 was down 20%. It was a little lower earlier this summer and it seems like it will open lower today. Obviously no one knows where it will bottom out. Plenty of people have an opinion (including me; 1095) of course but that's all anyone has -- opinion.

All the news of the last 18 months, SPX 1251 (as of Friday). That is a fact. The market might get much worse, but what it might do is not fact. Even with the news from the weekend, 1095 is still kind of a long way from here -- not very far, but kind of. If the bottom were 33% (still close to normal) from the peak that would be 1049, that is a noticeable drop from here.

Before I go any further, let me say for anyone new: I have been thinking we would have a normal bear market since before summer 2007, I said that I thought a bear had started on December 13, 2007 and have been consistent in thinking a normal bear would be about 30% down from the peak. As I began to write about my thoughts in this regard, a commenter heckled me daily about my thoughts that a bear was coming -- I was 'too bearish'. Now, although I still have the same opinion, some think, albeit much more respectfully and intelligently than the heckler, that I am too bullish.

Bear markets have certain sentiment-based things in common, little truisms that repeat over and over. They repeat with such consistency that they are almost facts.

During every one of these big bad events that I have been through (I have been in the business since 1984), there is incredible fear about how bad this time is. The reasons why this time is different are always well reasoned and plausible. I have tried to make this point before and invariably a comment gets left telling me why this time really is different.

The fear is always bigger than the reality. One thing I am very good at is remembering how afraid people have been during other events. I can tell you the fear now is the same as it is every time. I also realize this point will fall totally on deaf ears for some people.

Let me be clear about something: The context here is what the stock market is doing. Whatever the deficit is doing, whatever the foreclosure numbers are, whatever houses are dropping, my job is to navigate the capital markets, and in this post, that is the only context.

For many months before the bear market started, I described how bear markets start -- they roll over slowly for several months (look at the chart in the post I linked to above); an inverted yield curve (when they occur) is a reliable catalyst; most talking heads tell us not to worry, the bull is alive. All of that was the case in this bear. It has been so textbook that there is a humorous element to it.

Another part of normal is enormous failures; I'd say Fannie (FNM) and Freddie (FRE) fit the bill here.

Another historical element, also sentiment-based, leads me to conclude this is a normal bear market: the frequency with which the US market cuts in half. Typically there are decades in between 50% declines. This has been fact. The reason for this, in my opinion, is that once you go through a 50% decline you are so fearful of it happening that you sell before it happens. A 50% decline, again in my opinion, requires a new generation of investors who do not know this fear.

So in terms of the normal fear that now exists, the textbook nature of the bear thus far, the big failures thus far, and how recently the S&P 500 cut in half, I conclude this will be looked at in hindsight as having been a normal bear market. This is my opinion, and so of course it could be wrong. Nothing has changed my mind, but none of the things I cited have to matter either.

As many times as I have talked about my expectations for the bear, I have also talked about having a larger cash position than normal, having some double short and remaining underweight financials throughout all of this, with the goal of missing a chunk, not all but a chunk, of down a lot. You can look at my quarter-end videos for the last couple of years to see how that has worked out.

The alternative to my way of thinking is having no defensive plan ahead of time. That leaves you having to try to decide what should be done now after a 20% drop. So if I am wrong, I feel as though the consequence of being wrong about the bottom is not that great. I am already defensively positioned and would get progressively more so if no other action is taken (the idea being SDS would hedge more portfolio as it went up in price).

As for the general thought process: The stock market goes up most of the time and occasionally it goes down in bear markets. The cycles repeat over and over with different details but similar results. This is an inevitability. Fortunately bear markets offer some warning ahead of time and heeding those warnings can add to the return over the entire stock market cycle, which is a better measurement of time for people trying to accumulate enough money for retirement.

If bear markets are inevitable, then as I see it there is very little to worry about, you know ahead of time they will come, you know this.

In terms of the US being somehow broken -- okay, but other countries are not broken. They may take longer than normal to come back but I believe many other countries are dealing with cyclical issues. If this turns out to be a secular issue for the US, okay, but the cycles in other countries will start to turn up. We need to have exposure to those countries whenever that happens.

Is this is shocking or new to anyone? Of course not.

Let me again reiterate that the context of this is the capital markets and protecting client assets as best as I can, not being right about how low the market goes or how bad anything else gets. I think that being correct directionally, which I have been and have shared on this site every step of the way, does a lot of the portfolio work. I will also reiterate that I could easily be wrong about where the bottom of this bear is.

Comments

[MarvinMBA:]

Bear markets are scary...and the events today and the past few weeks add little to investor confidence. An honest appraisal would say were in deep s$%@t trouble and there seems little probablility of the US getting out of this downdraft soon and without great distress. The paradyne of a new beginning for the US seems nowhere at this moment in time. When M1 starts rising we might be pulling out but until then I'm afraid its status quo which is nothing to write home about....Marvin the Maven

2008 Sep 15 11:09 AM

[Larry House:]

Hi Roger. I just don't understand your fixation on "normal," "texbook," etc. You hedge everything you say because, as you say, you may be wrong. Why keep beating the "normal" horse and wait and see what actually happens? This post sounds very self-promotional, and that is a turnoff. You are going to have to wait several months before you can say I told you so. And you may have egg on your face and not be able to say it at all. By the way, I hope you are right and I am wrong, but I still say this perfect storm of economic problems is not normal, and the depth and length of this downturn will not be normal either. Time will tell.

2008 Sep 15 03:41 PM

[Roger Nusbaum:]

My "fixation on "normal, 'textbook,' etc" is to encourage people not to panic. Before anything bad happened I harped on have a plan for defense and then stick to it so you don't have to panic. Now that things are bad "don't panic, stick to your plan" seems like obvious follow through for people who have been reading me for a couple of years, or longer.

"i told you so" is pretty low on my priority list, thanks.

2008 Sep 15 07:08 PM

[Alan von Al...:]

You're a likable guy, Mr Nusbaum. I appreciate the heads-up about normal and 1095 as an inflection point. Thank you.

2008 Sep 15 09:13 PM

[Larry House:]

If your message is don't panic, I agree with you totally, Roger. I own LEH bonds and AIG bonds, I probably should panic, but I'm not (for one thing, it is too late). It is part of what happens in investing. Like I said, I hope you are right about a normal bear market. Also, I am glad you don't go in for I told you so.

2008 Sep 15 09:40 PM

[z06kenny:]

This past weekend, I watched three programs that I had recorded off the History Channel - all were documentaries showing the events of September 11, 2001. I am not feeling particularly panicky about the markets these days, just grateful to be here.

2008 Sep 16 10:07 AM

[svkoho:]

Roger's strong suit is his mantra to always have a plan for the vicissitudes of financial markets. When the great depression stocks dropped 20%, it was a bear market. What do call a bear market when it drops 90%? Just citing percentage drops and ignoring the causes is not providing much of a service to readers. The Great Depression was not just a bear market.It was the collapse of a financial system. I would say that we are looking at the collapse of a financial system and possibly a currency. If the government cannot meet it's obligations, you are in a collapse scenario. The collapse does not have to be a crash collapse, but it is still a collapse. The current Dow has a PE of around 25 with a historical mean of say 14 to 17. Do the math. At the nadir of the great D the PE was single digits.Do the math.

2008 Sep 16 10:14 AM

[Roger Nusbaum:]

cal48koho, your comments about PE ratios raise potential issues. I'm not sure where you get 25X, is that a forward number? looking at the components it is tough to find companies above 20. C and GM have negative PE but their low prices give them less weight in the index and so I don't think they could move the needle to 25.

the more important issue, assuming your numbers are correct, would be DJIA composition. I do not have the 30 names from 1929 if the sector make up was as different as I think then comparing pe ratios from 80 years apart may not be a good idea.

a little more generally i am not a fan of pe ratios for trying to predict anything because they can stay high or low for a very long time.

you might be right to be very bearish (if i read you correctly) but if you are right it won't be for the PE ratio part of your thesis.

2008 Sep 16 12:00 PM

[Steven Hansen:]

Roger, you make excellent points but i still do not agree. I like reading opposing opinion looking for elements which will change my understanding. To me, there have been few times in the last 30 years when wall street and main street read from the same scripts. each did what it did.

this time, wall street is beating the sh$t out of main street. it has evaporated so much capital from so many. i can only think of one time in history this was true. will this be a normal bear? you may be right. nothing is true until it happens.

2008 Sep 16 10:40 PM