Thursday's 102-point drop in the Dow led many to believe that the top was in for the market's current rally. The 33% rally looked to have stalled with the release of the stress tests results and the inevitable pull-in looked to have begun running its course. Yet, Friday stunned many as the Dow rebounded, rallying 164 points closing on the highs of the day and achieving a new high for the 2-month rally off the March 6th lows.
As many on the short side are stopped out of their positions once again, it is useful to understand how far the market could rally without much change in the underlying economic circumstances. Many pundits continue to argue that the market has rallied too far, too fast without the necessary improvement across the economic landscape. But, if a large portion of the market's crash was caused by panic, a subsiding of that panic should allow stocks to rally even if conditions do not change.
It was best said by Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds, when he wrote "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." Mackay argues that while people panic in crowds, panic only subsides as people individually realize that perhaps the situation is not as dire as they once thought. It seems that we have a very similar situation occuring in our equity markets.
Lehman Brothers' bankruptcy was, as Warren Buffett said, an "economic Pearl Harbor" that caused panic in the credit markets. The credit market freeze was evidenced by the incredible spike in the TED spread (the difference between three-month futures contracts for U.S. Treasuries and three-month contracts for Eurodollars (investopedia.com)). The TED spread serves as a proxy for the pricing of risk. In one of my previous posts, Fear Abating, I highlighted the dramatic spike from a spread of 1% in early September to a new all-time high of 4.64% on October 10th. As Federal Reserves around the world unveiled aggressive liquidity programs, credit markets began to thaw and stabilization set in by the end of the 2008.
Three days after Lehman filed for bankruptcy, the government restricted short selling of 799 financial companies. This unprecedented move caused a large jump in stocks and in two days stocks fully recovered the drop caused by the initial Lehman fallout. But, as if markets suddenly realized this sort of manipulation would do nothing to fix the situation, stocks plunged, falling 3,505 points in 15 days. Complete panic had hit markets already exacerbated by frozen credit markets, which forced many institutions and hedge funds to blanket sell their most liquid holdings, equities.
But, as we moved away from the October 10th low, equity markets began to stabilize and the TED spread dropped back to prior levels. Panic receded as participants gathered their senses and markets stopped falling. The beginning of 2009 saw further weakness in the stock market with the Dow breaking lows again and dribbling lower throughout February and into March. March 6th saw an intraday low of 6,469, stocks turned on a dime and began rallying to where we are today.
Now, I am not trying to argue that the Dow will quickly recover to 11,000 or that the entire bear market was simply caused by fear. Rather, I am merely attempting to outline a line of thinking whereby traders can understand how the stock market can rally much farther and faster than one would believe without much fundamental improvement. The abating of panic will allow stocks to rally because irrational fear drove them to extremely depressed levels.
Traders must be very nimble on the short side and be willing to give up the short bias quickly as it continues to be proven incorrect week after week. Clearly, stocks will not rise in a straight line and there will be at least a pull-in at some point. But, that time has yet to come and there is enough justification for a massive rally as investors simply "recover their senses slowly, and one by one".
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