Preparing for the Fall

Prepare yourself now.

The market is widely referred to as a discounting mechanism. However, its ability to discount anything extends only as far as the collective knowledge of its participants. And to be blunt, the vast majority of today’s investors— professional or otherwise— know little if anything about making money in the market.

With the advent of discount brokerages— E*trade (ETFC), Ameritrade (AMTD), etc— in the late ‘90s, a huge wave of novice investors entered the US financial markets. Between 1990 and 2000, the number of US households invested in mutual funds doubled from 25 million to 50 million. This wave of new, uninformed money supported two major trends: the Tech Bubble, and the rise of the financial media.

Regarding the latter, in 1990, stock market developments were relegated to 15 minutes of coverage on major news programs. Only ten years later, there were at least three entire channels—CNBC, Bloomberg, CNNfn— devoted solely to financial markets. The commentators and hosts of these shows looked good on camera, spoke knowledgably enough about markets, but in reality, didn’t have a clue what they were talking about. Their job was to provide content in large quantities, not content of high quality.

The issue of ignorance extends beyond individual investors to professional traders. As Bill King put it in an earlier essay, “There is a whole generation of traders whose knowledge of investing and financial history dates back to 1990 at most. Put another way, there are thousands and thousands of guys in their 40s who trade for a living and have never seen a real bear market or recession.”

These investors, while more sophisticated than their novice counterparts, are almost equally ignorant of any market development outside of their trading models and investment frameworks.

I mention all of this to illuminate why the market has rallied in the last two months, why investors need to be extremely cautious right now, and why the potential for a major market plunge in the coming months has increased dramatically.

As much as the financial media likes to refer to the Bear Stearns bailout and the Federal Reserve’s other recent actions as unprecedented, the reality is that similar events have occurred in the past. And history offers some striking advice as to what to expect for the remainder of 2008.

There have been three March financial crisis and subsequent interventions in the 20th century alone—1907, 1929, and 1980. And while the ones intervening changed— JP Morgan in 1907, Herbert Hoover in 1929, and Jimmy Carter in 1980— the effects of the interventions were always the same: The intervention marked a temporary bottom followed by a brief two to three month rally, then a very ugly fall (literally and seasonally).

Even if we overlook the intervention, the market has followed a similar pattern— brief summer rally followed by an awful fall— in years in which the first quarter was soft or recessionary. It did this in 1990, 2000, 2001, and 2002. Thus far, the market has followed this pattern to a “T”— the first quarter for 2008 was definitely a recessionary one and stocks have since posted a 2-3 month rally.

Thus, I believe the market is ripe for a major (20% or more) downturn in the coming months. Novice investors would do well to shift a sizable portion of their portfolios to cash.