Making Cents of this Bear Market

by: John Gilluly

I think it’s time to put forth an investment (or rather trading) strategy that adequately copes with the “reality on the ground” in our sudden and swift markets. I think this strategy will be operable for several years too – maybe even a decade or more – as financial institutions continue to de-lever, a process of unwinding that began with the Nasdaq and dotcom disasters, and continues apace today with the commodity and real estate busts. Maybe the SEC will finally regulate all investment funds to stop this rolling series of disasters, but I’m not going to hold my breath.

There is historical tradition behind what I am about to write too. For over a century the Dow Industrials has maintained a curiously biblical cycle of 18 years of plenty followed by 16 lean years in which the indices effectively go nowhere. The last 16 year lean cycle was 1966-1982. The current “lean one” began in 2000.

The economies (and U.S. presidents) of the lean years have had a hard time of it too: Hoover and Roosevelt in the 1930s and 40s after the 29’ Crash; then Johnson, Nixon, Ford, and Carter - a string of unsuccessful single-term presidencies in the 1960s and 70s. Our current lean cycle president – George Bush – has one of the lowest approval ratings on record. The president following him will face challenges not seen since the first term of Franklin Roosevelt.

On the other hand, the previous fat cycle yielded three popular presidencies: Reagan, Bush Sr. and Clinton. Maybe it is easy to look good when an economic backdrop raises the Dow from a 1,000 to 12,000?

On last Tuesday morning, the Dow was at 11,700, the same price level as the year 2000; flat for 8 years. Adjusted for inflation in real dollars, the Dow’s return has been decidedly negative for almost a decade. If history is to repeat itself (and I’m sure it will), we’ll have another 8 years before some kind of new, significant expansion lifts us out of this 10,000-14,000 range.

There’s another problem traders and investors are having this summer: making a plug nickel. Year after year - for 50 years - the period between June and September has yielded consistent losses; the other 8 months being the profitable ones in the year. The months of July, August and September have been the occasion of numerous sell offs and bear market bottoms, and although you might escape a tough July or August occasionally, the bears will most likely be clawing at your account by September and October. This summer is no exception. Look at where we were on May 15th of 2008 and where we are now, holding on for dear life. These aren’t my random musings but stats that can be found in the Stock Traders Almanc.

The resources for my article today will draw from:

Thesis 1: This bear market has been caused by over-speculation, not valuations or supply/demand. The market is de-levering, and everything is being sold – good and bad – to cover the gargantuan margin calls.

Rampant pyramiding (at leverages approaching a 100/1) in real estate, commodities and correlated “stuff stocks” caused the “rolling crash” we are now in. By the time 2008 had rolled around, speculation had driven gold, oil, copper, etc into parabolic and unsustainable prices, just like it did to U.S. home prices in 2006. This rise in prices had less to do with the underlying fundamentals of the commodity markets themselves (or the real estate market before them) but everything to do with speculation.

The current fable of a dramatic “slow down in global demand for oil” (It appeared just 6 weeks ago?) is a ruse for the massive de-levering of wrong-way commodity positions by institutions. The pullback in oil we’re now seeing is the evaporation of the long side of the trade. 

When parabolas correct, they lose half their value in a relatively short time. Later, they’ll lose half again, but over an extended period of time. If you do the math on parabolic oil at $147.00/bbl, a figure somewhere north of $70 is oil’s first real support. The oil stocks have already corrected to this price level (April, 2007), why wouldn’t the underlying commodity?

The commodities market – like the Nasdaq and the real estate market before it – was a bubble that has now popped. If you were a bubbleonian and able to jump from one 6 year surge to the next new thing, bully for you. But investors in the real world are getting clobbered by the forced selling of these overleveraged assets (oil, homes, commodities) that were priced far beyond any ‘reasonable’ value.

Are we so stupid as to believe the worldwide demand for oil tripled last year and then dropped 30% in a single month? Does any commodity behave like that in the real world? No. But speculators do. That’s exactly how rampant speculation behaves. And the commodity markets have been a mirror of speculative behavior. The SEC’s clamping down on the naked shorts in financials in July, 2008 was the beginning of the end for this kind of trading in financials, which in turn caused the drop in commodity prices.

Thesis 2: If we don’t get some real regulation in the markets, the new “Gilded Age” of hedge funds could drive the U.S. treasury into penury.

It’s been a “hardy party” for Wall Street these last 10 years, and it all began with the repeal of the 1933 Glass-Steagall Act in 1998. It took twelve attempts and $300 million in lobbying efforts over twenty-five years, but the finance industry (aka Citi) finally got the Act repealed with the help of Fed Chairman Alan Greenspan. Supporters at the time hailed the change as the long-overdue demise of a Depression-era relic. Nothing could be further from the truth.

The real deal is that Mr. Glass – Chairman of the Senate banking committee in 1933 - was a developer of the original U.S. Federal Reserve Bank and former secretary of the Treasury. He knew a thing or two about finance and placed partial responsibility for the 29’ crash and ensuing real estate implosion on bank speculators and brokerages who hoodwinked a willing but unwitting public. He crafted a law that prevented the insurance, brokerage, and banking sectors from crossing party lines, effectively separating the activities of banks and securities brokers. He also created FDIC insurance as we know it today.

What’s happened in the current crisis is our brokerages have become banks again - but without maintaining the capital requirements of banks, and banks have become brokerages - outside of the constraints of their Federal charters to be well-capitalized. That is why Mr. Bernanke has opened up the discount window to investment banks, financial institutions that shouldn’t even be allowed in the Fed’s door.

The real culprit behind the massive moves in the commodities markets (and the U.S. real estate market before it) is the brokerage houses who have worked the markets like foxes in a chicken coop (GS, MER, C, JPM, LEH etc). They’ve done this by facilitating the creation of a massive, unregulated banking system of derivatives that caters to large institutions (hedge funds). These institutions collectively trade billions of dollars; are subject to herd mentality, and they have just lost billions ($) on bad bets gratis the “advice” of the brokerage houses. These same brokerages are also being sued left and right by states Attorney Generals for their municipal bond scams.

The shadow banking system they’ve created can move hundreds of billions of dollars electronically into synthetic positions (derivatives of all types) almost over night. This is what caused the massive surges in oil futures in May and June, 2008 and why the fifth largest investment bank in the world - Bear Stearns – was worth just $2 bucks after a single week of unwinding.

The opacity of the shadow banking system is also why the financial institutions don’t trust each other now. No player knows what cards the other players are holding (what Bill Gross of Pimco calls “Who’s got the Old Maid?”) nor the full extent of the bets they’ve made on bad real estate and bad asset plays. Their capital requirements are vague, the regulations too loose, and they don’t trust each other.

A truly regulated market by a new non-Laissez Faire SEC could change our market’s trading environment. If you can’t generate the capital for a truly risky deal you can’t make that deal. It’s as simple as that. A regulated financial system (that includes the hedge funds) would create a safer environment for dividend investors in the future.

Thesis 3: The aging of America will profoundly affect consumption and investment strategies going forward

There are a lot of Americans over 55 and they are losing mucho money in their over-priced homes and bleeding retirement accounts. Why? Because their homes are over-levered through home equity takeouts (the proverbial household ATM) and the stocks in their IRA accounts are being clobbered to cover margin calls for institutions - who in turn have made overleveraged bets with their clients’ money on all kinds of stocks – good and bad.

How long will the selling and unwinding last? On the stock side, no one knows, because the shadow banking system has kept the underlying truth of its financial assets a secret, even from its own members. But every three months at reporting time another 25 cockroaches with billion dollar price tags on their chests crawl out from behind the woodwork. On the real estate side, homes must fall to 2001 prices in order to be in line with their long-term statistical medians and norms. That’s another minus15-20% from here.

Given the demographics of the baby boomer generation, I think high dividend-yielding will be increasingly important as we move forward. Dividends were practically forgotten during the great bull market of 1982-2000. There are many solid financial companies today – especially in business development and commercial mortgage who were tossed into the trash heap along with the egregious offenders mentioned above. Yet these solid companies have their own in-house due diligence staff (not Wall Streeters), are sitting on mountains of cash, and deploying it at terrific spreads in the current “pennies on the dollar” environment. Cash is king when you can buy the good stuff at steep discounts.

Who are these companies? ACAS, NRF, KCAP, CSE, WFC, are just a few names to begin with, and many of their dividends at these depressed prices are stellar (15-20%/year). You get paid to wait.

Other ‘safe’ stocks with new balance sheets are the survivors of the Nasdaq and dotcom busts 6 years ago. Several of them (including 4 semiconductor companies at multi-year lows) were mentioned in S&P’s new ‘Buy it like Buffet’ list this weekend. They are loaded with cash, have little or no debt, and employ a “pay as you go” philosophy of business. Techs who haven’t learned to do business this way are on life-support today (just look at AMD). The tech and telecom companies learned their lessons in 2000-02 and it’s about time the Wall Street financials did too. It’s all about how you handle debt. When it is done right, Clean profitability is a beautiful thing to behold.

Thesis 4: There will be an equal amount of frequent and recurring bull and bear markets; and they will alternate in cyclic fashion within a relatively tight time range.

Thesis 5: A long-only strategy - without culling stocks and taking profits – is a recipe for disaster.

The days of buy and hold in a secular bull market are over. Investors in today’s markets must learn to play it both ways through the use of sector ETFs. The cycle will wax and wane as the market moves sideways interminably. ETFs make it very clear that the hidden vagaries and fortunes of individual stocks are merged into a collective Yes/No (Long/Short) decision for a particular asset class at a particular time.

In the last 14 months we’ve experienced 6 dramatic sell-offs and 4 rally recoveries from deeply oversold levels. It’s been straight up and straight down over and over again. Depending on where you began investing in this scenario, you are either continually losing the profits you’ve just made or recovering from steep losses back to net zero. In either case you are going NOWHERE, and getting there fast.

How can we know the turn? My three favorite indicators are the number of stocks above their 50 day moving average on the SPX, Nasdaq or NDX 100; also the Nasdaq or NYSE advance decline issues, and the relative positions of the VIX and VXN. Links for these technical indicators (and more) can be found in the research section of my website. Everything on the site is free.

Disclosure: I have no commodities positions whatsoever. I am long the financials UYG, NRF, KCAP, CSE, ACAS; the techs USD, LTL, TAN, KLIC, KLAC, TER, VSH; and the indices QLD, SSO, and UWM.

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