My job is to help keep you on an even keel, make sure you have all the facts and some of the inside dope, and help you make some money. So let’s get right to it.
Keeping things simple, the big themes this year have been commodity boom and bust; home price devaluation; bank and hedge fund deleveraging; financial corporation insolvency; and government intervention.
The biggest events have been the Bear Stearns bailout in March; the government attack on short-sellers and commodity speculators in July; the Treasury takeover of Fannie Mae and Freddie Mac last week; and the collapse of Lehman Brothers (LEH) and sale of Merrill Lynch (MER) this week.
Amid these amazing events, the U.S. stock market has rolled over but has yet actually crashed. The major U.S. indexes are down 18% this year, which is bad—no doubt. But compared to the 30% decline in the London stock market or the 38% decline in China or the 35% decline in South Korea and Russia, we have it easy so far. That will change.
Here’s why: Capital, which fuels the market, is disappearing.
Last week the federal government took control of troubled mortgage titans Fannie Mae (FNM) and Freddie Mac (FRE) with a financing deal that essentially extinguished the companies’ common shares and smashed their high-yielding preferred shares as well. Both companies’ shares are down 99% because they took too much risk without enough capital cushion, providing a terrible role model for the rest of the sector.
This weekend, the Federal Reserve Bank of New York turned turned a cold shoulder to Lehman Brothers and forced the 158-year-old firm into bankruptcy. There goes another $70 billion in capital.
It’s not just money. It’s job and spending power. Just think of the impact of a Lehman deal on the New York, New Jersey and Connecticut economies. That’s a company with 25,500 highly paid employees, all of whom are now out of work. Plus most of whom have loyally socked away LEH stock in their portfolios for years.
Employees own 30% of the company, and no matter what deal is worked out you can be sure they will be left with crumbs as shares will be worth less than $4. That means middle managers with two decades of service and a retirement portfolio that was worth, let’s say, $10 million in LEH shares a year ago, are now looking at being thrown out on the street with a portfolios worth nothing.
The whole affair is really sad, a great American tragedy, and the reverberations will be felt for years.
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Stock Demand Still Anemic
Meanwhile, demand for stocks continued to diminish last week well before the 500-point drop on Monday.
A 90% downside day was registered first this month on Sept. 4th, and at the time I told subscribers to my Trader’s Advantage service that it would likely lead to a tepid rally and then more big down days.
That is pretty much what happened, as a few days of desultory moves higher were followed by another 90% downside day on Sept. 9th. And that one was a doozy, with 92% of all volume on the downside and points lost were 98% of total points changed. Now we have had a third on Monday.
Three 90% downside days within a week of each other confirm that a bear market is in force, and suggest that more liquidation likely lies ahead. Research shows that this type of action signifies a new phase in a bear market in which investors turn increasingly negative and make it harder for everyone to simply "ride out" the remainder of the bear market with the expectation that things will be better soon.
Paul Desmond, chief analyst at Lowrys Reports, recalled that in the 1962 bear market there were seven 90% down days before the final low. In the 1973-1974 bear, there were 15 90% downside days before the final low. One of the few things that can reverse this sort of liquidation is a point at which prices get so low that they inspire a rush to buy that amounts to a 90% upside day. And yet even 90% upside days don’t always signal the end of a decline, as any rally that ensues from one must be monitored for strong investor demand across the spectrum of stocks; rallies that are confined to just a few sectors typically fail within a month or two.
In short, investor demand remains weak and the worldwide liquidation of most equities remains the main theme. In these kinds of conditions, it’s tempting to want to buy early and hold but history suggests it’s not a great bet. Many of the greatest investment minds of our generation have already been flummoxed by what appeared to be great values this year.
They include David Bonderman, the great private equity investor in Texas, who is down at least $5 billion on his $7 billion investment in Washington Mutual in April, and probably a lot more when you consider his levered financing.
They also include Rich Pzena, the value investment legend in New York, who told me in January that he was buying as many Fannie Mae and Freddie Mac shares as he could get his hands on, and that his analysts were buying them for their personal accounts because "they believe they have properly analyzed these franchises [and] buying low is a strategy that has never failed to work."
To those who said the mortgage titans’ books were cooked and are impenetrable even after two years of untangling by independent auditors, he added: "I love it when people throw their hands up and say they don’t understand! It means that if you do understand, as we think we do, then you have a pretty nice chance of earning a great return." Rich has seen shares of his own firm, Pzena Investment Management (PZN), sink 64% in the past year.
Without doubt, some banks and brokers will survive and clean up. And some of the financial stocks now trading around $5 or less will rebound by 10x in ten years.
The history of bear markets shows, however, that most are likely to suffer through a tedious, multiyear consolidation within around 50% of the current prices—much like Cisco (CSCO), Intel (INTC) and Microsoft (MSFT) have still not recovered much from the 2000-2002 tech bear market.
To survive this crisis, check out my Trader’s Advantage newsletter, which is full of bear-market strategies to help you profit amid turmoil.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.