Feature Stories | Oct 14 2008
By Greg Peel
Why did we enter a full-blown bear market in 2008? Because a bursting of the US housing bubble – all bubbles eventually burst – exposed an unsustainable level of leveraged debt in the global financial system which then needed to be unwound. Without knowing which institution was most up to its neck in now effectively worthless debt securities, credit markets froze. Thus it became inevitable the world must enter a dramatic economic slowdown, if not a recession.
A lot of comparisons have been made recently between this month’s market and the crashes of ’87 and ’29. These are not really appropriate events to compare to given neither were bear market events. Both were bull market corrections of 25% in a day. They were incredibly painful, but the band-aid was ripped off in one swift motion. A bear market on the other hand is known as a “death by a thousand cuts”. You only know you’re in one with the benefit of hindsight, and that’s when the band-aid is being pulled off very slowly.
A big market fall will only end when an oversold condition is reached. Last week, and indeed all month, we reached “oversold” status. That is because fundamentals no longer mattered, and because the rush to sell started a snowball. Redemptions were being made forcing funds to sell stock to raise cash. Margins were being called forcing investors to sell stocks to raise cash. In each case, the lower the prices go the more cash needs to be raised, and thus even more selling is required.
There is another element at play, this time in the proprietary trading market. It is best exemplified by the now popular measure of fear – the VIX volatility index on the US S&P 500. What the VIX is effectively measuring in this turmoil is demand for put options over the index. If you have a portfolio of stocks (and a large fund would have a large portfolio) then rather than trying to sell out all the stocks in one go you can instead buy put options over the index. Put options appreciate in value as the index falls, thus providing an offsetting hedge.
Up until about August we were still looking at the high 30s for the VIX being about as far demand could rise before clearly a capitulation level was reached and bounce would be nigh. But last week the VIX hit a historically high 77, blowing any previous theories out of the water. This means there was an unprecedented demand for put options. The bulk of those put options would have been sold by proprietary market-makers.
Those market-makers do not care which way the index then moves, for having sold put options they will then sell index contracts as a hedge. However, if the market moves down they need to sell ever more index contracts, thus adding more exacerbation to the equation. All the put buyers have done is transferred the selling responsibility to the option market-makers.
So what we ended up with is selling that begets more selling. The lower it goes, the more is sold, pushing it lower again. But this soon works like an upside-down bubble, and that bubble must soon pop. The pop came with the global measures announced to shore up the world’s banking system.
So there is some sense of comparison to ’87 and ’29 in that last week’s sheer capitulation matched the sheer panic of those earlier crashes. (Incidentally Yours Truly was an options market-maker short puts in ’87). In both earlier cases there was a very sharp bounce. And now we have had our own bounce. So the question thus is: Have we thus seen the bottom of this bear market?
First we must examine why we have bounced so hard. How can sheer panic one day turn into sheer jubilation the next? The answer to that is this is not jubilation, this is just “upside panic”.
What was notable with regard to Wall Street’s 11% rise last night was its lack of volume. Now, this situation is clouded by the fact it was a bank holiday in the US, but it is not unusual for such bounces to occur on low volume. It’s simply a matter of who is in the market. Firstly, your redemption sellers hold off if they can. Secondly, there are no more margin calls. Thirdly, short term professional traders jump in to pick up bargains on the momentum trade. Fourthly, traders who went short in the fall now have to madly cover positions by buying stock. And fifthly, those option market-makers who sold stock on the way down now have to buy on the way up.
What you have is a lack of selling being met by a comparatively small level of either forced or opportunistic buying. If volume is low, it means most of the market is still on the sidelines waiting for volatility to settle. There are those jumping in for the value trade, but a lot of spectators.
Wise old hands on the floor of the NYSE last night expressed their concern that the market ran too fast. Ironically they would have preferred a smaller up-day. But they wanted small on big volume rather than big on small volume. Until the former occurs, they will not be able to shake off the belief this is only a “dead cat bounce”.
(This charming analogy is based on the concept that if you throw things off a balcony from high enough up, everything, including even a dead cat, will bounce. But the cat will still be dead.)
On October 19, 1987, the Dow fell 25% from 2246 to 1738. It was a Monday. By Wednesday it had rallied 16% to 2027. By the following Monday it was back at 1793 – a fall of 12% from Wednesday. This was the “double bottom”, the latter bottom of which was higher than the first. Thereafter the Dow traded with a high degree of volatility until reaching the ’87 high once more in 1990.
1929 was a different story. On Black Monday the Dow fell significantly but then did so again on the Tuesday. This put it 46% below the September high of 381. Over the next few months it rallied back 48% to 294. But by 1932 it had hit 41 – 89% below the high.
The magnitude of the Dow’s fall in the period was due to the Great Depression. It is now history that the Fed decided the best response was to raise interest rates. Economists will tell you we can’t have another Great Depression for many reasons, one being the right central bank response. We can only hope they are right.
We never had an actual “crash” day this time around to set off a bear market. The bear market of 30-32 followed the Crash of ’29. The bear market of 1990 followed the Crash of “87. That bear market was worth 21%.
We have experienced a bear market this time with a magnitude in the Dow of 44%. We are somewhere in the middle of the earlier experiences. The recovery from the ’90 bear market also featured a couple of false starts before a big rally back to the highs by mid-91. Most of 1991 saw sideways movement in the recession before a spurt into 1992, and then more sideways. 1932 saw a huge rally and then another spectacular collapse before the Dow could really push higher again. The Dow did not recover the 1929 high until after the War.
Can any of this history lesson help us predict the future from here? No really, but one consistent theme, be it following a bull market crash or a bear market capitulation, is that the bottom always features false starts and dead cat bounces. So don’t be surprised if we see the same again.
Why the dead cat bounce?
The answer to this is simple, and harks back to the wise old hands on the floor of the NYSE being concerned with the extent of the rally last night. The rally was not driven by solid buying, it was driven by there being no sellers. In any bear market there will always be the investors who sat back and watched with increasing horror, stupefied into taking no action. They are the ones that go to bed every night trying to convince themselves that the market will bounce tomorrow. But it doesn’t.
Then finally, it does. This is what the fail-to-believe-it investors have been waiting for. They can feel so much better for selling into the bounce rather than chasing on the way down, even though it would have been a lot smarter just to sell out straight away. This is the Johnny Come Lately wave of selling.
Veteran investors know all about dead cat bounces, and thus are more inclined to wait for such phenomena to occur before jumping in with gusto. They are looking for confirmation of the bottom, which in itself becomes a little self-fulfilling because it’s a bit hard to set a bottom without buyers. But soon the trickle will come, and thereafter the flood. As to when exactly that is still up for debate.
There will also be redemptions not yet settled, and the short term opportunistic buyers will want to take profits.
That’s the shorter term picture. The longer term picture is dominated by the general belief we will see a global recession. A slow economy will mean major downward earnings revisions. While credit markets will unfreeze (and there are already signs from Europe that the Libor rate is falling), lenders will remain once bitten, twice shy. Without the obscenely easy money of 2004-07 this market cannot return to its highs anytime soon.
But one must always remember the stock market is a leading indicator. The Dow rallied strongly during both the aforementioned recession/depressions before they had run their course. One thus has to ask: Has the market now discounted a global recession?
That remains to be seen. What we do know is that any rally will always see disturbing pullbacks. The debate lies as to whether Friday truly marked the bottom.
To take some broker views, GSJB Were today provided in extensive report in which Were’s equity strategists have moved to a prediction of a “hard landing” for the Australian economy based on their economists’ views. The equity strategists have now revised their earnings forecasts down significantly and expect other brokers to follow suit. Individual stock analyst earnings forecasts remain unrealistically elevated, the strategists note, and the 1991 experience shows that analysts will tend to underestimate the ultimate reduction in earnings even after having made their first reductions. They will get a shock.
Having said that, Weres is expecting minus 5% earnings per share growth for Industrials in FY09 and plus 15% growth for Resources in FY10, all leading to a June 2009 ASX 200 prediction of 4969. We’re currently flying around with great volatility at the bottom, but basically Weres believes levels reached last week are unduly factoring in a much harder landing than even the economists are already suggesting, and that implies upside.
Today’s thought from Citi (Smith Barney) is “As fear increasingly runs up against fundamentals, the possibility of a meaningful equity rally from here is rising”.
CSB believes the global credit market will soon stabilise, but that there remains considerable risk to the global banking system and economy. The Australian market will likely “languish” in 2009, the analysts suggest. Nevertheless, relative equity value is apparent, particularly given a new backdrop of more modest inflation and lower interest rates. Trailing stock yields are now at their highest in 40 years.
(Note that trailing stock yields, as you might read in the newspaper, are “old news”. Forward stock yields are more relevant, but as they are based only on analyst estimates they are only as reliable as stock analysts are reliable. See GSJB Were’s view above.)
Not that CSB is unaware of this anomaly. They note that the average dividend cuts in previous downturns since 1960 is 30%. However, dividends are currently higher than both bill and bond rates and that outcome was not witnessed in any of the four previous decent recessions. In other words, at least we’re starting from a better position.
The analysts at GaveKal are particularly heartened by all the various measures been taken across the globe to unfreeze credit markets. “Timing the turn is of course very difficult,” they note, “but we strongly suspect the last few months of 2008 will turn out far better than the rest of the year.”
GaveKal has picked up on at least one interesting point. While the Old World has been running around trying to prop up its banking system this last week, China has made a decisive move of its own. In short, China is considering land ownership reforms that will mean farmers actually own the land they farm.
“This would: (a) give farmers a massive incentive to look for productivity gains (capital investment, creation of bigger farms, etc); (b) reduce environmental destruction; (c) result in fewer illegal land appropriations, which have caused riots and unrest; and
(d) farmers will be able to unlock the value in their lands, creating a multiplier [effect for the economy].”
That’s at least some good news for the region whose performance through a global recession we are all concerned about.
Returning to the more micro concept of this particular snap-back rally, veteran trader Dennis Gartman warns that while he would like to think the bottom has been seen, he will not say it has. “We fear that the lows will be at least put closely to the test”.
Gartman’s concern harks back to the concept of all the sellers who never sold and who will now be sellers into the rally. There will be “massive” selling from baby-boomers, suggests Gartman, “who have peered over the abyss in the past several weeks” and will not again “put their future at risk”. However this may not happen until at least another several weeks have passed, if not longer. But the selling will always be there waiting.
So to conclude this discussion we can only say that there is a good chance a bottom has now been seen, but not a 100% chance. There is every chance we will at least double bottom quickly, and every chance a good solid rally from here will be met with another sell-off before anyone can truly say “bull market”. We will likely enter recession, which will devastate earnings, but stock markets always rally well before a recession is over. It will likely be years before we retest the highs.
Or history could prove no reliable guide whatsoever.