Death by a Thousand Cuts
The general stock market behavior recently has been painful, to say the least. Now with DJIA broke below March low, any hope of a quick ending on the current bear market diminishes. Even S&P 500 Index has not broken below the March low yet, even the market is very oversold at the moment and a rebound before the 4th of July Holiday weekend is possible, the damage is already done. January and March lows will not hold for the current on-going bear market, and we should expect a 2nd leg down leading the S&P toward the $1,100 level.
Usually strong rallies happen during bear market, partially due to short squeeze but more due to false hope that bear market would end soon and greed would take over trying to pick "bottom". This kind of bottom picking rarely works, especially during the early phase of a bear market, such as sovereign wealth funds (SWF) buying investment banks and other financial institutions in the 1st half of this year. At the same time, SWF's interest might not be totally bottom picking. Investment banking is a relationship and sales business, SWFs representing their countries were probably returning the favor to Wall St. for issuing all the IPOs of their government linked enterprises in the US financial market for the last couple of years. But once they realize they are the 1st round of suckers on this rip-off capital raising game, the relationship goes sour and it becomes difficult to squeeze more money out of their pocket in the future.
Two months ago, banking sector represented by KBW Bank Index (BKX) (or other similar indices) had been ranged bound and traded around $75-90, now below $60. From technical point of view, we might see a mini-rebound for BKX from the current oversold condition around $55-60 which could temporarily provide a weak support. In my last December blog of "My Ten Predictions for 2008", I felt very confident that Citi shares will be at teens this year, and now they are. I just hope that at the end of this banking bear market, which might have several more years to run, Citi shares could still hold up at double digits, instead of falling into the single digit territory, like Bear Stearns.
Overall, for the general stock market, especially the banking sector, last two months might be qualified as something called "death by a thousand cuts", an ancient form of torture and execution in Imperial China. If you look at the BKX chart, everyday the index has been dropping bit by bit, not drastic enough to have media headlines all over the place like 1987 crash, but still painful enough for buy and hold investors. And the pain has grown day by day, however so far there is no capitulation (I wouldn't call last Thursday's 6/26 crash as capitulation), which usually signals a relief rally coming soon. So we don't know how long this pain will last.
After the March bottom, I was looking for a strong bear market rally lasting for about half year, or at least getting us through the summer, since it is very normal to see such rally in the bear market after capitulation which happened in March. For example, we had two very strong rallies in 2001 for several months at the last bear market. However, this one was merely a one month mini-rally bringing us back to only $1,420, then the whole banking sector dragged everything down again. Usually we don't see a big crash in the summer time due to slow trading activities, maybe this year is different.
At the peak, financials were over 30% of total profits in the S&P 500 when they only represented 22% of the index's market value. Now with everyone realizing that their trading profits from structured products are phantom, non-repeatable, and likely gone forever, at the same time that their banking advisory fees from M&A, IPO, especially LBO from private equity firms dry up as long as this credit crisis is not over, it is actually very natural to see the banking sector suffer badly. Then S&P 500 is dragged down by it, similar to GE being dragged down by its GE Capital division. Even with totally no transparency on GE Capital portfolio, it is widely speculated that problems and losses have occurred in their commercial lending, asset back securities, and especially over the counter credit derivatives. Banking sector becomes a large liability item on our society's balance sheet.
At the last interview by Barron's early this year, Jeremy Grantham of GMO has predicted S&P will go down to $1,100 by 2010. When I read his wonderful insights and comments, my gut feeling is that he is too conservative on both the target and the time. I would not be surprised to see his target of $1,100 being reached this year, and by 2010, we will see only 3 digits left in S&P 500, which could touch $800, the bottom of last bear market, and possibly also the bottom of the current one. I have mentioned this $800 possibility in one of my blogs in August of 2007, and I don't think there were any believers at that time, but it doesn't seem to be as farfetched now as then anymore.
The current market behavior of slow death by multiple small cuts is not very usual, a nightmare for bottom pickers. We probably won't know the reason behind this until it is much too late. I feel that the market has smelled and figured out something really bad coming, especially for next year, that smart money is withdrawing capital from stock market gradually.
At the same time, I am also very concerned about baby boomers getting close to retirement. According to Jeremy Siegel, a professor at the University of Pennsylvania's Wharton School, his computer model shows that, absent help from overseas investors, the boomers' retirement could cause stock prices to fall 40% to 50%. This becomes more likely with depreciation of US dollar so that overseas investors will further shy away from US stock market. There is also more urgency now with real estate, a big nest egg for boomers, falling double digits, something they don't have full control. Who wouldn't want to protect the only other nest egg left, their stock portfolio, while they have some control and still can cash out their capital gain from last 20 year's bull market? At the end of the day, if people foresee capital flowing out of stock market, and their investment horizon is shrinking day by day, who would want to be the last ones holding the bag?
If you look at the period of 1968-1982, a bear market lasting 14 years, it has a lot of similarities to the current period. If we try to map the two periods, 1968 top is probably like 2000, and 1969 is the 1st crash like our last bear market, then the extremely difficult period of 1973-74 resembles the current one with the same concerns of oil, energy, agricultural commodities, inflation, and falling US dollar. History never repeats itself exactly and perfectly, so I wouldn't be necessarily counting on another 8 years of bear market from now. But from this historical perspective, at the same time, I wouldn't be surprised either to see that this bear has another 4-5 years to run. This recession will likely last longer than the previous several recessions.
The main reason for this is that during last several recessions, Fed had always aggressively reduced interest rates, then reduced some more. Whether it is good or bad, but in economics or financial market, no single trick will work forever. This one-trick approach most likely won't work this time due to inflation and in addition, Fed is running out of bullets to lower rates. This is why when Fed held the rate unchanged, the market went into crash mood last week. From the liquidity side, Fed has used up almost half of its balance sheet on subprime to rescue Wall St banks already. The next crisis of credit default swap will wipe out the remaining balance sheet of the Fed.
During the current market turmoil, I have maintained a strong confidence and commitment to gold, silver and precious metal stocks. They provide a good insurance for this period full of uncertainty. Gold and gold stocks have negative correction with equities, if we view their relationship for an extensive period of time. In other words, gold would go up and gold positions would provide some protection and offset to the hit we would take on the equity portfolio.
There will also be many unexpected crisis from outliers, anomalies and black swans in the future. During bear market and financial turmoil, capital protection and preservation is far more important than taking risk for capital gain. Gold also provides good protection to double digit inflation which we are currently facing (not the government published scale-down figures). When people's inflation expectation skyrockets, long bonds will suffer heavy losses and TIPS won't provide protection on the part of price increase that people need the most protection from, energy and food.
With equities, bonds, real estate and US dollar all falling to face slow death by a thousand cuts, only gold can save us now.