Investors are like six-year-old soccer players. They all run after the same ball.
NO matter what the government or Wall Street does, the downturn overrides any attempt to stop it. As time passes, things get worse, not better. Initially confined to the capital markets, the distress expands and multiplies, disturbing every layer of the economy.
Capital and credit in pain
A working financial system is essential to prosperity. Without healthy banks, insurance companies and investment dealers, business as usual is impossible. The economy suffers, and lifestyles deteriorate.
Confidence in the world’s financial system depends on deposits lent out with care and borrowers who pay their debts. For that reason, an epidemic of foolish lending and speculative borrowing always ends with the destruction of confidence in the financial system.
Even without a prior episode of loan fever, falling asset prices and increasing illiquidity slows the repayment of debt and lowers the value of collateral. Lower prices weaken both borrower and creditor.
Depending on the volume of debt it affects — which is proportional to the volume of speculation prior to the bust — a market crisis can mildly impair the credit system, or cripple it.
In most cases, a circular contraction begins. Lenders grow distrustful, and reluctant to lend. Borrowers need loans to bridge their shortfalls, but cannot get enough money or get it at a reasonable interest rate. With equity markets unreceptive, floating a stock issue becomes difficult. Then as insolvency increases, credit contracts further.
The economy weakens
As the mood sours, demand fades for high-ticket items like cars and appliances. People lose the desire to strap on more debt or spend much money. Many need to sell a few things of their own. Furniture, art, jewelry, second homes, motorcycles, boats, collectibles, and vacant land, all hit the market.
Companies review their spending. To conserve cash, some will postpone expansion plans, cut dividends, or sell off equipment, land and inventory. Other will reduce travel expenses, or suspend research and development. Most will advertise less, suspend training programs, or reduce employee hours. If necessary, companies will downsize by laying off staff or closing plants.
As companies cut staff, spending falls, and in turn, profits fall. More layoffs follow. The slowdown hurts both rich and poor. The rich see their wealth vanish; the poor fall deeper into hopelessness.
Eventually, the government announces the beginning of a recession, backdated many months. This announcement is of little use to investors, like figuring out where you are by your tire tracks from last week. Those who didn’t believe a slowdown was possible now say they saw it coming.
By this time, Wall Street is in a state of shock, worn down and dejected — the object of national hostility. Deals go on hold. Advisors, scared and impoverished, hate talking to upset clients. Money managers lie low, humiliated by every bargain hunt. Transfers-out and redemptions soar, and firms run low on capital.
The news, mostly bad as usual, now revolves around stories of financial pain, job loss, bankruptcy, and slumping business conditions. Morbid commentators refer frequently to the Great Depression and Japan’s Lost Decade.
At the bottom
Bear markets are shorter than bull markets because prices come down harder and faster than they go up. This makes sense, because it takes only a day to tear down what took months to build. Another way to understand it is to observe how sellers move faster than buyers when investors are scared.
You don’t get declines without a large number of investors heading for the exits. They sell for three major reasons:
They sell because they’re scared of the future, and worried how bad it might get. They don’t know what to do, but they feel an overwhelming need to do something. So they run away.
They sell because they need the money at home. Personal budgets are under pressure, income is low, and money worries abound. It’s not the best time to cash out, but they have to.
They sell because they are forced out, due to margin calls, redemption requests and dynamic hedging. They’re cogs in the machine.
Even if they stick around, some investors suspend their dollar-cost averaging programs, because it seems wrong to throw good money after bad, and they’ve lost faith in a rebound. This is one expression of the buyer’s strike that marks the bottom.
It’s an important sign. When investors start to believe that another serious down leg is certain, that recovery is years away, that free markets and capitalism are doomed, and that what we are experiencing is the end of western civilization, then chances are good that prices will not go much lower.
Another valuable sign is keen interest in money market funds and treasury bills. Near the bottom investors get excited about short-term investments that are guaranteed and can be liquidated instantly.
In contrast, at the bottom investors have next to no interest in stocks, and are suspicious of them. Stocks are too risky.
The air hums with news of disasters, strife and misfortune. As prices fall, the media pay closer attention and stir up worry, shock and uncertainty. Along with dire predictions and advice to be cautious, they tell us that smart money is waiting for things to stabilize.
The final downmove takes place when confidence reaches its low. Confidence in the stock market, confidence in the bond market, in the government, consumer confidence, business confidence, the confidence of the foreign investor, all reach bottom, in an atmosphere of anger, resentment, disgust and grief.
A bear market is a heavy rock rolling downhill; it won’t stop falling until it hits the lowest point and loses momentum along the flat. Prices must decline to the point where buyers emerge from the shadows in numbers sufficent to outnumber sellers.
Given enough despondency, that could be a long way down. Unlike bear market rallies, which attract only short-term support, the bottom must feature prices low enough to arouse sustainable greed.
The first rally of the rebound bounces off the ground and breaks the downtrend. Selling pressure subsides, and some of the money on the sidelines flows back. This reservoir of buying power, formed during the bear market, will propel the market higher and higher still, for years to come.
Yet very few people will be in a position to profit from the lows in stock prices. Post-crash aversion will keep some away. Others will have no cash on hand, only beaten-up stocks. Just a few will have the combination of skill, temperament and the money to take advantage of the rebound.
As the rally develops, it stops looking like a typical bear market rally, and more like the beginning of a new bull market. Yet the economy is still mired in recession. Job losses continue to rise. How can the market recover?
Most investors cannot believe their eyes, and their newfound pessimism prevents them from seeing the storm clouds of financial disorder passing over.
The chart below shows the same bear markets seen in Over the Top, but instead of the tops, these are the bottoms, charted over a two-year span. For comparison purposes, the vertical scale here is the same for all, with the bottom at 100.
You can see the trauma of the so-called Crash of 1929 with horrifying clarity, yet this chart understates the damage still. For instance, if the bottom in 1932 was 100, then the top would have been 924 (versus 231 for the S&P top in 2007 and 453 for the Nasdaq top in 2000).
Usually the first move after the bottom is a bounce; it looks like another bear market rally, and is almost always followed by another decline a few months later. This decline is shallow, and when it ends, the rebound resumes with vigor.
The second stage of the rebound surprises investors. The preceding decline was supposed to be the return of the bear market. Another rally doesn’t seem possible.
At the same time the rebound kindles considerable and contagious optimism. It’s taken as a good omen. Perhaps the economy will improve. In the meantime, those playing wait-and-see are tortured by the rising market.
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