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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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This was the first time that the market most investors thought of as the real stock market was overwhelmed by the violent activity in synthetic contracts traded in an exchangeBABY BEARS: THE EUROBEARS A Baby Bear is a vicious mauler. He gets very angry (Whos been eating my porridge?) and inflicts real wounds before hes driven from the scene. He gets that way because he is a Bank Bear who emerges when the bank ing system is in trouble, and he is out to wound or kill. His attack is a financial, not an economic event. The Greenspan Baby Bear: October 19, 1987 The classic Baby Bear was the 1987 crash. The Dow Jones Industrials fell 508 points22.6 percentin one terrifying daycompared to 12.8 percent on the worst day in 1929 (see Chart 1-4). Stock markets across the world crumbled as panic went global. To put the scale of that plunge into perspective, a 20 percent decline over any period of time is generally used as the threshold for calling a sell-off a true bear market. That the market could fall more than the requisite amount to be labeled a bear in one day was unthinkable. It had never happened before, nor has it happened since. Had central bankers not rallied resources, the global financial system might have collapsed. At the time, I was a portfolio strategist for Wertheim, a leading Wall Street research shop. (I recall the anguish of that day vividly, The market opened under the weight of an unprecedented volume of sell orders driven from the overnight collapse in the S&P 500 Futures and Options contracts traded in Chicago and Europe. The so-called cash marketthe New York Stock Exchangecould not handle such a torrent. This was the first time that the market most investors thought of as the real stock market was overwhelmed by the violent activity in synthetic contracts traded in an exchange (the Chicago Mercantile Exchange) that had previously been known as the home of contracts in pork bellies and cattle. The market plunged 200 points, then rallied so that it was down just 128 points at noon. An hour later it was down 185, and the rout was on. By days end, more than $500 billion had been wiped from stock market capitalizations. Some leading brokerage houses were in serious financial difficulties. President Reagan was called to the cameras to calm the markets, but the Great Communicator was, for once, not up to the job. He seemed befuddled, and said he understood that many investors were taking profits. During and immediately after the debacle, the media were awash in doomsayers who spoke of another 29 and other such auguries of despair. Few analyzed what had really happened. Indeed, little has been written about that collapse that explained how it happened and why it could happen again. A commission headed by Nicholas Brady pinned the blame on the large volume of trading arising from so-called portfolio insurance arrangements in which active trading firms used the futures and options contracts to back or hedge their stock positions. Some Pied Pipers at that time had claimed that you could achieve 100 percent protection of your stock portfolio against loss by skillfully balancing those positions. As long as you didnt have much company. If too many people buy heavy insurance, and the risk theyre insured against turns out to be bigger than the insurers imagined, the system implodes. Portfolio insurance had developed rapidly during the early years of what would be the biggest bull market of all time, and nobody involved in using or issuing anticipated anything like October 1987. This navely perilous concept made a bad condition much worse that day, but the real problem was a crisis in the dollar itself, as foreign holders rushed to exit from the greenback by unloading their holding of eurodollars. That, in effect, was the iceberg hitting the Titanic, and the muchpublicized portfolio insurance problems simply exposed the inadequacy of the lifeboats. Baby Bear crashes are financial crises born in the baby of money marketsthe eurodollar market. Crises develop because of the gigantic scale of that market, which is virtually unregulated. The big institutions that use it develop great faith in its functioning, and sometimes that faith turns out to be misplaced. In particular, major players develop great faith in synthetic financial instruments called derivatives. Derivatives are artificial financial products tied to the performance of real financial products, such as stocks, bonds, and currencies. They come in many forms, such as options, futures, and swaps. Theyre useful tools for spreading and controlling financial risk. But like everything else created by humans, they can break down. They become perilous precisely when too many major players have acquired too much faith in them and are betting too much on their invulnerability. That misplaced confidence in the stability of financial derivatives recalls the prescient observations of John Kenneth Galbraith, in The Atlantic Monthly of January 1987: History may not repeat itself, but some of its lessons are inescapable. One is that in the world of high and confident finance little is ever really new. The controlling fact is not the tendency to brilliant invention; the controlling fact is the shortness of public memory, especially when it contends with a euphoric desire to forget. Little has changed in 2000 years. According to some authors, Ciceros last words, just before Mark Antonys hired assassins cut his throat, were: Memoria populi parva est. The peoples memory is short. The Russian Bear: Summer and Autumn 1998 The Russian Bear was the most recent Baby Bear. (See Chart 1-5.) The Russian default during the summer was followed by the collapse of a major hedge fund that arrogantly called itself Long Term Capital Management. (It was a short-term player that was destined to be in business for only a short time because it relied on a short history of finance and proved to be an incompetent manager of capital.) This was a true eurodollar-driven financial crisis (discussed in Monetarism, 1975-1989 in Chapter 6) that savaged the stock market briefly. It did not mean the end of the bull market. Indeed, the people most frightened in October were a few insiders on Wall Street and the top people at the Federal Reserve. In fact, this was a case of a few overvalued and overpaid elitists in Greenwich, Connecticut, who had great connections, caused a near panic, and got bailed out. Financial historians would probably have called it one of the most unseemly episodes in American finance had the next four years not supplied enough outrageous stories to scandalize the most cynical reporter. The winning investment strategy in a Baby Bear market is to watch the TED spread (see The TED Spread: Global Finances Thermometer in Chapter 7) on a day-to-day basis. Because it measures risk in the financial systemby showing the spread in yields between eurodollar deposits and Treasury billsthe TED has an unfailing record for showing when the system is in trouble and for registering an All Clear after the crisis has passed. As long as the TED is wideninggoing upequity investors should be cautious, and should be reducing exposure to long-duration stocks (see Duration and Risk in Bonds and Stocks in Chapter 10). Only after the TED has fallen back sharply is it safe to increase equity exposure. The Baby Bear is a TED Spread Bearbut definitely not a Teddy Bear. PAPA BEARS The Papa Bear is the end-of-economic-cycle bear, and he never fails to appear when a recession is coming (see Chart 1-6). Hes stuffed with salmon and blueberries and ready to hibernate. He only appears in advance of a recession and goes back into hibernation a few months before a sustained economic recovery begins. Paul Samuelsons most famous observation was his sneer that Wall Street indexes predicted all nine out of the last five recessions. What the Nobel economist was alleging was that all bear markets are driven by fears of impending recession: In our terms, they would all be Papas. His epigram is enshrined in the economists pantheon, because it was so selfserving; the economic consensus had never predicted a recession in advance, and that futility continues to this day, more than three decades after Samuelsons utterance. The typical postwar economic cycle comes in stages: 3. Remaining excess levels of inventory get worked off amid rising demand, but new factory production continues to shrink, producing more layoffs. The Papa Bear is drawn from hibernation by the whiff of rising interest rates and rising inflation, mixing with the background scent of still-rising stock prices. He emerges, feeds heartily, and then disappears from the scene until the cycle has ended. The most recent Papa Bear appeared in 2000. The Mini-Mama collapse of technology stocks exposed vast overinvestment in technology gear. Business demand collapsed, and the tech stock plunge took some of the edge off consumer optimism. The entire stock market began to follow Nasdaqs lead downroughly 10 months ahead of the onset of a recession that wouldnt be certified as such until July 2002. Papa knew better. Papa appeared to go back into hibernation after 9/1l, but it turned out to be a raritya mere Papa pause. He reemerged in February 2002, amid fears of a renewed global economic slowdown and talk of a U.S. double dip recession. MAMA BEARS The female of the Bear species is far deadlier than the male. In particular, a Grizzly Mama with cubs is the most dangerous large mammal in the Lower 48 States. Campers and investors should walk, not run, from her. Better still, they should try to confine their activities to times and places where Mamas are unlikely to appear. The most vicious stock market bears are Mamas. There are two kinds: Mini-Mamas and Big Mamas. Mini-Mamas They only appear at the advent of Triple Waterfall collapses, which well discuss in the next chapter. They are the avenging bears who keep killing and devouring until an entire belief system has been destroyed. They can produce recessions or depressions. They are Mini-Mamas, despite their ferocity, because they confine their hunting to one industry or stock group, but they are major bears because their appearance means that a belief system and ethos will be wiped out. There have been four clearly defined Mini-Mamas in the past century: the Triple Waterfall plunges of gold, silver, and oil stocks, and Nasdaqs collapse. When gold, silver, and oil stocks collapsed, it meant that the inflation phobia of the 1970s had been vanquished. That was the sea change in belief that was needed for the unfolding of the 18-year disinflationary bull market in equities and the 20-year disinflationary bull market in bonds. When Nasdaq lost more than three-quarters of its value, it was convincing evidence that the New Era euphoria of the 1990s had been crushed, taking with it the equity bull market. The next bull market will be built on a new belief system. Like the making of fine wine, building such a system out of the wreckage of smashed illusions is a process that cannot be hurried. Big Mamas There have been three Big Mama Bears since World War I: the Triple Waterfall of 1929-1933, which led to the Great Depression; the Triple Waterfall of 1972-1975, which was a major cause of what proved to be the worst recession since the Depression; and the Japanese Triple Waterfalls of 1989 to the present. Each of these Big Mama attacks produced financial and economic catastrophe. Mama Bears are the ursine equivalent of Dresden-style bombing. They kill the guilty and the innocent alike, and continue to ravage until the core beliefs that allowed the Triple Waterfall to move beyond the Optimism stage (as discussed in Optimism in Chapter 2) have been totally eradicated. STRUCTURAL, NOT URSINE BEARS? What about structural bear markets, a term heard frequently since Nasdaq rolled over and commenced its death plunge? The esteemed Ned Davis uses this term to describe long sweeps of stock market history in which the market essentially went nowhere. The most recent was January 1966 to August 1982. At the beginning of that period, the Dow Jones Industrials were at 970, and at the end they were at 776. (According to some calculations, at that point the venerable index, adjusted for inflation, was back roughly to where it had been at its peak in 1929. In 16 years it went to the 1000 range 25 times and swiftly retreated.) Davis and other market mavens believe we entered a period of structural bear markets in 1998, when the Advance/Decline line on the New York Stock Exchange broke down. (That Advance/Decline line is the scorecard of trading on an index or exchange; it compares the number of stocks going up in a given day or week with the number going down, and expresses that number in a chart. In a true bull market, the line keeps going up, because more stocks are rising than falling. When the reverse occurs, the market is narrowing, and is preparing to enter a bear phase. It is a truly democratic market index, because it lumps together all stocks on the exchange, big and small. A rise in General Electric on a day can be more than offset on the Advance/Decline line by the fall of two little companies.) Thereafter, although most market indicesled by the levitating Nasdaqwent to new highs, most stocks did not. This failure of the broad market to confirm the indices was the sign that the markets underpinnings were beginning to erode. Structural bear market is a useful term for this phenomenon, but within such long market periods, there are intervening bullish and bearish periodsof differing types. As such, the term isnt particularly helpful to any investor except a major institution that will be around for centuries to characterize the whole period as a bear market. Market historians can use such sweeping terminology, but ordinary mortals need more precision. Although, all told, the 1970s were not a good period to be investing in most U.S. stocks, there were some splendid rallies. From the low of 577 in 1974, the Dow leaped to 1014 in 1976nearly a three-quarters jump. It also rose more than 30 percent from its 1978 low, to fail again at the 1000 level in 1981. These were more than brief short-covering rallies, they were powerful failing rallies, offering investors great opportunities. Moreover, as I can attest, the period after 1974 was a splendid time to be investing in most Canadian and Australian stocks, and in such U.S. stock groups as oils, gold, chemicals, agribusiness, and forest products. A broadbrush dismissal of the period as a structural bear market would have blinded the investor to great opportunities. I was a money manager in Canada during that period, and our clients were happy campers, regularly earning double-digit returns. The ursine categories cover the ways to lose serious money. A structural bear market covers a long period in which it is more difficultbut by no means impossibleto make serious money. We are probably in such a period now, but there are lots of investment opportunities. |
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