The Case for a Bear Market Written 5-25-2010
Every now and then, we think it is a good exercise to review our thesis, what we said in the past, and where do we still think we are going with this financial crisis. In 2008, when we had sent our clients managed portfolios to cash, we stated that we were in the beginning of an epic financial credit crisis and equity and fixed income positions were at great risk of significant declines. This indeed, was followed by a stock market decline for the record books, a significant decline in lower quality credit or fixed income investments, a failure of a well known money market, money markets in general were then propped up by the Federal Reserve, and the failure of many big swinging financial institutions, to which many of these were propped up by the Federal Reserve. Our expectations were for the market to finally achieve a temporary bottom sometime in the first quarter of 2009, to which it did when the S&P500 achieved its low of 666.79 on March 6th, 2009. Our expectation was for a massive "bear market" rally to then unfoand continue for many months. This "bear market" rally would be driven by the "worst is over" theory that would be proclaimed by the "herd" and quite possibly drive the market to record recovery levels, which it did. Finally, when the "herd" realizes the worst is not over, rather, the worst may be in front of us, they will head for the exits in a big fashion, and the next major downtrend will be underway.
We also have been convinced, since the end of 2008, that the last shoe to drop will be sovereign debt failures, municipal debt failures, major challenges of within pension funds, and a closing of several more banks. Our target for total bank closures was around 1000 or more before it was all over. A thesis like this, presented during the summer months of 2009, seemed to be ridiculous to the members of the "herd." In all fairness, our concern for a "bear market" rally top has proven to be premature a few times within the last few months, but calling a market top is extremely difficult. But, under this kind of overall thesis, our priorities with our client's managed portfolios is to attempt to minimize the loss of money during major down trends. We are convinced that if this happens the way we think it will, it will provide huge opportunities at the ultimate bottom. Therefore, we are sticking to our "Advance and Preserve" discipline. But we do understand that the markets do things that don't make sense, and therefore, we try not to argue with our quantitative models.
This brings us to where we are now. The internals of our quantitative models have continued to weaken and send our portfolios to cash, with a major shift to cash occurring on May 10th at the market opening. Our models have gone even further into cash this morning and have resulted in the portfolios being in a significantly defensive position. Within the uncertainties of life, we are always open to being wrong, and who knows, maybe we will see a bottom here, and find the portfolios fully invested soon. But, it is not looking like that is likely. In addition to our quantitative models deteriorating, there are other things within the market internals that are not looking good. There are subsets of market internal conditions, that when are looked at together, are associated with certain outcomes. These outcomes include oncoming recessions, sudden market weakness, etc. Of the 3257 issues traded on the NYSE last week, 2955 declined and 275 advanced. The S&P500 has now wiped away seven months of progress. The broader measures of the market action deteriorated to a negative trend as well. When a combination of market internals are negative, ones that we won't go into and discuss, bad things have happened to the market over the next 12 months, historically. Examples of the result of these type of conditions with market internals was in November of 2007, which was followed by a market decline of more than 50%. Another instance was in September of 2000, to which was followed by a two year bear market decline. Other instances include in July of 1998, just before the Asia-crisis crash, and the beginning of October, 1987, just before the market crash. Again, these are observations, and we try not to argue with our technical models. But our technical models have moved the portfolios to significant cash positions, and the recent market patterns and market internals back up our actions.
Looking Like the End of a "Bear Market" Rally?
So now this leads us back to our thesis and where we are from a current economic standpoint. So far this year, the FDIC has closed 72 banks. At the end of 2009, the total number of troubled banks was 702 compared to 252 at the end of 2008. At the end of last week, the number has jumped to 775, and the total number of banks that have been closed since 2007 has been 241, according the FDIC website.
Martin D. Weiss of Money and Markets discussed their bank rating system, which rated the conditions of the major banks within the U.S. It excluded the consideration of federal bail out or "too big to fail" schemes of the major banks and ranked them purely on the conditions of their balance sheets. The ranking is from "A" to "F": With "A" being excellent, "B" being good, "C" being fair, "D" being weak, "E" being very weak, and "F" being failed. Below is a chart from their website that lists the status of 20 of the major banks within the U.S. and shows their conditions based upon their rating system.
Though it has been projected that the level of bank failures will peak possibly this year, the financial condition of these banks continues to weaken. And as we expected, risk of sovereign debt defaults are now on the table, as well as serious financial problems existing in various states such as New York, Illinois, and California. Even municipalities face some serious consequences of carrying too much debt. It is being reported that the county of Sacramento is currently running over 60 days in paying some of its vendors, which is a sign that things are not improving, their worsening.
As we expected, the economic news showed that inflation remains in check as both PPI and CPI remain benign with a core CPI up just 0.9%. This is the smallest rate of increase since January 1966. The number of new jobless claims for the week ended May 15th jumped 25,000 to 471,000 versus the consensus of 439,000. The release of this new triggered selling again on Thursday.
In other developments, the Senate passed a financial reform package - Though the bill still needs to go back to the house before it hits Obama's desk. The current timeline is for the bill to be passed before July 4th. This is another 1400 pager that no one has read and the author seems to be anonymous as well, which bring us to ask who is writing this stuff?
