Juggling Dynamite

This week a NY Times article: To see a stock market bubble bursting, look at Shanghai, reminded me of some familiar human themes. In the past 2 years, Asian stocks had gone through an incredible bubble.
Chinese share prices had climbed 500%, setting off a national stock buying frenzy. As the fever peaked last year, people were quitting regular jobs to day trade shares full time. Millions were lining up around the block to open broker trading accounts. “Everybody was talking about how much they had earned, how much more they would invest, and which stocks had jumped 20, or even 30 times.”
Then the bubble burst. Since market highs last October, the Shanghai composite index has plunged 45%. In India and Japan stock prices have plunged 31%, in Vietnam a whopping 53%. Now people are angry and distraught, crying and burning a security regulator effigy in the street. Families are straining under the financial stress and the regret of capital now evaporated. Many people were trading on borrowed money desperately levering themselves into the soaring markets.
The stories are all too familiar. I am reminded of other market bubbles around the world: the tech led stock market bubble of the late 90's, the housing and credit bubble of the past 5 years. Each replete with stories of regular people leaving regular jobs to become day traders. real estate flippers, brokers and mortgage specialists.
Easy gains encourage reckless behaviour and over-leverage. It also underlines the real damage of bubble markets. Most people are attracted to “play” markets late in each market cycle. The easy gains are made early when prices are still low. Those that get in early and get out anywhere near the peak, win and get to keep their profits. Those who get in late or who don't devise rules to get out get creamed.
For those who stay too late and lose in the market correction, the math of loss is savage. A loss of 45% requires a subsequent gain of more than 80% just to get back to even. Often it takes the next full market cycle of 4-5 years to regain prior market highs, sometimes it takes a full secular cycle of more than 17 years. Most people cannot or will not wait that long to recover their capital. Those who use leverage usually have no choice but to sell and accept defeat.
The social and economic costs of bubbles are enormous. This is why preserving and growing our capital requires the discipline to protect it from market peaks and their inevitable contraction. The buy and hold proponents focus on the upside, but few comprehend the risk involved until it is too late. The losses happen much faster than the gains. It took two years for the Shanghai market to go from 1,000 to 6,000 and only 2 months to fall from 6,000 to 3,500.
“These days my family quarrels a lot,” says a 55 year old [chinese hotel waitress], who with her husband had invested all their savings in the stock market. “My husband asked me to sell; I wanted to hold for a while. Now my husband comdemns me as so studpid that we lost our family's savings.”
Whether its North American, Europe or Asia, it seems that humans share familiar stories of greed, ignorance and loss.

Today markets are bouncing with another surge of hope. As I have noted before, bear markets are typically populated with many days and even weeks of strong up rallies. But here is the thing. If world stock markets have put in their bottom already this cycle, then it will be a very resilient, shallow, even miraculous bottom. It will be one of the shallowest declines, stopping at the richest valuation levels ever in history. And it will achieve this remarkable feat amidst the on-going terrors of the worst credit and housing recession since the great depression. I would like to believe in this miraculous outcome, but I confess that I have a difficult time accepting that we have seen this bottom yet.
Here are a few relevant articles that I think we should consider before jumping blindly on to the bull bandwagon:
Did the US Economy really finish Q4 2007 in the black and Escape a fourth quarter drop?
Real GDP (after inflation) is obtained by dividing nominal GDP by the GDP deflator (x 100). The smaller the deflator is, the less of GDP gains can be attributed to inflation. Had recent changes to the GDP deflator not happened, Real GDP would very likely have been 0.0% — or worse.
Last year, Fed economist Jeremy Nalewaik suggested that a better measure is GDI, or Gross Domestic Income. Nalewaik argued in a 2007 paper that GDI “has done a substantially better job recognizing the start of the last several recessions than has real-time GDP.”
According to Nalewaik, GDP-based models did much worse at forecasting recessions than did GDI: The past four recession odds at their actual starting points were only of 52%, 40%, and 45% and, for the 2001 recession, just 23% according to GDP data. The alternative measure of GDI did must better, signalling odds of a recession of 78%, 44%, 72% and, for 2001, 70%.
And what of recent data? It shows an annualized GDI decline of 1% — its largest drop since the 2001 recession. The present GDI data suggests that we have already been in this recession for several months.
In addition Lowry's the oldest technical analysis service in the US, put out a long note yesterday which concluded that “our analysis of the forces of supply and demand suggests that calls to buy may be premature.” As Lowry's points out the average bear market since 1949 has been -29% on the S&P 500, a lot worse than the -18.6% decline since its peak this time in October 2007. Several bear markets have been much more severe:
1973-74 -49.9%;
1987 -35.85%
2000-2002 -50.5%
Ned Davis Research points out that since 1900, cyclical bear markets in stocks that have taken place during secular bear markets (like the one we entered in 2000) have lasted about 17 months or twice as long as cyclical bear markets that have occurred during secular bull markets. This bear market started in October 2007, so bottoming now within 5 months would be historically truncated by about a year.
Lastly, as we wait for the next knives to fall on unsuspecting investors, it is useful to note that analyst earnings expectations are still incredibly high looking out over the next 3 quarters of 2008 and into 2009. Watch this video podcast as to why. My question then is how can the market discount accurately an earnings contraction that it thus far refuses to see?

It is hard for many people to imagine the depths of greed and stupidity that have brought the world financial system to the brink again of late. It has been a complex web of players and parts over the past several years. Some of us that stayed on watch saw cause for concern 2 and 3 years ago and we have been following the evolution of this crisis closely. We find it surprising that others say they are surprised by recent events and losses. The financial engineers of this mess, the bank-broker-dealers, are living proof again of the old quote, “what a tangled web we weave when first we practice to deceive.”
Diligent, humble students of market history are valuable in flagging the risks in advance and in walking others through these times of crisis with a cool head. More than just a cool head, some of us also see our role as trying to get our clients and readers through these times with their capital in tact.
One of the people with valuable perspective on these issues is Jim Grant of Grant's Interest Rate Observer. You can watch his most recent interview this week on Bloomberg “Taking stock” here:
Other stories we are watching with interest this week:
Goldman forecasts global credit losses to hit $1.2 trillion
Goldman Sachs estimates the current market turmoil will result in $1.2 trillion in global credit losses and that Wall Street will bear 40% of the losses. “U.S. leveraged institutions have written off less than half of the losses associated with the bursting of the credit bubble,” Goldman Sachs economists said in a research note. “There is light at the end of the tunnel, but it is still rather dim.” Reuters (25 Mar)
Credit card asset-backed securities may extend crisis
Although the rate of delinquencies on credit card asset-backed securities has remained within the normal range, it has been rising over the past year and will likely continue to rise. “If card delinquencies continue to rise more rapidly than one would expect from the historical relationship between unemployment and delinquencies, we may still have to wonder about credit card ABS proving to be yet another shoe to drop in the financial markets,” CreditSights said in a report. FinancialWeek (27 Mar.)
Bear Stearns Sale to be probed by Senate. The top lawmakers on the Senate Finance Committee said they are reviewing the terms of the taxpayer-backed sale of Bear Stearns Cos. to JPMorgan Chase & Co. With jurisdiction over federal debt, it's the Finance Committee's responsibility to pin down just how the government decided to front $30 billion in taxpayer dollars. This week committee members sent a letter saying that they want to know the names of all negotiators and lawyers involved in the transaction as well as all the steps taken in the transaction and their specific dates and a list of steps yet to be taken.
They want a description of the assets to be secured by the Federal Reserve, including their value and the types of mortgages underlying the assets. The senators asked for all copies of documents that will be filed with the U.S. Securities and Exchange Commission. The senators asked for a response no later than March 28
Treasury spokeswoman Jennifer Zuccarelli said the department would work with the panel to respond to the request. JPMorgan spokesman Joseph Evangelisti declined to comment.
This will get interesting…..maybe even useful in getting on with the necessary fessing up and repricing.