What Time is It, Really?

These past few weeks have found us looking way back at Market history, and savoring the imminent undoing of what has become yet another “only game in town.” Disparate times seem to lead us to take disparate measures. The extent to which the past couple of months have seemingly undone what a couple of decades might have taught us about gauging Market sentiment, we find ourselves feeling as if we have been looking for something really important through the wrong end of the telescope. This causes many of us to start reading more widely than usual, or at least tuning in differently. In my case, the idea of being in “a cyclical market within a secular market trend” struck a chord. In the past, I have from time to time found the study of longer cycles to be an interesting diversion, but insights thus gained have tended to slip way into the background, if not all the way out the back door. There is something there, be it the “seven fat years, seven lean years” alluded to in the Bible, or sixty year Kondratieff wave theory or any number of not totally implausible ideas about the Tao notion that “every extreme condition contains the seeds of its opposite”. Most likely, it is about immutable human propensities to forget past lessons and the pains they inflicted. Every generation must learn anew, and all but fatal wounds turn into scars, which fade with time. The events since September, an interlude wherein palpable fear of the unknown supplanted mere anxiety about the health of the economy as the mental state of that all important investor at the margin, has caused many of us to revisit our understanding of “what time it might be” in terms of Market cycles that tend to be “too big to see”.

Over the course of the Twentieth Century, the Market (as measured by the DJIA) went through three cycles we can call “secular”, or The Market Cycle That Matters. Each of these cycles was characterized by a long and fairly steady rise that ran something on the order of 16-17 years and culminated in a manic phase, a long term Bull Market. This was followed by a very unpleasant undoing of the wretched excesses (in terms of both capital allocation and investor expectations) that accumulated during that rise, a Bear Market. What is less evident to the casual observer is that rather than making an obvious and quick transition from Bear to Bull and then back, there tends to be an era of “going nowhere in a hurry”, lots of fluctuation but little to change over several years. (Eight or so years of carnage followed by eight or so years of apprehensive psychological recovery) The 1930s was really three distinct Bear Markets, the first of which only lasted about 70 days. Likewise, the Bull Market that can be dated from 1949 essentially peaked in early 1966 and then experienced three bear Markets, the most memorable being 1973-74 within an eight year span. The years that followed are remembered as “going nowhere”, but in fact the Market rose dramatically from late 1974 until well into 1976, then experienced another decline before settling into a funk that would not be relieved until August 1982.

If one looks at the past Markets closely, there is a clear tendency after a severe downturn for it to make a very strong recovery and then settle back and be somewhat range bound for several years. It did so from 1938 (when the New Deal quit “working” and the economy relapsed) until 1949, with the range being 100 to 150 until 1945, as the outcome of the war was becoming obvious). At this point the range shifted to 175 to 225. (It was the interjection of a World War, that dreadful "consumer of consumers", that stretched out the aforementioned “eight or so years of… healing” to about eleven.) It broke out of this range in the midst of a recession and never looked back, experiencing its most meaningful downturn shortly after the son of a purported bootlegger became President. The Market would again be range bound after 1966, but this time the range was 650 and 1050 and would encompass several serious bear markets. It would be 1982 before the Market rose decisively above 1000. What followed was an extended rise not unlike the ones that ended in 1929 and 1966, and ending in early 2000. What strikes me now, as we approach nine years since the Tech Boom fizzled out, is that considering how long it took for the Market to “find its feet” after the prior secular Market peaks, it was unrealistic for us to expect the excesses that accrued over 17 or so years would be wrung out by a single Bear market that ran for two or so years. As the past fifteen months have made abundantly obvious, that downturn was no more efficacious in resetting the cycle for another Bull Market than were the Crash in 1929 (the 70 day sell-off that was followed by a brisk recovery and then the Mother of all Bears that lasted into 1933) or the two Bear Markets in 1966 and then from late 1968 to 1971.

My conclusion is that investors will do well to look to the latter half of the 1970s for a clue as to what the next few years are likely to look like. As in 1974, we are now about eight years into the Bear Market That Matters. In the previous BMTM, the first eight or years (1966-74) were characterized by the worst declines since the 1930s, punctuated with brief but spirited recoveries. The next eight (1975-82) differed insofar as the price movement became somewhat more muted and with less of a downward skew. There was money to be made, but it wasn’t easy. If “buy & hold” worked (and it certainly did in many instances) it probably had to be “buy & hold & forget about it for awhile”. As in that era, there will be great opportunities in the months and years just ahead, but only for the strong-of-stomach. Having spent the last eight years living through two Bear Markets of epic proportion (especially if one considers the carnage in the NASDAQ (2000-02), which arguably evolved into a more representative index than the thirty stocks that make up the DJIA), we can probably get to a decent answer to the “What time is it with respect to the market cycle that matters?” question. It sure looks to me a lot like early 1938 (in a weak and slowing economy, with three big sell-offs in the past eight years and world war looming) or 1974, in the wake of three sell-offs in the past eight years, in the midst of a struggling economy, with Jimmy Carter, the Ayatollah and disco looming in the future. I expect that in the very near term, we will see a rally in stocks not unlike that which characterized the 16 or so months that followed December 1974, which will be fueled by yet another undoing of yet another “only game in town”.

The only game in town? Repeatedly over the course of my investing career, from real estate and energy stocks at the end of the 1970s to, oh my, real estate in 2005 and energy stocks in 2007, some asset category or industry emerges at a time when nothing else seems to be working. Tech stocks enjoyed similar status at the end of the millennium, when stocks of what I was then referring to as the Real Economy were stagnating toward 1982-like valuations. For a season, but only for a season, something becomes what seems like “the only game in town”. Invariably, it ends ugly, like a party that started out nice but then there were far more guests than were actually invited and soon the actual invitees are long gone and the thing finally sputters to an end with much pain, indigestion, ruined reputations and strained relationships.

So what is TOGIT as 2008 draws toward a close? Seldom has the phrase “no place to hide” been more apropos than in the last ninety days. TOGIT has either been US Treasuries or being a short seller. In both cases, the well-remarked progression from innovators to imitators to idiots is very well advanced, but for the moment, the quiet exit of what remains of the innovators is being masked by frenzied inflows from the latter category. At some point, it will become evident that the game is over. In the case of the UST, one of the broadest and most liquid of securities markets, the rush for the exits will be interesting but not likely to resemble Wal-Mart on the morning of Black Friday. Such is not the case for many heavily shorted stocks in the equity market. There is a lot of money sitting on the sidelines (e.g., the big hedge funds that got very liquid over a year ago and so are not the ones making the financial obituaries we are treated to almost every day) These guys are always looking for the next game, and when it comes to games traders play, squeezing the shorts is an old standby that comes back into vogue as soon as it gets obvious that the prevailing bias is no longer turf-ward.

There really is smart money out there (smart enough it cash out and sit and wait, that is) and one of the things that defines smart money is the ability to recognize when seekers of “easy money” have overdone it and then find a way to take advantage of it. We have already seen a few instances of stocks (HIG & TLB come to mind) that doubled almost instantly in response to some development that, charitably speaking, did little more than make them “not such great short ideas after all”. The same smart traders who make a business out of knowing who is being forced to sell and then aggravating the situation with some sales of their own also make it their business to know what stocks have high short ratios (number of trading days worth of volume needed to cover the short interest). This game got a lot easier when they took away the 'uptick rule in back on more or less the same day the fun started in July 2007. No sane observer believes that short selling “caused” the mess we are in, and there can certainly be honest differences of opinion about the degree to which false rumors passed along by short sellers might have been the difference between life and death for the likes of Lehman Brothers, Merrill and Bear Stearns, as well as how such actions should be punished, if at all. However, only a nut cake free market ideologue or an “operator” with a guilty conscience (or more likely, an urge to cling to some pretense of respectability) would deny that short selling does exacerbate volatility during the season when fear crowds out rationality. (It was not puritanical spite that, at the suggestion of the aforementioned rum-runner, who apparently was a bit of a market “operator” as well, imposed the “uptick” rule in the first place. Its removal was encouraged by academics who, based on data from an era of record low volatility, assured us was a meaningless hindrance to free and efficient markets.) Up to a point, the short interest performs an important and healthy function, but like seemingly everything else about the Market, it can and does find a way to get overdone. This is especially true when it starts to seem as if it were the only game in town and the "easy money" crowd piles in. These things end predictably, so predictably that a 50%+ rise in the Market over the next year or so, with very little if any improvement in the economic or earnings outlook, would not surprise this grizzled old observer of human fatuity one bit.