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.

The Geithner Factor? Ha!

This edition of HRVA finds us, once again, none too thrilled about living through a moment of historic import. We are not referring to what some are calling 11/4, when the “the seas stopped rising” and all that, although that does play into this morning’s funk in an indirect sort of way. No, this past week took the Market indices to depths that will rank this Bear Market somewhere between “73-74” and The Big One in the 1930s. (Apparently, there were at least three distinct Bear Markets in that era, a 48% drop in just over two months in the fall of 1929, a similar drop over a one year period starting in 1937, and the Granddaddy of them all, the 86% drop between April 1930 and July 1932.) As of the morning of November 21, no Bear Market except the 1930 debacle has been worse than what we have now gone through (Those who were long the Tech Bubble going into 2000 and didn’t get out might beg to differ.) The spirited rally that marked the last hour on Friday might have lifted our spirits a bit. It was the media explanation that this time-worn observer of human folly found exasperating.

There are two explanations for why the media informed us that the Market broke loose from a pattern of meandering uncertainty and ripped about 6% in an hour or so. The one I would prefer to believe is that, as always, certain peoples’ meal tickets are dependent on coming up with reasons why inscrutable activities happen. Apparently consumers of information and insight expect an explanation for whatever is happening in the moment, and if one wants to keep their snout in the trough from whence investment insight is generated, they sure better come up with an answer. So like when the sun comes up its because the geese just flew by (or in another time and place, that first born male child got passed through the fire), the fact that the name of the likely Treasury Secretary was leaked around the time the Market took off was a slam dunk in the great game of spurious cause & effect. Never mind that having been crumbling the way it had all week it was as oversold as it ever gets. The media and the Street do this all the time, as if there was a possibility that if just once they did not have a glib answer for the day’s fluctuation, we might tune them out and not come back.

A less palatable explanation might be that the news media is still smitten with our newly arrived Savior and eager to do their part in helping Him make history. The announcement of the name of a likely Cabinet member does clear up a bit of uncertainty, but only a small bit. How much might this glimmer of clarification account for, say, the 12% rise in the value of Microsoft that afternoon? As a conservative (one who is squeamish about the prospect of squandering what the Founders bequeathed to us) it has been disconcerting to watch the institutions that have are supposed to hold the political class accountable show such abject adoration for any public figure, let alone one who has shown strong sympathy toward the thoroughly discredited ideologies that brought so much human misery to the Twentieth Century. It will not be a good thing if even the financial media is in the tank for the Anointed One and his crew of nice folks from Chicago. One is left to hope and pray that the opposition can buy time, rebuild and rise again as voters recognize life starting to resemble the aftermath of the Great Society again. In the very near term, though, there could be a silver lining in this. To the extent that the Market is very over ripe for some kind of rally, and “needs an excuse to go up”, this sort of cheerleading could prove helpful in weeks and months just ahead.

Most likely, what transpired Friday was that the Market got a just good enough “excuse to go up”. Any excuse would have done. The Nasdaq had traded down nearly 55% from its year earlier peak as of Friday, the S&P 500 about 52%, the DJIA just shy of 50%. The whole week had been disheartening, the final hours of the two preceding days in particular. The economy, which has been slowing for quite some time (the global purchasing managers index peaked over two years ago), got pole-axed by the shock waves emanating from financial markets in September. It might not start to recover until well into next year, and when it does start to recover it could be a very tepid recovery for quite some time. That said, it is important to never lose sight of how short term pricing activity almost invariably exaggerates what is actually going on in the world of commerce. And we have got the illustration of a lifetime of this from the recent price of petroleum.

Recently, when called upon to try and be helpful to younger colleagues, I find myself encouraging them to think of investing as the reconciliation of two distinct realities. There is the reality of the enterprise that underlies the stock, which I call Commercial reality. We need to devote most of our time, effort and thought to understanding this reality; to being assured that the enterprise we are investing in has a strong commercial position and can hang on to it. It works itself out in intrinsic value, which can be quantified, but only approximately so. The other reality is what I call Price Reality. It is about fear and greed, momentum and sponsorship, and while it can be precisely measured in whatever the price is in a moment of time, it can only understood for what it is, a manifestation of the mood of an ill-informed and emotional crowd. I try to encourage colleagues to view what they do this way, as an alternative to succumbing to the Analysis Delusion. This is a tendency to build models and then treat those models as somehow real in a way that exists outside the mind of the person who made the model. Models are useful tools, but not much more, and in the hands of someone who disregards what really real, they become implements of destruction.

With this in mind, consider what has happened over the last year or so to the price of something that is much more a part of how nearly everyone on the planet goes about their daily business than those abstractions that, figuratively speaking, change hands every day on the NYSE. It is hard to remember just where a barrel of oil was priced a year ago, but $60 in 2007 would not be off the mark. Indeed, I have dim recollections of $60 seeming kind of “out there” no more than two years ago. Somehow, it found its way up to $147. Then, perhaps ninety days later, it’s breaking through $50. Somehow, the stuff that makes the trucks run and the planes fly and puts the ester in your polyester, among about a zillion other things we don’t want to think about living without, lost two-thirds of its value in about a dozen weeks. It is true that many of us have found ways to drive a bit less, and likely that economic activity will continue to slow to an extent that some price retrenchment might be in order. Any fool could tell you as much. Many of us “knew” there was something in the realm between fishy and ridiculous about it going to $147, that the “speculative interest” was acting in a way that was contrary to the interest of the rest of us. Studies were made and experts hauled before committees, but the outcome was the familiar “I didn’t do it, nobody saw me, you can’t prove anything!”

Thus it will always be. Markets are peculiar things. People want explanations, as if they were as forthcoming as what the research of the past 200 years has rendered in fields like chemistry or astronomy. Such answers about why stock prices do what they do are not forthcoming, and never will be. Part of the reason is that most people seem to so prefer answers that merely seem substantive and they reject answers that leave that matter in the realm of mystery. (Mystery in the sense of how so much else, like weather or the workings of the body remained mysterious, until science provided a bit of illumination. Despite being much more understood, these matters also retain a bit of mystery.) Markets act the way they do because humans are, to varying degrees, speculative creatures, endued with an impulse to better their lot in life by making guesses about an inscrutable future. Speculation is always with us (as long as there is freedom, and even in oppressive states there will be covert markets). Most of the time, it is benign, even useful activity. Occasionally it takes on a life of its own and becomes a raging beast. We have just lived through such a time. This will be remembered as one of those times when speculation became the “tail wagging the dog”. Actually, this is the time when the natural consequence of that abnormal state, a painful unwinding of excess, takes place. Hopefully, this unwinding has found impetus from the rapidly approaching New Year. If it is things like tax loss selling and client redemptions that have kept the selling interest so much greater than the buying interest, we are now only a couple dozen trading days away from when that is no longer the case. Let us hope so.