The Market Selloff Fear Train

* When markets trade down, people go searching for a reason or catalyst for the markets actions. When the market goes up, anyone invested thinks they are a genius. From 1982 to 2000, stocks were in a major uptrend and this bull market launched a lot of geniuses. The 18 year bull market in stocks also correlated with two other secular trends: a bull market in the bond market and a bear market in gold. Since 2000, stocks have swung wildly around in a very large range. In fact, the swings since 2000 have been dramatic:


2000-2002 – down 50%

2002-2007 – Up 100%

2007-2009 – down 58%

2009-2010 – up 83%


Yet the net change has been modestly lower, as the 2000-2010 decade produced a net drop of 24%. Most people tend to ignore the 2000 to 2007 period during which prices made no net change, when you compare the two highs. In fact, most people associate the rally to 2007 as being part of the previous bull-run, when in fact the net change for the previous 7 years was about a break-even.


What causes markets to swing back and forth, with rather large moves? Typically, we like to ascribe major market moves to specific events, and secular trends. This creates an intuitive and intellectual connection to what the market is doing, with its participants, and the public at large. And if you go back in history over decades or centuries worth of data, you will see that there were major trends which can account for decade’s worth of market movements.


The world approached the past decade with trepidation, as Y2K was a possible stumbling block to the world’s future success. We got past Y2K, but the markets were about as high as they will be for a long time on January 1, 2000. There are two ways to approach the stock market in the context of the 2000′s:


1>  The markets are continuing the massive bull run of 1982 to 2000, or

2>  The markets are transitioning to a bear market. Whether the bear market began in 2000, or 2007 is irrelevant today, to proponents to this view.


If you listen to David Stockman, former budget director for Ronald Reagan, he will tell you that the markets are going through a secular debt and asset liquidation phase. Stockman contends that we are at the end of a 40 year debt and asset binge, and the unwinding of this binge has to work itself out before the economy can start to grow again. If you adopt Stockman’s theory on what is happening, then the last decade is one of transition, and the next decade will be one of deflation and decline in the US. 


No one is going to debate whether we are in a period of debt liquidation, but rather the conversation centers on what the impact from this liquidation is going to be. And this also characterizes the dichotomy between those forecasting deflation, the deflationists, and those concerned about inflation because of the massive growth in money supply.


Readers of this blog will know how much energy I spend trying to parse out the merits of each side of the inflation/deflation debate. It would seem to me that the normal rules of engagement with respect to monetary policy, (and inflation concerns), are being thrown out the window according to the “liquidity trap” theory taught in Econ 101. This theory, which was taught when I went to college and business school a while ago, contends that after interest rates are lowered to zero, monetary policy becomes in-effective, since rates cannot go lower, and policy at that point is the equivalent to “pushing on a string”; in other words, monetary policy is rendered useless when interest rates are at zero.


For the last year, I have been harping on the concept that the stock market rally, following the March 2009 low, was a counter-trend correction and would be completely retraced, when the bear market, which began in 2007, resumed. My thesis, and lower stock prices clearly fits within the deflationary camp, and it seems that most of the evidence I can draw upon, supports the deflationary thesis. And so it is with a resumption of the bear market, and phase 2 of the Great Depression, that stock prices are headed lower. Do the markets need a catalyst for a sudden drop to occur? I am concluding that it does not. I was out with a client on Tuesday night, and he expressed a bearish view towards risk assets. I told him I was looking for a catalyst for a market free-fall, consistent with the markets being in a third of a third (Elliott) wave. And as this down move unfolds, I am expecting a drop of at least 13% in 8 trading hours, which would at least equal the free-fall in October of 2008. In an email exchange yesterday, this client suggested the following:


“Like i said last night, I think fear will be the next catalyst for a leg down. I have been talking to a lot of people today, between running bonds and doing month end pricing, (and) there is an aversion to length and risk. I wouldn’t be surprised if we had a couple hundred point drop over the next week or two in the DJIA, due to fear coupled with a loss of confidence.”


This person hit upon a very basic concept which will likely be the driver on this leg down: FEAR and a LOSS of CONFIDENCE. The fundamental reasons for the market to sell-off is firmly in place, that being the debt deflation and asset liquidation, which appears to have many more years to run. As a side note, the DJIA is already down 225 points since he sent me that note yesterday.


Re-inforcing this concept, I will point to the first of two market free-falls, which occurred between October 3rd and October 6th (across a weekend). From Friday afternoon to Monday, there were no bad headlines or economic data. In fact, the selling began following a benign unemployment report earlier in the day, and after successful passage of the TARP legislation. Of course it did not help to have our President, George Bush, admonishing the American people (prior to the passage of TARP), to get their Senators and Congressmen to pass the TARP legislation, to prevent “The house of cards from tumbling down”. That comment did not help, and along with numerous large bail-outs, mergers or failures which were occurring on a weekly basis up to this point in time, when investor confidence was destroyed. Would-be buyers of stocks, who typically would have been there to keep the market from sinking, decided to hang onto their money, and allowed prices to drop.


I read an interesting piece by one market commentator this morning, who was trying to figure out why the stock market is off by 10% in the last 2 weeks. He concluded that he could not come up with a good reason. To that I would answer that all of the deflationary arguments that have been made, have not gone away. And as stock prices continue to drop, they will reach levels which cause investors to question the underlying premise behind an investment in any stock. Investors loved the idea of buying stocks from 1025 to 1050, and for a while it looked like they captured lightning in a bottle. What happens as the S&P breaks down through 1000, (it is at 1017 now)? The premise of the buyers starts to fade, and their confidence is first replaced with uncertainty, and with additional drops in price, uncertainty is replaced by fear, and selling. When everyone is bearish, and prices are much lower, is when you should think about buying stocks. But for now, the fear trains is just getting going, and in the absence of any real catalyst for a market sell-off, this train is right on schedule_..