Capitulation or Just Another Leg Down?

  • September 30, 2008

For the first time yesterday this bear market felt like the painful bear market I experienced after the dot com bubble and I could almost feel the fear and despair coursing through the market as the Dow Jones Industrial Average crashed 777.7 points or 7% because Congress rejected the $700 billion bailout plan. The day of unlucky 7s was a historic day because it represented the largest one day point drop in the Dow. However this does not compare with Black Monday experienced in 1987 when the Dow shed 508 points or 22.6% in a single day. The Dow would have had to drop 2,518 today to match that performance.

Watching the emails, IMs and calls I received along with the stories in every form of media, it certainly felt like a day of capitulation. The market had called Congress’s bluff. As the Editor-in-Chief of David Callaway so eloquently put it in his article,

“…the S&P 500 Index plunged to its worst day since the week of the 1987 stock-market crash, wiping out more than $700 billion in the index’s market value. In other words, we all just spent that $700 billion today — and still didn’t get a rescue plan.”

While I was totally against the original $700 billion bailout plan that felt like a blank check to Treasury Secretary Henry Paulson, the alternative of doing nothing is even worse. This liquidity crisis is going to affect everything from the ability of businesses getting lines of credit to students obtaining loans for college. As Mark Zandi, the Chief Economist at Moody’s mentioned in yesterday’s Nightly Business Report,

“I have a lot of clients, big clients, clients with names that you would know. And I’m getting calls from them telling me that they’re having trouble getting working capital. That is the cash they need to make payroll to go out and finance the inventories, to finance exports. And it’s not in just one industry, it’s in lots of different industries. And it’s not just small companies. It’s big — it’s very large companies. So this highlights the stress.

Bottom line, credit is the mother’s milk of economic activity. Without it the economy doesn’t function and that credit comes from Wall Street and the financial system more broadly. And if Wall Street is not working, neither will Main Street. And it’s not next year, it’s really next month.”

The Dow is now off 26.82% from its peak on October 9, 2007, while the S&P 500 is off 29.3% over the same time period. The Nasdaq, which mostly consists of tech heavyweights with tons of cash on their balance sheets oddly enough took the hardest hit today falling 9.14%. Having sold the last of our short positions a little over 10 days ago, the InsideArbitrage model portfolio took an equally hard hit. With the caveat “historic performance is not indicative of future results” in mind, let us examine the length and severity of bear markets since the Dow Jones Industrial Average was created in 1896. According to this article by John Prestbo,

“The average bear market over the past 111 years sent the Dow down by 34.63%. The declines ranged from 53.57% on the deep side (1932) to the shallowest drop of 21.16% (1990). They lasted, on average, nearly 11.5 months, ranging from 36.55 months (1946-49) to 1.81 months (1987).”

I have little doubt in my mind that this bear is going to be deeper and longer than the average bear market because the process of deleveraging is going to take some time both for Wall Street and Main Street. However we may have already experienced a bulk of the decline and liquidating long positions at this point does not make much sense. It may be tempting to start bargain hunting but what appears cheap tends to get cheaper in a bear market. I would be very selective and patient about adding new positions or adding to existing positions.

The Indian BSE Sensex, which dropped more than 500 points yesterday to 12,595.75 is actually up more than 140 points today as I write this blog entry. Given its 40% decline since January 2008 and India’s long-term growth prospects, the Indian market might be a better place to hunt for bargains.

Note: Due to time constraints, the next investment newsletter that is due out tomorrow, will be delayed until Monday, October 6th .