Rational Advisor

Panic selling is what we are seeing. Markets have seen their steepest ever falls as investors dismiss moves by governments and central banks to calm things. It’s all about Psychology over reality, and currently psychology and emotions (Signmund Freud) is triumphing over reality (Benjamin Graham)

The Chicago Board Options Exchange volatility index, or VIX, shot above 80 – another record high in what has been a series of record-breaking days and a sure sign that the level of fear among investors is at extreme levels.

The growing flight from risk has also pushed commodities sharply lower.

The straw that broke the markets back recently has been the liquidation of mutual fund holdings by retail investors. This has forced the hands of savvy managers to make selldecisions, when in fact they want to purchase.

The falls came in spite of a co-ordinated rate cut by six central banks, the unveiling of a never before seenbail-out plan for UK banks, and a move by the US Federal Reserve to lend directly to borrowers in the commercial paper market.

The U.S. is weighing two dramatic steps to repair ailing financial markets, according to the Wall Street Journal: guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits. If the two moves come to fruition they would mark the government’s most extensive intervention yet in the financial system.

Another thing that’s affecting the markets is computerized program trading. Because computerized program trading is based on algorithms, and they all use the same or similar algorithms, they magnify market moves by an order of magnitude. This makes the markets very volatile.

Traders have also attached significance to the fact that history’s previous great stock market crashes had all happened in October.

A Crash Course in History

Please note, I am using the market indices to explain the volatility and notyour portfolios.

The current selloff is very similar to the 1987 drop.

What the market has done over the past few weeks duplicates what happened in the one-day 1987 crash, when the Dow Jones industrial average fell a record 23%. In the past ten trading days, Standard & Poor’s 500-stock index has fallen about 20%. Could past be prologue?

The S&P has fallen about 42% from its record high exactly 12 months earlier. Since 1926, the average bear market has seen a retreat of 38%. But what’s really remarkable this time is how fast much of the damage has occurred. The S&P closed September 26 at a 22% loss from its peak. That was miserable. But what followed was much worse. Since then, the S&P has lost almost as much as it lost over the entire previous year.

In 1987, the Dow peaked on August 25 at 2,722. But the Dow was still at 2,508 on Tuesday, October 13 — a loss of just 8% — when the slide began in earnest. The Dow fell 95 points on Wednesday, which was almost 4%. Thursday, it fell another 58 points, and Friday it lost 108 points.

The big drop came Monday, October 19. It was a 508-point crash caused mainly by leveraged derivatives-portfolio insurance-(computer trading) which, ironically, had promised to insulate big investors from the risk of a sharply falling market. As Wall Street fell, portfolio insurance triggered selling in stock futures in Chicago, setting up a feedback loop.

In other words, the 1987 crash was, like the current crash, caused by financial instruments. The exotic mortgage securities billed as low-risk by Wall Street’s geeky rocket scientists are far more complex, but ultimately they had the same kind of nonsensical stupid thinking behind them: They basically offered a way to leverage up to great returns with no apparent risk.

On October 20, 1987, the financial markets nearly collapsed. Stocks simply didn’t open for trading when the market did. No one was willing to buy. Ultimately, however, the market rallied, and October 19 turned out to mark the bottom of that bear market. There wasn’t even a recession, even though everyone and their uncle said there would be one. In one and a half years, the market reached a new high — and kept rising for another ten years. (The more broadly based Standard & Poor’s 500-stock index hit its bear-market bottom on December 4.)

Given the depth of panic in the stock markets, I think we may well be near the bottom. Of course, I can’t be sure. Indeed, I thought it was time to buy a week ago. But the wisest hands I know among fund managers are all finding terrific bargains among the highest-quality stocks.

What we are seeing is classic market panic.

Here’s how we expect the situation to unfold. In a few weeks, Treasury’s plan will start up. Uncle Sam will begin buying up banks’ toxic debt, getting it off their books, sequestering it for resale later. If the reverse auctions planned aren’t clearing away enough of the rubble to get banks lending again, Treasury can and will step in even more directly — taking the route the U.K. plans — buying banks’ shares to provide the liquidity needed to keep wheels turning.

By year-end, credit markets should be functioning better. Commercial paper will be moving again. Long-term lending — corporate bonds, and so forth — will start picking up. It will take more months to return to normal, however. Wide interest rate spreads will linger well into 2009. Typically 50 basis points, the gap between T-bill rates and those for three-month euro dollar loans, for example, is now about 10 times that much and getting wider. That won’t reverse. And corporate bond issuances and bank lending won’t return to more normal levels until confidence in the credit markets is restored.

Clearly, the markets are not going to go to zero - even though there seem to be a lot of smart people that feel that way. At some point, investors will have to recognize that there are stocks out there that have been unfairly punished and are dirt-cheap bargains.

In fact, it’s harder and harder by the day to argue that the market as a whole is overvalued. The S&P 500 is trading at just 9.5 times 2009 earnings estimates.

Once fear begins to subside, he thinks investors will flock back to big companies with relatively healthy businesses that look attractive.

Closer to the Bottom

There’s reason to believe that the stock-market averages will hit bottom sometime in the next few months, even if the economy is still in the middle of a recession.

The lesson of history is this: The average U.S. recession since the late 1940s has lasted 10-12 months, and stocks typically hit their low point about three months before the recession ends. So, if the U.S. entered a recession on July 1, as many economists now suggest, and the recession was to last until April 2009, a typical bottom for stocks would occur some time in the next few months.

Granted, much depends on the ability of the Federal Reserve and the U.S. Treasury to put rescue measures in place that will unlock today’s frozen capital markets. And there are nagging concerns that the next disaster may lurk in the unregulated $60 trillion market for credit-default swaps. But the fear that sent the market down so sharply may have driven stocks close to their ultimate lows.

Recessions certainly have been both shorter and longer than the 10-month average. On a positive note, five recent recessions were shorter. The 1980 recession lasted a mere six months, and there were four recessions that lasted only eight months, according to data from Bespoke Investment Group.

Though a typical recession would end by next spring, economists are paying increasing attention to longer downturns, specifically the two recessions since 1940 that each lasted 16 months. The November 1973 to August 1975 downdraft was sparked by the Arab oil embargo, while the July 1981 to November 1982 recession was triggered by the Federal Reserve hiking interest rates dramatically to curtail runaway inflation. In each case stocks bottomed about three months before the recession ended.

The good news today is that stocks appear to have gotten out ahead of any recession, falling so sharply that they might already have priced in pretty horrible times ahead. The Dow is down almost as much in the past year as the 45% it fell in the 1973-1975 recession, and its 12-month decline far exceeds the 24% it lost in the period leading up to and during the 1981-1982 recession, according to Birinyi Associates.

Today’s 40% drop also far surpasses the average bear-market slide of 30% since 1940. Markets that decline for more than a year average a loss of 42%, says Paul Desmond, President of Lowry Research Corp. The Dow has fallen by more than 40% 10 other times, with all but one such drop occurring between 1900 and 1930. It slid by more than 50% only once, between 1929 and 1932, when it shed 89%. That bear was bracketed by the Great Depression, which lasted for 44 months.

A recession is labeled a depression when economic activity shrinks by 10% or more. From August 1929 to March 1933 U.S. economic output contracted by more than 30%. That’s what made it “Great.”

But back in the ‘Thirties, the financial markets lacked many of today’s safety nets, like deposit insurance, and the Federal Reserve didn’t loosen the purse strings quickly, as the Fed lately has done. Also, the stock-market rally leading up to the Depression was much more frenzied. From 1921 to 1929, the market rose almost 500%. In the rally from 1987 to 2000, stocks jumped 574%, but did so over a much longer period. From 2002 to the market’s peak in October 2007, the Dow rose 94%.

Given stocks’ swoon in the past 12 months, prices look much more reasonable today. The companies in the Standard & Poor’s 500 trade for an average of 11.6 times the profits that analysts expect them to earn next year. And the index trades at 17.1 times the companies’ most recent earnings. That’s only slightly below the market’s 60-year average price/earnings multiple of 17.8, according to Birinyi Associates.

The current P/E is still high compared to the low P/Es of previous major recessions. During the ‘74, ‘80 and ‘82 recessions, the S&P’s trailing P/E dropped to between 6.8 and 7.2. But in the ‘70, ‘90 and ‘01 economic downturns, the P/E ranged from 12.9 to 23.5.

Keeping cool

I have been saying that we are in an irrational exuberance negative bubble (similar to a recent oil bubble or internet bubble of 2000, only in reverse. As was the case when momentum buying created irrational enthusiasm in anything housing, credit or commodity based, redemption and fear-based selling is causing the opposite effect of excessive despair - Irrational fear has gripped the investing public.

The hardest thing for most investors to do is to go against the crowd, to keep a cool head when other investors are losing theirs.

Don’t lose hope. A financial panic causes people to lose their ability to reason. But just because a panic can end in utter economic disaster doesn’t mean that it will. Just as banker J. Pierpont Morgan could quell the Panic of 1907 by walking onto the floor of the New York Stock Exchange and buying bank stocks, so too could decisive government action contain the Panic of 2008. You may not know the outcome of this drama for weeks or months to come.

Will this decline go on another six months? Another year? It’s possible, of course — and probable, if government rescue efforts fail to gain traction.

But I have little doubt that buying stocks when panic is so widespread will look like a wise move in a couple of years or less. For those who own stocks, it’s way too late to sell. For those who can afford to invest more in stocks, I think this a time to do just that-as was October 19, 1987.

I am inclined to believe that, the more things change, the more they really stay the same. Though, at an outer level, recent events are undeniably without precedent, at a deeper level, the same forces that always make the market tick are still at work.

Here are some good things to think about

* Ottawa is buying $25-billion in insured mortgage pools in an effort to boost lending by the country’s banks and reduce borrowing costs for Canadians.

* Global interest rate cut followed weeks of central bank moves aimed at unclogging credit markets.

Amid the sell-off, some analysts pointed to possible opportunities in the coming weeks.

Tim Bond, head of global asset allocation at Barclays Capital, wrote in a report last week: “We believe global equity markets are starting to offer a long-term buying opportunity that is typically only seen once in a generation. We are not calling the bottom in the bear market today, but we do suggest that the low will be seen within the next two or three weeks.”

He went on to suggest that returns from equities purchased during this interval may well be extremely high over the next 12 months and could – if history is any guide – average double-digit long-run returns over the next decade.

This global slump is going to take a while to unfold, play out and finally end. But I believe that a few years from now, we’ll look back on this period as one of the great buying opportunities of a lifetime — like Dow 777 in the dark days of mid 1982, when a Newsweek cover story speculated on whether another Great Depression was at hand.

The fear then was understandable, because U.S. unemployment rose to almost 11% that fall, before the economy and markets began to recover. Other great buying opportunities? How about the days immediately after the crash of October 1987. Wise investors did a lot of buying then too, which they’ve never regretted. I don’t think this is the end of the world as we know it.

This is not a Benjamin Graham market, the father of value investing. This is a Sigmund Freud market. eventually though Benjamin Graham will make more sense.

Rational

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