Preparing for the Fall

by: Graham Summers June 06, 2008 | about stocks: DIA / QQQQ / SPY    

Graham Summers

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Prepare yourself now.

The market is widely referred to as a discounting mechanism. However, its ability to discount anything extends only as far as the collective knowledge of its participants. And to be blunt, the vast majority of today’s investors— professional or otherwise— know little if anything about making money in the market.

With the advent of discount brokerages— E*trade (ETFC), Ameritrade (AMTD), etc— in the late ‘90s, a huge wave of novice investors entered the US financial markets. Between 1990 and 2000, the number of US households invested in mutual funds doubled from 25 million to 50 million. This wave of new, uninformed money supported two major trends: the Tech Bubble, and the rise of the financial media.

Regarding the latter, in 1990, stock market developments were relegated to 15 minutes of coverage on major news programs. Only ten years later, there were at least three entire channels—CNBC, Bloomberg, CNNfn— devoted solely to financial markets. The commentators and hosts of these shows looked good on camera, spoke knowledgably enough about markets, but in reality, didn’t have a clue what they were talking about. Their job was to provide content in large quantities, not content of high quality.

The issue of ignorance extends beyond individual investors to professional traders. As Bill King put it in an earlier essay, “There is a whole generation of traders whose knowledge of investing and financial history dates back to 1990 at most. Put another way, there are thousands and thousands of guys in their 40s who trade for a living and have never seen a real bear market or recession.”

These investors, while more sophisticated than their novice counterparts, are almost equally ignorant of any market development outside of their trading models and investment frameworks.

I mention all of this to illuminate why the market has rallied in the last two months, why investors need to be extremely cautious right now, and why the potential for a major market plunge in the coming months has increased dramatically.

As much as the financial media likes to refer to the Bear Stearns bailout and the Federal Reserve’s other recent actions as unprecedented, the reality is that similar events have occurred in the past. And history offers some striking advice as to what to expect for the remainder of 2008.

There have been three March financial crisis and subsequent interventions in the 20th century alone—1907, 1929, and 1980. And while the ones intervening changed— JP Morgan in 1907, Herbert Hoover in 1929, and Jimmy Carter in 1980— the effects of the interventions were always the same: The intervention marked a temporary bottom followed by a brief two to three month rally, then a very ugly fall (literally and seasonally).

Even if we overlook the intervention, the market has followed a similar pattern— brief summer rally followed by an awful fall— in years in which the first quarter was soft or recessionary. It did this in 1990, 2000, 2001, and 2002. Thus far, the market has followed this pattern to a “T”— the first quarter for 2008 was definitely a recessionary one and stocks have since posted a 2-3 month rally.

Thus, I believe the market is ripe for a major (20% or more) downturn in the coming months. Novice investors would do well to shift a sizable portion of their portfolios to cash.

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This article has 102 comments:

  •  
    Jun 06 06:09 PM
    "Novice investors would do well to shift a sizable portion of their portfolios to cash."
    Why cash? Historically, when stocks crashed, gold rallied. See Year 2002 chart: finance.yahoo.com/q/bc...
    Reply | Link to Comment
  •  
    Jun 06 07:24 PM
    Finally, an hard, honest look at how this financial quagmire is going to play out over the next few months. Its nice to get a breath of fresh air once in a while. Graham, I'm with you. Cash remains king!
    Reply | Link to Comment
  •  
    Jun 06 07:27 PM
    If you think the market is falling 40%, you should be directing novice investors to leveraged inverse ETFs, not cash.
    Reply | Link to Comment
  •  
    Jun 06 08:21 PM
    Isn't it funny how some decent market downturns drive all the bears out of hibernation with their 'I told you so' articles scaring everyone about the coming doom?
    Reply | Link to Comment
  •  
    Jun 06 08:31 PM
    Since beginning to learn how to invest/trade or both two years I have concluded that making money from investing is very difficult. One thing I have learned in the last year is that the market can go way up without any real economic ( or at times rational) reasons.Or maybe the why is information I dont have..or whatever...
    I have learned a great deal, and am facinated and hooked, but I remain 90% in cash since fall of '07. I can figure out what should do well and why, on many occasions, but this market is too scarey for me to risk losing my money!
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  •  
    Jun 06 08:35 PM
    To blah-blah: better to be a bear arisen from hibernation than a bull who is killed for his meat (or a bull run over by the freight train called Recession or Depression).

    And if there is anytime during our lifetimes that "a coming doom" may actually come to pass, it's now.
    Reply | Link to Comment
  •  
    Jun 06 09:17 PM
    We have only seen the tip of the iceberg recession and the market has not discounted it. Head for the exits. cash is king now!
    Reply | Link to Comment
  •  
    Jun 06 09:30 PM
    "As much as the financial media likes to refer to the Bear Stearns bailout and the Federal Reserve’s other recent actions as unprecedented, the reality is that similar events have occurred in the past."

    never in the history of the federal reserve have they exposed themselves to significant balance sheet risk by directly backing funding of one private party to acquire another. this was unprecedented and it was a panic move, which tells you the mindset of the federal reserve about the stability of our financial system.

    those legions of investors who have come to think that the all-powerful federal reserve can solve the collapse of housing, the evaporation of credit, a declining dollar, rising inflation and an increasingly-pinched consumer stretched to the limit because of a quadrupling of oil prices over the last 4 years i have news for you:

    it ain't going to happen.

    anyone who is strictly long stocks in this environment needs to reevaluate their strategy. we've just begun to feel the effects of years of cheap and easy credit. and the fed is out of ammunition.
    Reply | Link to Comment
  •  
    Jun 06 09:46 PM
    20% plunge is too optimistic. I would not be surprised to see DOW at 5000 and S&P at 600.
    Reply | Link to Comment
  •  
    Jun 06 09:46 PM
    I agree with most comments here.

    Fact: The US stock market is now the most manipulated & corrupt market in the free world. Our own gov't and FED admit that they "influence" the direction of the market, thus making it very hard to game the market for those of us like me who use about 15% of our portfolios to "boost" returns by making directional bets on the market"
    And I have been at this for 15 years already. I cant even imagine a novice trying to make money here.

    However....

    The 85% of my portfolio that is "long term" is, and continues to be, invested in individual stocks, that trade directly on exchanges, in countries that, compared to the US, are fiscally more responsible, do not manipulate their so called free markets, and do not face an insane amount of entitlement program problems over the next 25 years.

    Thats probably why I am up 8.5% this year so far, and up over 120% in my portfolio since Jan 1, 2000.

    To invest and "beat" Wall Street you have to ignore the noise and lies, and "buy them when nobody wants them" (and no, we are not even close to that point).
    And when stocks are high and you have made boatloads you say to everyone else "Here, take mine"

    That is how you beat Wall Street. Not by watching Mad Money, Fast Money, etc.

    Good luck to you all. I really hope, that at some point, the criminals running our country into the ground, Kudlow and the rest of the bold faced liars on CNBC ,et al, get theirs for all their lies.

    Don't think for a second that all the multi-millionaire CNBC anchors give a damn about the market going down, nor for the average american who is getting killed and going to get killed even more, regardless of how they spin it on TV.
    Reply | Link to Comment
  •  
    Jun 06 10:02 PM
    Not to quibble, but the statement that in 1990 there were no financial channels such as today's CNBC, CNNfn, Fox Business News, and Bloomberg is simply a false statement. I was watching the Financial News Network, with Bill Griffith, Sue Herrera, Ron Insana, and technician John Bollinger back in the mid-80's. CNBC entered the scene in 1987 if memory serves. At that time, CNBC was struggling mightily, much worse than Fox News is struggling today. It takes time to find the right formula, but with enough time and money, it happens.
    Reply | Link to Comment
  •  
    Jun 06 10:23 PM
    The Fed Chairman Monday speech only lasts for 3 days, lips service for strong dollar.

    Fast/Mad money are just noises.

    Read Fischer Black.
    Reply | Link to Comment
  •  
    Jun 06 10:25 PM
    My solute to Rick of CNBC, he is a real guy.
    Reply | Link to Comment
  •  
    Jun 06 10:25 PM
    Pilar, the stock market is not right for everyone. There are no "sure winners," and the market always scares investors. What would it take for you to be "sure" and buy stocks? I am very cautious of this market, so I am taking a conservative approach. I will post some ideas on what I am doing--just as food for thought--not as a sure plan.
    Reply | Link to Comment
  •  
    Jun 06 10:27 PM
    Remember how the Fed starts to cut rate and thus caused the global inflation? it begins with the infamous "thy know nothing." noises.
    What a farce, ECB at least has a clear focus. Life is simple, who complicated it?
    Reply | Link to Comment
  •  
    Jun 06 10:29 PM
    We can make money no matter it is bear market or bull, only pig get slaughtered..

    I did not say that...
    Reply | Link to Comment
  •  
    Jun 06 10:34 PM
    The author of this article is foolish at best. He calls most investors novices that have no idea of how to make money in the market. That is just dead wrong.

    How well have the professionals done lately? Hmmm... doesnt look to me like the professionals know their arses from their elbows either! Honestly, I dont think I could lose billions if I tried to.

    Sad truth, most professionals are greedy idiots who participate in rising markets. Anyone can make money in a bull market, anyone. Many hedge fund managers are ex atheletes and others who came into a little money and decided to start investing for others too. Time has shown now, that the bull is gone, that they SUCK. I consistently outperform the S&P, 80% of all mutual funds dont. But I am a poor novice who doesnt know how to make money. Give us a break!!! Most investors simply dont have the TIME, its not their job.
    Reply | Link to Comment
  •  
    Jun 06 10:39 PM
    Oh yeah, this "novice" investor cashed out of the market at 13,800 completely because he knows who to listen to and saw the writing on the wall. How many professionals did that?? Most persons I know have had their 401Ks in cash since late last yr as well.

    He has one thing right, the fall is coming.
    Reply | Link to Comment
  •  
    Jun 06 10:47 PM
    Believe this. The bottom will be in when no one wants to own stocks anymore. No one. As long as investors and institutions cant wait to get back in, we will be no place close to the bottom, thats still a sign of bubble-mania. We will not plunge, this will be a slow slide with ups and downs over maybe a year till we bottom.

    Reply | Link to Comment
  •  
    Jun 06 11:27 PM
    So the author argues that today's investors are generally amateurs and therefore the market is overpriced. Then he rolls into a few years over the last hundred where a "March fnancial crisis" occurs, followed by an "intervention&quo... I'm sorry but, anyone can find 'historical patterns' to support any market movement that want by cherry picking the years that work for their model. I do not subscribe to technical analysis. The author will have to show a fundamental reason for his prediction of a 20% or more correction if he wants to convince me. The author predicts the market will be 20% or below "in the coming months". Therefore, it is reasonable to assume he believes the S&P 500 will be at 1,100 or below "in the coming months". If it the market ever goes below 1,100, then I guess his prediction will have come true, but it doesn't sound like something of use to many investors.


    Reply | Link to Comment
  •  
    Jun 06 11:43 PM
    We've been in a bear market for a long time. For instance, the NASDAQ is about 1/2 of what it was at its peak in 2000. Many stocks like Microsoft, Johnson & Johnson, and General Electric are selling for about what they were in 1998.

    What we're looking at right now is a consumer under pressure, unable to spend at the rate he was before. Yesterday's performance was a perfect storm of rising oil prices and unemployment. Rising oil prices affect the ability of some businesses to survive, much less operate at a profit.

    Still, gas is cheap in the US, about half of what it is in Europe. Homes are cheap compared to Europe, and getting cheaper. Unemployment is 5.5%, but that's a rate that most European countries would love to have.

    I think that the financial news channels tend to drive the markets faster in either direction, but I'm not sure they have any long-lasting effect. America has incredibly strong brands that will be dominant for generations, and these brands are doing well in developing markets. I'm a skittish bull these days, doing OK on my energy-related stocks, getting slaughtered on BAC, and breaking about even on my REITs.

    There is a lot of liquidity around waiting for a signal to join the party. We'll see what happens to that money when the market makes a move up.
    Reply | Link to Comment
  •  
    Jun 07 12:02 AM
    Its much worse than that. The consumer is not under pressure, they are finished, tapped out. As long as the housing bubble was creating the illusion of increasing wealth, consumers were happy to spend into debt, not saving anything, depending on rising home prices to be their "savings".

    Thats over for the foreseeable future. We are going to see an epic bust in home prices, and consumer spending. Combined with severe contraction in credit, we will have deflation in all assets and a sever e and protracted economic downturn.

    Consumers have finally noticed that it takes two parents working to maintain a standard of living that one did 30 yrs ago, and that everyones quality of life and family is actually worse. Government lies about inflation, employment, and prices used to propagate the bubble, in addition to blatant market manipulations, have destroyed all confidence in the governmental oversight of financial markets.

    If it gets bad enough, we could see a revolt against the US government and pigmen.
    Reply | Link to Comment
  •  
    Jun 07 12:12 AM
    @Eagle-Chief - for those who live off capital appreciation and the short term, I would fear for them too.

    @The rest of the commentors - I'm not selling, a long bear market would be a wonderful thing. Scare as many as you can, I need to keep buy for the next two years and a new bull would only slow me down.
    Reply | Link to Comment
  •  
    Jun 07 12:29 AM
    Look at this way...

    Is what's happening around you ($150 oil, rising unemployment, declining home prices, banks struggling, etc.,) sign of current and continuing prosperity?

    I can't predict the future with certainty, but the present sure looks pretty bad. Better to sit out and miss a small gain than to blindly stay put and suffer a huge loss.

    Get out, sit back, relax and let the skies turn blue again...
    Reply | Link to Comment
  •  
    Jun 07 01:08 AM
    Who really cares anymore? Maybe a good slap on the rear will do us good.
    Reply | Link to Comment
  •  
    Jun 07 01:13 AM
    OIL IS $140!!! In 1998, is was $10. 14x return. And only getting worse. Maybe we could invent something harvest the Carbon out of the atmosphere, the American lifestyle deserves a second chance!!!
    Check out SDS... is an Ultrashort (2X inverse) fund on the S&P... up about 7% today alone and doing good for the year.And DBC is a good all around commodity bet. It went up 6% today. Being in the stock market is like gambling to a degree, but my gut is definitely more involved this time. And the market is going to go on a diet. We are going to get a reality check. We are basically going to resemble Europe as our unemployment and gas goes up....
    Reply | Link to Comment
  •  
    Jun 07 01:15 AM
    Mkts that breech their winter lo's in Jan fall on avg 39%.
    We had a 1st week in 2008 that was DOWN;a DOWN JAN;& NEGATIVE MoMo!

    also the DOW UTIL's are tracing out the same topping pattern that it did in #2001. Then as it appears now JUNE will drop off of a cliff! The trigger? who knows, but the news will accomodate the trend!
    Reply | Link to Comment
  •  
    Jun 07 01:23 AM
    And this is a good thing. We need to slow down. There is enough for everyone that is serious about survival. In the history of the world, no one has ever said that they regretted slowing down to enjoy the simple things in life. Never.
    The fact that America suffers from an epidemic of obesity is a spiritual symbol of our culture. It couldn't get anymore literal.
    Study a movement called Calorie Restriction. An adequate survival level for calorie is around 1000 per person.
    And for the record, I can be a frivolous carbon consuming fool at times. But I definitely welcome any changes. Hopefully I can handle it too.
    Reply | Link to Comment
  •  
    Jun 07 01:52 AM
    If you look at historical charts, about twice every decade, the stock indexes plunge about 35% from the top. This current market is considered to be almost an equal %wise to the Great Depression in housing asset devaluation...
    That index run-up was totally manipulated - volume has been 1/3 of a true, expected rally's volume.
    Reply | Link to Comment
  •  
    Jun 07 02:15 AM
    The author should look in the mirror, he is one of the ignorant media talking head referred to in this article.

    If this article was posted even a few days earlier, it would have some value. Posting this after the friday bloodbath shows he's just another lemming following the herd to create fear after a down market, they are the same ones that were posting bullish crap when the sp500 was at a double top at 1420 a few weeks ago.

    Dont listen to any of those "experts", seekingalpha is a cesspool full of those amateurs. Use your own technical and price/volume/time, filter out all the noise. I belive we still have a few relatively large down days left, then the market should be bottoming out, setting up for a good summer rally.
    Reply | Link to Comment
  •  
    Jun 07 03:07 AM
    We (South) Africans have long ago learned how to have a good quality of life on very little. Its time the US also learned this (hi-tech is only partially the answer). The US is the most efficient economy? Please. I'm putting my money squarely in the new energy camp. And that doesnt mean a battery-powered Cadillac . Its a headspace thing.
    Reply | Link to Comment
  •  
    Jun 07 05:53 AM
    Technically, most market indexes (and this includes Europe) have retraced to the pre 911 level. By doing this they have built a HUGE double top and "w" reversal formation. Additionally, Moving Averages show 'death crosses' . The outlook for the next months (except for certain sectors) is certainly not brilliant. Hence the idea to move into cash and to reallocate it later this year upon weakness surely is not a stupid one. One ONE condition though... assets must be moved into REAL MONEY (gold and silver). (goldonomic.com publishes more on these reversal patters)
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  •  
    Jun 07 07:13 AM
    Oil at $139 a barrel. I'm short the SPY. So far , So good. I will explain my short @ theinvestingspeculator...
    Reply | Link to Comment