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THIS IS THE REAL THING

Now the bubbles have burst, the boom has gone bust, and the priests at those temples of investment have revealed themselves to be emperors without cloths. The mighty George Soros, lost $2 billion on his speculative plays in Russia, which I insisted was a no-go area quite some time ago. Omega Fund was down by 26% during the month of August. John Meriwether’s Long-Term Capital Management announced that it had lost $2,1 billion, half it asset value, so far this year.

Since July, the total market capitalization of US stocks has fallen by $2 trillion. Citicorp’s stock has dropped to about half its recent high, losing $ 40 billion. General Electric Corporation, the world’s most valuable corporation, and one of the most admired, says its stock fall by 22% for a loss of $68 billion. As of mid-September, stocks traded on the New York stock Exchange mere showing an average loss of 38% this year while more than half of all the US domestic stock funds were losing money for the year.

Obviously, the real losers were the private investor who believed that following a trade which was the strategy executed by most fund mangers-represented some kind of investment expertise. The true test of any fund managers is his performance during a complete up and down stock market cycle, not simply a bull market cycle. Just for the record, during the month of August, the Beckman International Capital Accumulater Unit Trust, whose £48 million portfolio of investments were under my stewardship, was making new all-time highs while clients of my private portfolio management were showing gains of 6% on average during the month.

There is no shortage of reasons offered to explain the recent sell-off in equity markets. These range from the problems in the Far East, to the turmoil in Russia, to the domestic political problems in the US, and much more. Yet, while these this factor may appear to be the determinants of the current chaos in financial markets, these are merely catalysts, rather than an underlying cause. It is important to identify the underlying cause of the ongoing decline in financial markets for the purpose of determining how long that decline is likely to last and how much further stock prices have to fall.

It is currently the view of the consensus that problems in Russia and the Far East will be contained and have little impact on Western economies. As such, it is also the view of the consensus that as the west demonstrates its resilience to these problems; financial markets will begin to rise again. Therefore, the investment advice offered by the consensus is that the investors should simply « sit tight » and do nothing. I truly believe this to be the worst investment advice anyone could take.

Conceptually, the relationship between financial markets and contemporary economic condition to which the consensus subscribe is wholly inappropriate. Sentiment has shifted decisively for the first time in 22 years. This is the true cause of the malaise in financial markets. The reasons for the shift in sentiment are multifarious and peripheral. The important factor to consider is that once there is a change in sentiment, it takes quite some time to reverse that trend.

 

THE WORST IS YET TO COME

Bear are inevitable. There should no doubt about that. Based on a standard definition, a 20% markdown in stock prices from the previous high, and the US experiences a bear market about as often as it elects a president once every four year. European markets invariably follow the US market. Depending of whom is doing the counting; there has been twenty-four, twenty-five or twenty-six bear markets this century. Savage bear markets occur about every six and a half-year. Smaller declines of about 10 %, called « corrections », happen every two years or so. Taken together, this minor and major setbacks have produced losses in thirty-three years out of the past one hundred, leaving investors quite unhappy one third of the time.

Currently, all of the world’s major equity markets are experiencing cyclical bear markets simultaneously. Like bull markets, there are certain patterns of behavior that are common to bear markets. One pattern of behavior that every investor should commit to is psyche during the course of any bear markets is that during a bear market stock prices will always tend to fall faster, much further, and for much longer than anybody believes possible. Stock prices peaked in July of this year. If I am correct in my assumption and this is a cyclical bear market, it therefore has quite a long way to go both in terms of duration and amplitude.

The amplitude of a bear market can be far greater than most assume. When a bear market is preceded by speculative mania, as was the case during the 1920’s and the 1990’s, losses of 80-90% from the peak in the major indices are common place. Between 1929 and 1935, the Dow Jones Industrial Average lost a full 90% of it’s value. It would therefore not be unrealistic to expect the Dow Jones Industrial Average to fall below the level of 1, 000 before this bear market is over.

Those who believe they can merely wait through a bear market, and wait for a recovery, should give some serious thought to that strategy. Investors who bought at the market top in 1929 didn’t see a hint of profit until 1954. In other words, investors had to wait 25 years to break even. Most couldn’t wait that long!

Trying to sit through a bear market could also mean missed opportunities, especially during a deflationary economic cycle. While stock prices plummeted from 1929-1932, government bonds prices scared. The yield on US Treasury bills became negative while long term US Treasury bonds rose to a level where the yield dropped to under 3,5%. Bond markets could readily become « bubble » markets in the period ahead. On the other hand, beware of corporates.

RC BECKMANN

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