Is Market Warning Of The Next Lehman Event?
Mark Twain once said; "History doesn't repeat itself, but it does rhyme." which is a line that any market participant has heard at least as often as "Those who cannot remember the past are condemned to repeat it" by George Santayana. Yet, ironically, as often as these lines are quoted throughout the mainstream media and by analysts and economists alike; human nature keeps us "hoping" that somehow "this time might be different."
That is the case today. The mainstream media and the analyst community have been espousing that even though there are many headwinds currently in the economy and the geopolitical scene alike; the markets will still rise in 2012 as earnings press higher to new record levels. It is possible, of course, that this time could indeed be different. Maybe the crisis in Europe will somehow be ameliorated. It is possible that the "Super Committee" will come through with a plan that will begin the deficit reduction process without collapsing the economy. There is hope that the economy can somehow press forward without a recession in the next 4 years as estimated by the majority of economists and obtain growth of near 4% on average. These are possibilities that, as investors, we can certainly "hope" for. Those outcomes would certainly be much better than the alternative.
However, as investors, "hope" is not an investment strategy. As investors we must focus on what the market is telling us. We can hope for the best, which is certainly much better on the human psychology than the depression onset by delving in the worst, but we must invest according to what the market is telling us. Therefore, what the market is telling us today is a story that it told us previously in 2007.
The Past Is Prologue?
The red graph is the S&P 500 index from June of 2007 through July 2008. The orange is 2011. If we review our history back to 2007 we will remember that the mainstream media, analysts and economists were telling us at that time that the "subprime mortgage" issues were "contained" and that the economy would experience a "goldilocks" slowdown. Of course, even though we wrote in our newsletter in December of 2007 that the recession started in that month, for a while the market kept holding itself together.
At the end of December 2007 the first major warning that something was "wrong" was shot across the screen as the market broke below the support levels of the "Market Topping Process" (Geeks Note: Head and Shoulders Neckline) at the same time as our shorter term moving average indicator crossed below the longer term. This was a clear signal from the market that the "bullish" dynamic had changed and it was time to become much more defensive.
The market then sold off for the entire 1st two months of 2008 before rallying strongly. That rally took the markets back above the moving averages (a short term bullish signal) which had the mainstream media abuzz that it was time to get back into the markets as the danger was past. What was important to note at this time was that the shorter term moving average was still below the longer term - a very important signal was still warning that something was wrong. The rally, a "sucker rally", had brought many an unwitting player back into the casino just as the hands quickly turned cold - the market quickly began its next descent.
All of this occurred PRIOR TO what happened next - the Lehman bankruptcy and financial crisis in October of 2008.
Is The Market Predicting The Next Lehman?
Whether it is a failure of the spending cut "Super Committee", Italy, Greece, Spain or a variety of other issues from the economy to the consumer, there are more than enough potential catalysts for the next market "crisis". It really isn't as important to know which one it will be as understanding that the impact to the financial market will most likely be sufficiently negative to remove a substantial portion of your portfolio regardless.
In 2011, as shown in the chart, the market has been tracing out a eerily similar pattern as it did in 2007-2008. The same sell signal is in place, the same rally and failure of the market has occurred and the negative trend is clearly still intact. The rally in the market got the media very excited and bullish calls on new market highs and earnings records have been found aplenty.
While no one can predict the future accurately; what we do know is that more often than not what has occurred in the past does tend to occur in the future - for better or for worse. As investors all we can do is to manage the risk of begin "wrong" with our assumptions as it is only in being "wrong" that there is risk to our three most precious forms of capital - monetary, mental and time.
Monetary Capital - your principal investment is important to safeguard at all times. If you cut your investment capital down by a third it reduces the amount of growth or income that the portfolio can produce in the future.
Mental Capital - to be a successful investor in the market you need the right state of mind. A clear vision and discipline of your investment strategy and the exclusion of emotional biases are required to be successful in the long run. A destruction of mental capital leads to emotional mistakes such as buying or selling at the wrong times. These emotional investment mistakes have led to more losses of money in the markets that at the point of a gun.
Time Capital - unfortunately there has not yet been a remedy for age. We cannot live forever and we only have a finite amount of time that we can work, save and invest. Once it is gone...it is gone forever.
While monetary capital can be regained over a period time; the mental capital that can be lost due to depression, anxiety, and stress can have deleterious physical effects on your health which can be hard to recover from. Furthermore, if the damage to mental capital if severe enough it will lead to a "paralysis" that have kept individuals from ever returning to investing again making the capital destruction permanent.
Time capital is, by far, the most important of all forms of capital. When it is lost - it can NEVER be recovered. While investors can lose money in the markets and eventually get back to even - the time lost in between is gone forever. Getting back to even is NOT and investment strategy. Take a look at individuals that had 20 years to retirement in the year 2000. Today, they have made very little headway, if any, towards that goal and now only have a little more than 8 years left to get there. For many of them retirement is a dream that they can no longer afford to have.
This is why we continue to harp on capital preservation, income generation and risk management in portfolios. The cost of missing an opportunistic rally in the market is minimal compared to the cost of trying to replace lost capital. The market is trying to telling us something and we need to listen. All we have is the past history of the market to divine the future. It is an inexact and imperfect art form. It is nothing more than a well-informed guess. However, it is better than "hoping" for a positive outcome and risking the loss of monetary, mental and time capital.
The risks that are prevalent in the market today are far more than I ever remember in the past 25 years of being in the markets. I don't know what will happen for sure in the next month, the next year or the rest of this decade. No one does. However, what I do know, is that mismanaging the risks that is inherent to investing in the financial markets can lead being left broke in the casino that we call the stock market today.