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Yellen Bloody Murder - Bleeding The Stock Market To Death Properly

Segments stock market officially entered bear market territory a couple weeks ago. Through much of April, they were floating above the -20% mark. Now it is below that mark. Is the question for how long? A look at the history of bear markets shows everything from lasting mere days to dragging on for years. The bear market of 2020 was the shortest on record, lasting less than a month. The longest lasted nearly 7 years during the 1970s. The three worst declines were 58% in 2007, 49% in 2007 and 48% in 2000.

The problems used to explain this bear market are many and suspect: Inflation, China, supply chain problems, rising energy prices, rising interest rates, a threatening Federal Reserve, decaying corporate earnings. How about none of those? How about really deep structural problems which effectively require the market to “unwind” incredible overvaluations in virtually every sector?

May 18 was the big day that sent the signal. May 17th, the Dow closed at 32,654 which was a drop of 1,164 points. Yes, that is a lot in one day. The next day, the Dow dropped another 137 points, giving a two day drop of 1,301 points and closing at 31,253. The Dow’s recent high was 36,800 on January 4th. That is a 14.3% drop from the high. That is still not bear market territory, but that rapid drop is a warning. Curiously, from high to current low, the canary in the coal mine, the Dow Transportation Index is also down 14.3%, as of this writing on June 6th. Why?

How many times have we been subjected to MORE quantitative easing, MORE flooding the market with cash to sustain much needed liquidity? Commentators have warned repeatedly about what would happen when the Fed takes away the “punch bowl”.

Well, now, supposedly, they are taking away the punch bowl. The threat has been enough to shock some investors.

An unanswered question is how long has this really been going on? By one historical interpretation, the current problems can be dated to the repeal of the Glass-Stegal Act in 1999. This allowed commercial banks to engage in risky trading practices – enter credit default swaps. Suddenly, Wall Street banks developed a massive appetite for highly leveraged positions. In a case of grave extreme one investment firm, not named here, actually took a position of leverage of 1:113. In other words, for every dollar lost, the firm would have had to pay $113. Now, in fairness, some firms would claim they had positions that cancelled each other out. Well, that didn’t stop firms like Bear,Stearns, or Lehman Brothers or AIG from getting into big trouble. Bear, Stearns is noteworthy because the other part of the story of 2008 was blowing up of the real estate market. They were more heavily invested in the deadly mortgage backed securities (MBS) than other firms.

It was from that time that the Fed has kept interest rates artificially low. It has taken some 14 years to finally begin to get to a point where interest rates can be returned to historical norms. The artificially low interest rates allowed the Fed to engage in quantitative easing that propped up the stock market and have it reach these inflated valuations. One measure was the street’s fascination with “sexy” stocks like Robin Hood, Roblox, and ARK Innovation. These are unprofitable firms, but they were expected to become profitable at some undefined point in the future.

At the beginning of 2022, investor sentiment changed to focus on companies that actually earn money. With that, the market started its process of decline. The many explanations for market decline such as inflation and energy prices have a role, but not nearly as profound as the decisions by the Fed and something investors search for but don’t like to talk about: Fair value.

What is the correct fair value for the stock market? It is a moving target. With a weaker economy, a lower valuation of the stock market is appropriate.

Now, the big question is over whether or not the other factors will weigh the market down even further. The short answer is yes. There are enough trending events bringing negative impacts all around the globe that point to further market declines. But how serious will these declines will be? Could the market go down by nearly 60% as In the recent past? Or maybe it will be something worse.

Bleeding the market to death is a funny thing. The history of bear markets, is a history of moments when the market is given up for dead (call capitulation), only to sudden rise Phoenix-like and enter a new growth phase.

As is often said, when it gets this bad, one waits for “blood in the streets.” Some commentators will argue that at -20% and only days in, there is a long way to go. There will likely be more blood-letting, the patient will get worse, and history will likely repeat itself. A growing number of investors will give the market up for dead. It will have been bled dry of liquidity. But as has so often been the case, the national economy will chug along, work its way through the many problems, and then the market will rise from the dead and works its way back. Keep the faith.

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