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Investors praying that the most inept federal government since the Hoover administration has engineered an end to the credit crisis with a plan to rescue Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) may be on track to see their delusions shattered.
At the root of investors' hopes in recent days has been a sharp jump in the shares of banks and brokerages even after the companies reported terrible second-quarter earnings and acknowledged that profits will likely be impaired for at least a year to come.
Yet optimism -- and a trading phenomenon known as a "short squeeze" -- can take banks' shares only so far before the laws of financial gravity take over. So make no mistake: Those shares are headed back to where they came from unless Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke can pull a miracle out of their briefcases.
Even though Congress is lending a helping hand, for once, with its passage Wednesday of a bill to help struggling mortgage holders, that miracle is looking less likely. Consider, for instance, that American Express (AXP, news, msgs) on Monday revealed the biggest open secret in the world: Its portfolio had suffered massive levels of defaults in California and Florida, as customers strapped for the money to pay delinquent mortgages on overpriced homes weren't paying their credit card bills either. Fancy that. AmEx shares plunged, but bank stocks remained stubbornly buoyant, which was a bad sign.
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A field guide to bears
Why is hopefulness bad? It's because bear markets can end only when everybody has found their inner Eeyore. Bear markets are all about extinguishing hopes, crushing dreams and, most of all, smashing idols of the previous bull market. They end only when no one even wants to think about stocks anymore. So fake-out advances will be a fixture of trading until all optimism fades.To help you prepare for the next downdraft -- which should start once the Dow Jones Industrial Average ($INDU) reaches the 11,750-to-12,100 level or the S&P 500 Index ($INX) gets to around 1,325 -- I've prepared a compact Bear Market Users Manual:
- There's no credible evidence that the market has bottomed. You can talk all you want about sentiment being too low, pessimism being too rampant, financial crises setting bottoms and all the other subjective fluff that is thrown around. It's all speculation and wishful thinking. The reality is that pessimism alone cannot set a bottom. There have to be enough buyers. And for now there is no proof that big investors at mutual funds, pension funds and hedge funds have been aggressively acquiring stocks from panicked sellers. Quite the opposite.
- Evidence suggests the worst of the bear market lies ahead, not behind. The first sign of a new bear market occurs when an index or a stock trades below its average price of the past 12 months. That happened to the Dow in late December. But now we need to focus on the importance of the 200-week average. When that level breaks, veteran independent analyst Michael Belkin says, damage is so great that there is little hope for a market to recover quickly. The Dow has had four straight weekly closes below its 200-week average and remains there now. As a market falls, volatility also intensifies. Expect to see many more days ahead when the Dow sinks or rises by about 250 points.
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Can any company be trusted?The crisis at Fannie Mae and Freddie Mac wouldn't be so threatening to US financial credibility if these mortgage giants hadn't fudged the truth to sell their bonds, Jim Jubak says.
- A market that falls below its 200-week (3.8-year) average usually heads straight for its 200-month (16-year) average. I learned this concept from Belkin during the past bear market, and it was great guidance to the then-shocking deterioration in Intel (INTC, news, msgs), Cisco Systems (CSCO, news, msgs) and Oracle (ORCL, news, msgs). Lest you think that's a crazy idea, the Philadelphia KBW Bank Index ($BKX), which encompasses Bank of America and Wachovia, already is well below this level. So are General Motors (GM, news, msgs), insurer American International Group (AIG, news, msgs), International Paper (IP, news, msgs) and Merck (MRK, news, msgs). General Electric (GE, news, msgs) is close. Moreover, you should know that the 200-month average was the exact spot where the plummeting Nasdaq Composite Index ($COMPX) finally bounced and recovered in 2002. The 200-month averages for the big indexes now are 981 for the S&P 500 Index, 1,771 for the Nasdaq and 8,360 for the Dow industrials.
- The best course in a bear market is to use rallies to close out all long positions in the riskiest groups, including tech, consumer durables and cyclicals. It's a tough game to try to hold on to the seemingly best sectors or best stocks in those sectors. You might pick out the one or two that survive, but it's unlikely. The majority of your funds should be in cash, with some risk money devoted to selective buying of well-behaving groups, some spot speculation in the worst groups and some short-selling. Beware of rumors of government intervention or the widespread belief that trillions of dollars are on the sidelines ready to be invested, or the removal of a single threat, such as higher energy prices. None of these things matters until you get a firm signal that buyers are really coming back to the market with intensity. Bull markets may rise along a "wall of worry"; bear markets fall along a "slope of hope."
Continued: Long-lasting bear markets
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