A wise friend who has Bob Farrell’s Rules posted on his wall has written insightfully about Rule #8: “Bear markets have three states: sharp down, reflexive rebound and drawn-out fundamental downtrend.” Here are his comments:
“While pondering how not to blow it by failing to cover my shorts at some reasonable level now that we are in the ‘C’ Wave of this Secular Bear Market, several light bulbs went on. I remember back in October 1987, we all went to a ballroom at the Hilton (there was no internet back then) to tune in to a Merrill Lynch closed circuit presentation for AEs and their clients to express the Merrill Lynch view after the Crash. The Merrill Lynch View back then was pretty much the Bob Farrell View and Bob was unequivocal about the 1987 Crash being completely different from the 1929 Crash. Unlike every other Wall Street Analyst, Bob correctly identified the Bull Market that began in 1982 as young and the Crash as a market event, not a forecast for Depression.
That reminded me not to fight the last war. If the stock market crashes now, it will not be a market event so much as a fundamental event, algorithmic trading not withstanding. That is because we are in the early stages of a secular credit collapse and the fundamental, economic part of the crisis lies ahead. I was reminded of a quote that Art Zeikel included in “On Thinking”. The quote was from Dick Stoken: ” Because human psychology is slow to change, a broad economic move usually occurs in three stages. The first stage begins when some unexpected event shatters an overdone psychological environment (like the bursting of the housing bubble). Yet, while some people respond immediately to this new lesson, most people, as they find it outside their past experience, do not believe it. They need more evidence- that is, a second stage. Typically, the majority become convinced during the second stage and therefore the psychological background changes. People begin to act differently, and their behavior soon affects the performance of the economy (my italics).”
It sounds quite similar to the quote from Bob Farrell (attached) about how people behave in the early stages of a new secular paradigm. In any event, it is likely with all the banter about how deep recessions yield sharp recoveries, that most people have remained, up until now, on the fence about seriously embracing the “New Frugality” that we coined in 2008. How many families sat down at the table and hammered the budget? How many over-leveraged real estate investors didn’t opt to wait for the market to bounce back before listing the extra bedrooms? But now that the Bear Market Rally has run its course and the private sector never really grasped the baton from the government stimulus, we are probably headed into stages two and three.