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Stocks Bear Market Deflationary Outlook

Stock-Markets / Stocks Bear Market Feb 25, 2009 - 07:15 AM GMT

By: Michael_Swanson

Stock-Markets Diamond Rated - Best Financial Markets Analysis ArticleI had a simple thought the other day. It has been over ten years now since I have been investing and trading in the stock market and the stock market right now is so much different than it was ten years ago, yet no one seems to realize it. Everyone wants stock tips and is trying to guess the bottom.

There are a lot of people who lost money in the Fall and decided that they can do better than their broker or their mutual fund manager. So they have decided to do the smart thing and take control of their money. However, they think all they need to do to make money is get in the right stocks.

When I started trading in the late 1990's I didn't pay much attention to the stock market averages at first. I learned charting and trading techniques and everyday would search for stocks that I thought would go up. I would buy them, sell them a few days later, and then do it all over again.

It worked. And then in the last few months of 1999 it worked like crazy. You could literally buy a stock and see it go up 30% in just a few days and then sell it and buy another one and do it all over again. I know of someone who have $30,000 and turned it into a million doing this in just a few months.

The reason things were like this though is because the stock market was going straight up in the final months of the great tech bull market.

Luckily for me I always thought that it was a bubble and eventually the bull market would come to an end.

It was one day in fact that my whole outlook on the stock market totally changed.

It was April 3rd actually. For various reasons I thought the stock market was on the verge of making a bull market top. On the 3rd the market fell hard in the morning and then had a sudden reversal. I thought that reversal would lead to a final last gasp rally that when it ended would mean a new bear market.

I actually went short on that rally and sent out emails to everyone I knew telling them to sell everything. But that day - April 3, 2000 - was the day that my thinking about what the stock market was going to do underwent a paradigm shift. Really in just a few hours as I watched the action.

For the next two years I primarily made money by shorting stocks. I recognized the reality of the bear market, aligned myself with the dominant market trend, and made money.

There have been several times since then that I believed the market was making a huge change that I would have to adjust to in order to make money - or that my thinking of what was happening to the market and the economy underwent a rapid change.

That's what I want to talk to you about today, because even though everyone now realizes that there is a bear market, most people still are just trying to play the same games of buying stock picks or holding on in the expectation that everything is just going to get better. Even if they are downbeat about the economy they are not translating what they know is happening in the real world to their investment life.

Most of the time people decide to invest in a sector - or in the stock market - and then adopt a rigid belief system to back up those investments. Usually this involves believing in a story of what you think is going to happen in the future that will make your investments pay off.

In the 2000 bear market most people had been conditioned by the eighteen year long bull market that preceded it to believe that stocks go up forever and therefore all dips should be bought. As a result the masses just held on and got slaughtered.

Just a few years ago - those same people jumped into real estate, speculating on condos and housing in the belief that since housing prices have gone up for the past twenty years that they would go up forever. That housing is the one true "safe" investment. These people learned absolutely nothing from the bear market in stocks and are now bankrupt as they get foreclosed on.

Right now in the stock market there are people just holding on who apparently learned nothing from these two bear markets that have occurred in just the past few years. Even though it was absolutely clear to anyone paying attention a year ago that a vicious bear market and slowdown in the economy was only beginning they ignored the real world and just held on into the Fall stock market crash.

They are still holding on now.

That is why I think the stock market when you think about it right now has more dumb money then it probably has ever had in its entire history in it - because the people holding on now should have learned from the last two bear markets, but they didn't. This bear market won't end until these people sell out of it, and we're going to see an occasional 10-20% rally in the market averages occur from time to time to keep their hope alive.

But when it comes to the market even if people are bearish on the market as a whole or the economy they are still focused on buying the right stocks that they think will just go up no matter what. They might think oil stocks are going to go up or gold stocks or some other pet sector that they like - and they have stories and narratives about the future that they believe in and think will make them go up in time. They may think they are in the one true "safe" investment.

Everyone does this.

The problem is that nothing in the future ever happens exactly as you expect it will. When things don't happen exactly the way people plan then they just sit their in disbelief and don't adjust to what is really happening - just like all of those who just held on during this bear market did - or else they just rigidly keep on believing what they thought was going to happen will happen, thereby ignoring reality. People who do that often come up with excuses - like it would go the way I think it if wasn't for manipulation.

To be a successful investor in the market you have to be willing to adjust to changes in the economy and the stock market. To do that you must be willing to recognize the fact that you can't predict the future and things you may believe in may not happen the way you think they will.

Let's use gold as an example.

In February of 2002 my thinking accepted a new paradigm that would greatly impact my investing from then on. Although I remained bearish on the overall stock market, I became super bullish on gold and commodities sometime in February of 2002.

Actually what happened was that I got sick for about a week. People would call me on the phone and because my throat was really sore and I was just laying around I wouldn't answer it.

Then finally I started to call the people back. I called my trading partner Andy Emerson who told me he had been trying to get in touch with me for the past week and found what he thought were incredibly bullish charts for gold stocks.

I looked at it and he decided he was right - not only that but I decided that not only was gold going to go up, but it was going to begin a brand new secular bull market.

I started to invest in gold stocks and went to several gold conferences. I met people inside the gold industry, many of whom it turned out were bullish on gold forever and are always bullish on gold, but many of them were helpful in educating me about the sector. I learned a lot from them.

At the same time that gold started this new bull market it became clear to me that the dollar was in a new secular bear market too.

There were two main reasons people gave for investing in gold at the time. One was that there was a gold "conspiracy" on the part of central banks that were supposedly keeping gold at an artificial level. This conspiracy would eventually fail and make everyone who bought gold now rich overnight. I didn't really believe this, but I did believe the second main reason - which was that the twin budget and trade deficits of the United States were growing at unsustainable levels and could eventually cause a run on the dollar - which would make gold go up as a safe haven.

I believed this for years.

I participated in many of the big gold rallies since 2002 and made a lot of money doing so. I also bought several times thinking that a big gold rally was coming only to get stopped out for a small loss too. In fact I did that probably about a half dozen times in 2006 and 2007. This actually cost me potential gains, because I focused so much on gold stocks that I didn't participate much in the rally going on in the broad stock market during that time.

That is why it is so critical to stayed aligned with the broad market trend.

By the middle of 2007 I started to become concerned that another bear market would be around the corner for the stock market. There were plenty of warning signs. For one most stocks and sectors fell into bear markets of their own ahead of the two major market averages. Real estate had already made a peak and bank and mortgage companies were in decline. Some sort of slowdown was likely.

But I thought it would probably be a positive for gold stocks since at the least it would mean the Fed would lower rates, which would mean more inflation and a weaker dollar.

However, something happened in August of 2007 that gave me some doubts. August the 16th to be exact.

On that day the stock market totally plunged in the morning and something happened that I had never seen before - the credit market contracted, with short-term Treasury rates dropping at a rate faster than they did during the 1987 stock market crash. I believe the Fed actually intervened in the market on that day to save it from crashing.

However, as you now know, Fed interventions cannot create bull markets.

On August 16th, 2007 though my thinking underwent a new paradigm shift.

Two things happened.

First gold stocks crashed that morning and then recovered by the end of the day. Most of the big cap gold stocks were down over 30% on the open. I had actually been long some gold and silver stocks and gotten stopped out two days before the 16th. I owned one stock that was trading around $30 when I bought it. I sold it for a dollar loss and then it fell over 50% from where I first got in by the 16th.

But most of the people I talk to in the market were in gold stocks and didn't sell. They just road out that drop. To me it was a shocking drop to happen in just one day - and the lesson I learned from that is even if the stock market drops and the Fed lowers rates in the future gold stocks may go down too.

Gold stocks are not a safe haven immune to a bear market in the broad market.

That meant I that I had to come to conclude that many of the things that I thought about gold in the past may not happen - or may not happen the way I thought. It may not pay to just stay bullish on gold in the face of what was to come. And I didn't.

The other thing that happened on that day is that I recognized the reality of the coming credit crisis and decided that a new - and massive bear market was likely ahead.

A day or two after this day I was at a party and met someone who worked as a mutual fund manager or trader for one of the country's largest banks. I told him that I was very concerned about what happened in the market a few days ago and worried about what was going to happen with real estate and all of the mortgage backed securities. I thought there were serious problems ahead.

He didn't see that. He just thought the market went down, because people got scared from the TV and that nothing was wrong.

I left that party knowing that we were headed for a disaster and it was going to happen, because of people like him. People who ran money from banks and had absolutely no idea of what they were doing.

This guy had only been working on the job for six months and was managing money for a bank.

He was a total bubble head. It wasn't just that he disagreed with me, but the way he talked about investing it was clear to me he had no idea what he was doing. And there thousands of people like him working in these banks buying up mortgage backed securities.

I watched things unfold over the next few weeks with an uneasy feeling that what happened on August 16th could just be a prelude to a much major stock market crash to come - one that could even knock down gold stocks.

I played things very cautiously. No longer investing heavily in gold stocks, buying them only with tight stops in place to make sure I don't lose money, and taking a short bet against the market at the end of October that I made a nice gain on when I took my profits a month later.

As we got to the end of November I saw plenty of technical signs in the market that confirmed to me that we were now in a bear market. I then wrote several articles warning people to this fact.

As January 2008 came I was in cash and watched the market decline. On the 18th the market fell so much that it became historically oversold on many indicators that I follow and I thought a bounce was in order so I went long going into the close.

Over the weekend total disaster struck as several large banks got in trouble and so did some big bond insurance companies. On Monday the US market was closed, but most European markets fell over 5% on that day. At the time it was a shocking drop.

A potential crash was now in the cards.

Monday night I looked at the DOW futures and saw they were down over 500 points. I had put myself fully invested in the market on the 16th and braced myself for the possibility of losing 30% of my money in one single day.

The market opened down and then bounced back up. The next day it came back down to test the lows and reversed to make a double bottom. I added to my position by buying gold stocks. The market then made a double top over the next few weeks as I held my positions.

It turned down and stopped me out so that I pretty much broke even on the trade. The market then fell in March as Bear Stearns went broke.

I studied the situation closer. Looked over my trades and read as much as I could as quickly as I could about what was going on with the banks.

First I realized I had made a critical error. Despite being bearish on the market I almost took a big hit, because I tried to go against the broad market trend. Not only that, but I should have shorted at the end of February and made a profit in March. If I hadn't gone long I would have done that and made money.

The best thing I could do then is wait for a market rally to short into and then make a big gain. I did that by shorting in May and then covering on the exact low of July. Then shorting again in August and then covering in the Fall. Those trades enabled me to make around 50% in my account last year, but I would have made more if I had never tried to go long at all. It was a mistake I would make again with gold stocks in August, but I will get to that in a minute.

Secondly, I have to tell you that sometime in February and March I came to the realization that the entire banking system of the United States was broke - and that meant an even severe bear market and recession were to come.

What had convinced me of this reality was the existence of so called "Level III" assets on the balance sheets of the nations largest banks. These were subprime mortgage assets that no longer had any value to them, but on the balance sheets the banks were listing them as having a future or potential value. Some of the big banks had 20%-30% of their balance sheet listed as "Level III." That meant they were broke, because they were holding fictional assets. Of course this was totally legal, because the SEC let them do this and Congress turned a blind eye to it, but it was a fraud.

But it meant to me that things were much worse than most people imagined. And they were - and still are.

It was another turning point in my thinking for me.

In May I put out a series of videos warning people of what was to come, imploring them to get out of the stock market.

As July came though it became evident to me that a new huge storm cloud was on the horizon - one that would lead to a stock market collapse and I thought an explosion in the price of gold.

This was the coming bankruptcy of Freddie and Fannie Mae. Anyone who paid attention to the news saw it coming. I knew it would mean a big drop in the markets and the Fed would have to intervene again somehow, probably bailout Fannie and Freddie for hundreds of billions of dollars, I couldn't even conceive of the trillions which is where we stand now.

So I went short the stock market in July and again in August.

But I also tried to go long gold in August, thinking that money printing from the government would have to mean a higher gold price. I bought in August when the HUI was around 300 and then at the end of August took a much bigger position shorting the S&P 500 through the ulra-short ETF.

I fully expected the market to crash sometime in the Fall and for gold to go up.

But then gold stocks broke down. I got stopped out on September 3rd of all of my gold stock positions.

I knew that if I was right about gold going up this wouldn't happen. When the HUI closed below 300 this told me that my thinking on gold was wrong. And to be a successful investor means listening to the market and not just sticking to some rigid ideas of what you think should happen.

I might be right about the rest of the market but wrong about gold. Despite the Fed printing money for some reason gold was not going to go up contrary to what I expected and most gold people I knew did too.

But they just sat there and held to their beliefs.

You see we all have a tendency to think about the future and what we think is going to happen. I've talked about times that my thinking has evolved and changed, but the problem is most people just get a scenario in their head and keep believing in it no matter what. But no one can predict exactly what is going to happen and things change.

The most important thing to do to make money in the stock market is not to sit their with a set of rigid convictions, but to understand how to read market trends and then to adapt when those trends change. This will give you flexibility and keep you aligned with the big trends of the market - which is how money is really made.

When the HUI fell below 300 in the summer I decided that all of the things I believed about gold in the past did not matter. Gold was going to do what it was going to do and maybe for whatever reason even if a financial crisis does come it won't mean gold is going to shoot up and the dollar would collapse.

And so when the storm hit in the Fall we saw the dollar go up and gold stocks totally crashed.

Now gold and gold stocks have rallied strongly off of their November lows and are now smack into long-term resistance points. People are getting more bullish than ever as every single day I get an email from someone asking whether they should buy or not. The only other thing they seem to be fascinated with is energy stocks.

The way I see it gold stocks started a bear market this past summer. I don't know what else to call something that falls over 75% in value. Yes gold stocks have doubled since their bottom in November, but need to go up another 46% just to get back to where they were this last July.

The big question is whether or not the bear market in gold stocks is over. This rally has convinced everyone that it is. But if I put aside my biases and what I want gold to do, I don't see how you can draw such a conclusion from this rally - really any conclusion from it. Gold stocks have rallied just like they would if they were still in a bear market after suffering such a huge drop like they did in this past or if they finished a bear market and were getting ready to go into a bull market.

In other words I can't look at a chart of gold stocks and draw any meaningful conclusions out of it right now. What I can tell though is that the gold stock rally appears to be getting tired, because the HUI/gold relative strength line, which tends to lead gold stocks, has flat lined and is no longer confirming the rally. In the bullish scenario I would expect gold stocks to give back at least half of their gains and then to consolidate as they build a base to begin a new bull market.

In the bearish scenario though they top out and follow the CRB commodity index and the rest of the stock market into making new lows.

Most people that are bullish on gold believe that huge inflation is going to come around the corner. But we had massive interest rate cuts from the Fed last year already and when the stock market crashed last fall gold stocks dropped too.

Right now in fact we are a deflationary environment with the CRB index recently making new lows and consumer and producer prices having declined sharply in the past three months.

Maybe the huge inflation everyone expects to come will happen one day, but it is not happening now - and in the end the only way you can make money in the stock market is by understanding what is happening right now and adjusting when things change. That is why understanding how to use stock charts is so valuable - they enable you to do this.

But some times you look at a chart and can't draw any firm conclusions to it and that's what happens when I look at a gold stock chart. The good news for gold bugs though is that the time this most often this happens is in a transition period between a bull and bear market.

What I want hammer home to you though is that drawing up scenarios and narratives of what you think is going to happen in the future and investing based on that - and rigidly sticking to that scenario without paying attention to market trends - will eventually make you broke when you end up wrong. Which will one day happen.

That said we all do this and you can't help but do it. I've given you several examples of how my thinking has changed and evolved already.

Now I want to tell you what I think now.

In the Fall when the stock market crashed I think it was obvious that the United States - and the rest of the world - was in a financial crisis, that would lead to a severe recession.

However, after the crash by December it also seemed logical to expect some sort of counter trend rally. Even though we were in a bear market I did not think it would be a good time to short until sometime in 2009. Therefore the only way to try to make money would be to go long.

So I tried to do that, by going long the only sector in the market that looked to me to have the ability to begin a new bull market in the first quarter of 2009 - airlines. As the market fell in January though I got stopped out for a small loss.

Of course this is the type of thing that happens when you try to go against the big trend of the market - you lose money.

That trade reminded me once again of the importance of recognizing the reality of the bear market. That means the best way to make money this year is to try to short the market when it has its 10-20% rallies until it is clear that the bear market is over.

The thing is though very few people are respecting the big trend. Almost every single email I've gotten since this year began has been from someone wanting to go long the market - they either want to know what stocks to buy or are enamored with gold or energy stocks.

I get the impression that many of these emails are coming from people who are total beginners in the stock market - which I tend to get a lot of, because I really try to educate people with my writings and website. However, what is happening is that these people seem to think all they need to do is buy into the right thing.

This isn't like the old days in the 1990's when you could just buy a stock and see it go up. In a bear market stock picking means absolutely nothing.

The only thing that matters is respecting the broad trend of the market. Trying to pick the right stocks is a fool's game until this bear market is over.

Most people don't know that - especially people just starting in the stock market, because every book they read and talking head on TV wants to teach them or tell them to buy stocks. People are watching Cramer and Fast Money and think the stock market is just going to print them money.

In bear markets though you get your occasional 10-20% rally, but trying to pick stocks and go long isn't a winning strategy. Even playing the rallies doesn't benefit you much. The best way to make money is to short rallies and have heavy cash reserves available so you'll be able to buy in when it is clear that the bear market is over.

The only thing that has a chance to go up this year is gold stocks and I'm not sure about them.

And that comes to my last turning point. Although I tried to dabble on the long side at the beginning of the year by the end of January it became clear to me that this recession and bear market is going to be much worse than most people imagine.

The 4th quarter GDP numbers released a few weeks ago were a real eye opener to me and created the last turning point in my thinking.

The headline -3.8% number was better than expectations, because it was helped by a steep drop in the consumer price deflation to the tune of 17.8% for durable goods. Yes, the price for big ticket items fell 17.8% from where they were a year ago. That is deflation folks - nightmare deflation - and helped the GDP report "beat" its number.

Oh yeah government spending helped too - which rose 5.8%.

So did a big rise in inventories. Both the fall in prices and rise in inventories helped the overall number, but in reality they are troubling signs. Maybe inventories rose, because people couldn't sell their stuff.

Of course that's what happened.

Because inside the report overall nominal demand collapsed at an 8.9% annualized rate. Consumer spending fell 3%. In fact consumption as a percentage of GDP shrank from 71% in the third quarter to 63% in the fourth quarter.

Now if this was the end of the recession none of this would matter. We would go run out and buy stocks right now.

But business investment - which is more of a forward leaning indicator - fell 19.1%. That's the worst performance since the early 1980's.

You can't expect economic growth in the economy when business investment is in freefall.

To me it looks like the economic recession is picking up steam and if we are going to get a trough in the recession next year then you have to ask yourself how much worse is it going to get?

It is unreasonable to expect a bull market to begin right now in such an environment.

In fact this could easily lead to the type of bear market bottoms that we saw in 1982, 1933, and after WWI and WWII.

I don't know exactly how it would get there - but that would mean the S&P 500 falling below 600 and probably to 500 by the end of this year or sometime in the first half of next year. Maybe we still rally here first. That is what I was expecting - a big rally into March-June then a big drop.

I looked at the historical data - and the only times that the economy contracted that much in a single quarter were associated with these major bottoms. Now they didn't mark the bottom - what they did was show you that the economic environment was so brutal that stocks fell so much that they actually became cheap - so cheap that stocks were valued in such a way that they were actually cheaper than the break up values of the companies that they represented - way below book value even.

For our market to get this cheap the S&P 500 would have to fall into the 500-600 area, even below 500 is possible.

The other thing all of these environments had in common was deflation in consumer and producer prices.

This is something that is happening right now.

The problem is the economy. The recession is not going to end this year, because real estate prices are not going to bottom out this year. According to futures contracts on the Schiller/Case real estate index there will be no bottom in real estate until at least the second half of 2010 - they are projecting a bottom sometime in the forth quarter of 2010 and first quarter of 2011.

That is over a year and a half from now from now.

What I've come to conclude over the past few weeks is that we are not in a normal recession and most people do not recognize this. They think this is like the 1970's in which the market went sideways while there was a lot of inflation. Gold and commodities went up and so did some stocks during that time. People think the Fed is printing money and any rally could be the start of the next bull market simply because of that fact. Therefore they are desperate to look for new stocks to buy into or are just holding on to their losing positions long enough for them to go up again. No one is preparing for continuation of the bear market.

But I think this bear market is going to to be longer in duration and more severe than almost everyone expects. If I'm right though stocks will become so cheap that those that buy in when this bear market ends, probably sometime next year, will make a fortune. And those that learn how to trade market trends and short bear market rallies will make a ton of money this year before then.

This is a bit different than what I was thinking at the start of the year. I had never experienced the 1930 bear market or lived in Japan in the 1990's. My experience is the same experience of most Americans when it comes to the stock market - the past thirty years. I saw the last bear market and the last bull market. I was thinking we could see some base building and a recovery like we saw from the second half of 2002 through 2003 after the last bear market, because the stock market fell in half last year.

Just about everyone I know was thinking at the start of the year that the market fell so much in the Fall that it HAS to be the bottom or at least the start of a big rally. That and the fact that it wasn't a good time to short so I was looking for long opportunities led me to dabble for a few weeks on the long side and bet against the primary trend of the market. I quickly recognized the error in that thinking.

The reality of the economic data has made me come to conclude that this was just a temporary bout of overly optimistic thinking on my part. I think the market is going to go lower over the course of the this year and I'm ready for that. I'm ready to go short against the market the next time it has a 10-20% rally. I'm ready to make money in this market. I hear what the market is saying and I'm listening. Are you?

By Michael Swanson

Mike Swanson is the founder and chief editor of WallStreetWindow. He began investing and trading in 1997 and achieved a return in excess of 800% from 1997 to 2001. In 2002 he won second place in the 2002 Robbins Trading Contest and ran a hedge fund from 2003 to 2006 that generated a return of over 78% for its investors during that time frame. In 2005 out of 3,621 hedge funds tracked by HedgeFund.Net only 35 other funds had a better return that year. Mike holds a Masters Degree in history from the University of Virginia and has a knowledge of the history and political economy of the United States and the world financial markets. Besides writing about financial matters he is also working on a history of the state of Virginia. To subscribe to his free stock market newsletter click here .

Copyright © 2009 Michael Swanson - All Rights Reserved.

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