VIEWPOINTS : When Investing in Stocks, Beware of the Soothsayers

You can identify several typical stages in a major market movement. In this case, let’s start with when the market was at its top late last summer. The cry is (1): “Stocks can only go up.” This time, the prediction of 3,600 for the Dow Jones industrial index by everybody’s favorite technician, Robert R. Prechter Jr., gave the investing public a convenient target.

As a bull market top approaches, an increasing number of experienced large investors, aware that prices are objectively overvalued, become poised to leap out when they feel the moment has come. It is like an ogre’s dinner party, at which the last guests are eaten themselves. Along around the souffle, there will be a noticeable edging toward the door.

Finally, the market loses momentum on the upside. A decline begins, and then accelerates.

There is often a last bounce-back--in late September this time, although more usually it comes in March--which I call the “trap rally.” It can last a number of weeks, and pulls in the final round of optimists. It’s the last good chance to get out. The cry is (2): “See, the market’s still OK.” As a reminder of the music you hear on these occasions, here are the first two paragraphs of the (London) Financial Times Wall Street section on Oct. 3, 1987:

“The bull has done it again. The market appears to have survived another grueling test. The skeptics have been financially embarrassed and intellectually humiliated. With the shakeout complete, everything is now set fair for a new assault on market peaks far higher than the records hit in August.

Few Chances to Sell

“After the powerful rally on Oct. 1, the first day of the new quarter, everybody’s immediate objective is 2,700 on the Dow Jones industrial index. On technical grounds this should present no problems.”

This was at the exact top of the trap rally. After it failed, the market dropped like a stone as rapidly declining prices spurred more selling. The public decides that maybe the market won’t go on up forever after all, but isn’t sure. The cry becomes (3): “It’s still too early to sell.”

The market continues to fall and one hears (as indeed we are now hearing) the next cry (4): “Sell on the next rally.” (All the way down, yesterday’s prices look attractive.) But alas, in the early phases of a bear market, there often aren’t many chances to sell. The market goes on down.

So after some further months we move to the next phase. The new cry is (5): “It’s too late to sell.” Often, things have dropped so far and so fast that people can scarcely believe it.

Then, well along in the bear market, which typically lasts from six to about 18 months, the public, influenced by the market swamis, most of whom follow the trend, develops a strong bearish consensus (6): “The market looks bad; the prudent thing is to sell. Switch to bonds.” People feel poor, jobs (and houses) are being lost, and the dominant emotion is fright. The decline becomes a rout, with the final cry (7): “All is lost! The market’s going way, way down.” Sinister economic and political predictions abound. Bargains become widespread, and the professional starts to buy with confidence.

Of course, some of these stages may be compressed--by computerized trading plans or other factors--like Prokofiev’s Classical Symphony. The late October drop, specifically, may have moved so fast simply because, thanks to electronics, the exchanges can handle such high volumes. It takes time to get out of a theater even after someone shouts “fire,” but not out of a tent.

Could Have a Rebound

This last top, in August, was actually quite characteristic. Stocks had been rising “exponentially,” that is to say, in an unsustainably accelerating curve that had to peak out somewhere. When the loss of momentum became apparent in September, the market broke sharply.

What next?

I suspect that the great Reagan bull market is over, simply because it got too high and had to be corrected, and that we are now in a primary bear market, which will last for at least quite a few months, and perhaps more than a year. (The best cycle to trade for is the basic bull-bear alternation, whose peaks and valleys normally are about four years apart.)

It would not be surprising if the recent drop was followed by a substantial upward rebound, called a “retracement” in Wall Street lingo, but I’d regard this as more of an occasion to lighten up than something to try to trade for. Of course, I could be wrong, and I’d have to eat crow. (I find it’s a bracing diet.)

There are a number of defensive moves that one will need to make during this particular bear market, notably investing one’s reserves--cash equivalents and short-term fixed income instruments--to preserve capital. The old solution of putting everything in Treasuries or municipals is no longer enough. One needs reserves in currencies that, for the present at least, are likely to be stronger than the dollar: West German bonds, British gilts (government bonds) or European Currency Unit bonds.

No one can tell when a bear market will turn into a major disaster, and to that end I, at least, expect to continue selling most of the way down, the opposite of what one would do if one had perfect foreknowledge. One’s cardinal strategy should be to avoid suffering through another 1930s-style wringing out, rather than to maximize profit over any short period. This means taking out an insurance policy by continuing to raise reserves as long as the situation continues to deteriorate. I have found that I can scramble back into the market soon after a major bottom, which is much easier to pinpoint than a major top. One can usually recognize the bottom within a couple of months after the fact, which gives a tremendous run to look forward to before the cycle peaks out again.

There are enough apparent structural weaknesses in the present overall economic scene so that my own reserves are at their highest level in many years; there is little penalty, since the after-tax returns on reserves are attractive compared to prevailing stock yields. One can even obtain satisfactory after-tax yields on risk-free investments in substantially stronger currencies than the dollar, which has rarely been true in the past.

So batten down the hatches, prepare for foul weather, and be patient!