All Out Crash
October 9, 2008
 
The Dow closed down 678.91 points, or 7.33%, today.  For the month of October (7 trading days), the Dow has lost 2,252 points, or 20.93%. 
 
On October 19, 1987, Black Monday, the Dow lost 22.61%.  That drop was the worst since the crash of 1929.  I contend that we have just experienced a crash that lasted 7 days.  Sort of a Chinese water torture, vs. a one-day event.  The end effect is the same.
 
I have to be honest.  I did not see this coming.  The magnitude and conviction of this sell-off has surprised a lot people, including me.  I knew we would have a "swoosh", but not to this extent.  My original thesis still holds, that after the final sell-off, we would have a bull run in the 4th quarter.  I still stand by that view.
 
As you know, I spend nearly every waking moment listening to and analyzing the capital markets.  In my opinion, we have 2 distinct reasons for the current panic sell off:  
 
1)  The reluctance of lenders to provide loans
If American business is a machine, then loans are the grease that keep the various parts moving.  Why did you take out a loan for your house?  Because you can borrow at 6%, and use your cash for better returns. 
 
The small business owner typically borrows money for 30 days to bridge the gap between when he has to pay for raw materials and salary to when he receives the Net 30 payment from customers.  These are called...drum roll please...bridge loans.  In official MBA parlance, this is Commercial Paper.  When short-term borrowing is locked up, as it is now, business can not operate. 
 
Traditionally, lenders are ultra-conservative.  They are even more so now.  They will not loan money until they are 110% sure that the lendee will pay back the loan, with interest.  If there is any question of viability, the lender will take a pass. 
 
2)  The uncertainty of future earnings
How do we value companies if we don't know what near-term, future earnings will be?  We can't. 
 
Why are future earnings so hard to predict?  Simple.  Borrowing costs are a total unknown.  As I described above, an integral part of business in America is borrowing money.  This is normal.  If you borrow at one rate, but use the money to make a higher rate, you do it.  That's how banks operate, for example.
 
Now extrapolate that out to, say, all 500 companies in the S&P500.  We don't know what  their borrowing costs, and therefore expenses, and therefore profits, will be.
 
In fact, almost all businesses need credit in some form or other.  To estimate future earnings, we need to know, to some degree of certainty, what their borrowing costs will be.  We can not do that right now, and the market assumes the worst.  Borrowing costs will eat into earnings.
   
If we use a normal P/E for the S&P of 13, then here are 2 scenarios:
 
Assume annual earnings of $75/share for 2009.  A P/E of 13 calls for an index value of S&P500=975.  Mind you, the S&P500 closed at 910 today.
 
If, as some analysts are reporting, the earnings could be as low as $60/share for the index next year (based on the above financing hardships), then we predict an index value of 780, a full 14% below where we are today.  In other words, all this selling may be just a prelude to further selling, getting the index to where its fair value is.  This is the worst case scenario.
 
Just how bad is it?
I am not an alarmist, and I am currently long the market, having scaled in this week.  However, I read a news piece today that bothered me.  Iceland's government took over it's 3rd bank today.  I know, it's only Iceland, buy hear me out.  The government guaranteed all deposits within Iceland proper, but not those deposits outside the country. 
 
In the U.K., some 300,000 citizens are customers of the bank's online service, IceSave.  Several government municipalities in England are also depositors of the Icelandic bank.  Gordon Brown, Britain's Prime Minister, has threatened to sue Iceland to recover all of it's citizens' deposits.  In fact, Britain has invoked it's terrorist laws to sieze assets in the local branches, thereby preventing the Icelandic bank from withdrawing funds from it's U.K. branches until the whole mess is resolved. 
 
Invoking terrorist laws to seize assets.  That is desperate, and scary.
 
Going Forward
It is always darkest before the storm.  Unlike other, recent down days, there were some stocks that actually finished positive today.  Research In Motion and Mosaic, a cell phone firm and fertilizer company, respectively, both finished up 2%+.  Southwest Airlines was bought today, to the tune of 1.38%.  Even YRCW, Yellow Trucking, squeaked out a .5% gain.  Truthfully, that's about it.  Nonetheless, it shows that there are value buyers out there.
 
This, too, shall pass.  I am hurting like everyone else in the market.  I was fortunate enough to enter this week all cash in my trading account, but I bought every dip, and am down significantly like many folks.  I made new purchases this morning, and by lunch-time I was down big, not to mention how things rolled over by the close.
 
Nonetheless, these are truly remarkable times for people who pay the bills by trading the markets, like me.  These all-out crashes have always been buying opportunities.  Even in the immediate days after the 1929 Market Crash, stocks rose 32% in one month (see Chart 1).  This may be no consolation to those of us in the red, but there is a light at the end of the tunnel.
  
Chart 1
Reaction Against the 1929 Crash 
  
CLICK ON CHART TO ENLARGE

 
I'm still long the S&P, Nasdaq, and some oversold names such as FCX, MOS, DRYS, as well as UYG and URE (the bank and real estate ETFs).   Don't panic, protect your capital, and look for values.  I'll post my thoughts on cheap stocks this weekend.  I expect more selling during at least part of the day tomorrow, as traders fear going into the weekend long. 
 
Rate of Change Record
Finally, for those of you keeping score at home, we have a new extreme in the 2 week Rate of Change I've written about before.  Below is a chart showing that the indicator has hit -24.99, far below any reading I have found in the previous 48 years, posted here.
 
Chart 2
Rate of Change Extreme
CLICK ON CHART TO ENLARGE
 
Parting Shots
As dire as things seem in the market, there really isn't anywhere else to put money to work.  Look at the current yield curve (Chart 3 below).  You can get a whopping 1.65% on a 2 year commitment.  As most of you have found out, savings accounts are paying diddly nowadays.  Money will flow into the markets, and high-cash, strong earnings or dividend paying stocks will roar back with plenty of new capital.  Just when is anybody's guess.
 
Chart 3
Current Yield Curve

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