CHAPTER 15.

The Panic of 2008 The remarkable 2002-2007 bull market * * no bullish crowd evident at the top no bullish crowd evident at the top * * the bullish crowd in the housing market the bullish crowd in the housing market * * bear market signal bear market signal * * when will the conservative contrarian increase his stock market exposure? when will the conservative contrarian increase his stock market exposure? * * the mortgage mess the mortgage mess * * a debt-deflation spiral a debt-deflation spiral * * the government steps in the government steps in * * credit crisis and the aggressive contrarian trader credit crisis and the aggressive contrarian trader * * breaking below the moving average breaking below the moving average * * failure of Bear Stearns in March 2008 failure of Bear Stearns in March 2008 * * Fannie and Freddie in July 2008 Fannie and Freddie in July 2008 * * the crash the crash * * world panic in October 2008 world panic in October 2008 * * an amazing sequence of magazine covers an amazing sequence of magazine covers * * the aggressive contrarian contemplates a new bull market the aggressive contrarian contemplates a new bull market THE CONSERVATIVE CONTRARIAN DURING THE PANIC.

From its low at 777 in October 2002 to its high at 1,565 in October 2007, the S&P 500 index more than doubled. This was an unusually long bull market, exactly five years in duration-longer than the typical bull market, which lasts two or three years. The 100 percent gain in the averages was not as unusual, although a 65 percent gain would have been closer to the average.

To me as a contrarian trader the remarkable thing about the 2002-2007 bull market was the persistent pessimism expressed in the media about the U.S. economy and the stock market during those five years. There was never any indication in my media diary that a bullish stock market crowd had formed.

However, as I pointed out in the previous chapter, a very big, bullish investment crowd had formed in the residential housing market, not just in the United States but around the world. In October 2007 it was hard to imagine that the collapse of this housing bubble would have the devastating consequences for the world"s economy, financial markets, and banking system that developed during the subsequent 12 months.

From its closing high of 1,565 on October 9, 2007, the S&P dropped to a closing low of 752 on November 20, 2008, a decline of 52 percent in barely more than a year. A conservative contrarian trader who followed the Contrarian Rebalancing strategy would have reduced his stock market allocation to normal levels on January 6, 2006, with the S&P at the 1,285 level. The 200-day moving average of the S&P turned downward from its bull market high by 1 percent on February 20, 2008, when the S&P closed at 1,360. But this event would cause a further reduction in stock market exposure only if the conservative contrarian believed that a bullish stock market crowd had formed by 2007. I for one did not think so, but I know other investors who did. Consequently I did not interpret the 1 percent turndown in the 200-day moving average as a signal for the conservative contrarian to move to a below-normal stock market allocation.

In either case, it is important to remember that the panic of 2008, as terrifying as it was, did not hurt the conservative contrarian"s portfolio performance relative to the buy-and-hold benchmark. And it is only his performance relative to this benchmark that matters. The name of the game every contrarian trader plays is beating the benchmark, not being right about the stock market"s direction.

As this is being written (in late November 2008), the conservative contrarian is awaiting a turn upward in the 200-day moving average in the S&P 500 by 1 percent. This will be a signal that the panic of 2008 is history and that a new bull market has begun. An enormous bearish stock market crowd has formed in the stock market, not just in the United States but around the world. So when the moving average turns up by 1 percent, the conservative contrarian should plan to increase his stock market exposure to above-normal levels.

There is no way to predict when and at what price level this moving average upturn might develop. At the moment the 200-day moving average of the S&P stands at 1,244 and is dropping at the rate of about 50 points per month. No turn upward in the moving average is likely until the S&P rises above it. Currently the S&P stands at 800. From this data it is reasonable to conclude that the moving average upturn lies several months in the future.

In the rest of this chapter I follow the development of the panic of 2008 through the eyes of the aggressive contrarian trader. First, though, I want to explain just how and why the panic arose from the collapse of the housing bubble.

THE MORTGAGE MESS.

What caused the panic of 2008? In a word, mortgages. When the housing bubble burst, the resulting unexpected drop in residential home values led many borrowers to default on their mortgages. But these mortgages had been packaged into bonds called mortgage-backed securities mortgage-backed securities. Worse, even more complicated securities called collateralized debt obligations collateralized debt obligations were manufactured from mortgage-backed securities by Wall Street banks in order to satisfy the demand by investors for higher yields in a low-yield bond market. Mortgage defaults arising from falling home prices made it very difficult to determine the value of these complex securities. There simply was no historical precedent for what was happening. Residential home prices had not declined nationally in real terms since the 1930s and even that decline was smaller that the one experienced in the U.S. between 2006 and 2008. Because these complex securities were so hard to value objectively the bond market a.s.sumed the worse and consequently traded them at very low prices. This raised the specter of ma.s.s insolvency for banks and other financial inst.i.tutions that owned them. were manufactured from mortgage-backed securities by Wall Street banks in order to satisfy the demand by investors for higher yields in a low-yield bond market. Mortgage defaults arising from falling home prices made it very difficult to determine the value of these complex securities. There simply was no historical precedent for what was happening. Residential home prices had not declined nationally in real terms since the 1930s and even that decline was smaller that the one experienced in the U.S. between 2006 and 2008. Because these complex securities were so hard to value objectively the bond market a.s.sumed the worse and consequently traded them at very low prices. This raised the specter of ma.s.s insolvency for banks and other financial inst.i.tutions that owned them.

What is a mortgage-backed security? It is a long-term bond created when an investment bank buys portfolios of home mortgages from the mortgage originator (usually a commercial bank or mortgage loan company) and bundles them into a single portfolio. It does this by transferring ownership of these mortgages to a special purpose ent.i.ty (sometimes called a Specialized Investment Vehicle or SIV-this is usually a trust or nonprofit corporation). This special purpose ent.i.ty then issues bonds (mortgage-backed securities) whose sale finances the investment bank"s original purchase of these home mortgages. Mortgage-backed securities promise their owners a series of payments from the pool of monthly interest and princ.i.p.al payments made by the mortgage borrowers, homeowners like you and me.

So far this seems a straightforward process of financial intermediation. Securitization of portfolios of illiquid home mortgages converts them into a more liquid a.s.set and at the same time reduces the risk to mortgage lenders that can arise from, say, economic difficulties specific to a single geographic housing market. In this way mortgage securities make home financing cheaper and easier for the average home buyer.

The value of a mortgage-backed bond depends on the interest and princ.i.p.al payments homeowners are expected to make on the mortgages that make up the portfolio backing the bond. It was from the process of evaluating these expected payments that trouble arose. The trouble was greatly amplified by the fact that mortgage-backed securities were often repackaged into even more complex securities, collateralized debt obligations, in a process called structured finance.

The dramatic increase in U.S. home prices during the 1996-2006 period moved them to levels at least 30 percent above construction costs, a divergence that in the long run was unsustainable. Even so, people began to believe that the price of owner-occupied housing could only go up. This made the prospective mortgage borrower see a home purchase as an essentially riskless investment. Worse, mortgage lenders viewed mortgage loans in essentially the same way, as riskless a.s.sets whose value would be protected by ever-rising real estate prices. The convictions of both borrowers and lenders that the price of owner-occupied real estate would only go up reinforced each other. Not only did the demand and the supply of mortgage loans go up, but this increase in mortgage credit further fueled the advance in home prices. A real estate bubble was the result.

As in any credit bubble, lenders gradually lowered their lending standards in compet.i.tion to originate more and more mortgage loans and earn the resulting fees. It was here that the financial technology of the mortgage-backed security short-circuited prudent mortgage lending standards. No longer did loan originators-banks and home-loan inst.i.tutions-have to keep mortgages on their books. Instead they bundled these mortgages and sold them to investment banks. Since they did not retain the mortgage loans they originated in their own investment portfolios, they had little incentive to make sure such loans could be serviced and repaid by the borrowers.

As long as home prices went up, these lax lending standards caused no problems. In fact, the historical data used to estimate the chances of the mortgage loans being repaid showed that even low-quality borrowers, the so-called subprime borrowers, had good repayment records. After all, home prices only went up, didn"t they? This data was used by ratings companies like Standard & Poor"s (S&P) and Moody"s Investors Service to justify rating even those securities backed by subprime mortgages as AAA quality, especially after they had been repackaged into collateralized debt obligations.

Few people thought to ask what would happen if home prices stopped going up and, worse, started to fall. Even those who did ask this question and knew that problems would arise did not have any idea of just how destructive to balance sheets the drop in the value of mortgage-backed bonds would be, and of the complex securities that structured finance would produce from them.

According to the S&P/Case-Schiller index of U.S. home prices, the value of owner-occupied housing peaked in mid-2006. During the subsequent two years home prices dropped more than 20 percent nationally. People who had purchased homes at the height of the boom during 2003-2006 with small down payments were in financial trouble. In many cases the drop in home prices made their mortgage debt exceed the value of their homes. This led to an increase in mortgage defaults, especially among subprime borrowers. Suddenly the repayment expectations that supported the beliefs about the value of mortgage-backed bonds were proven wrong by events.

But the situation was much worse than that. The real estate market had entered truly uncharted territory. There was no historical basis for estimating the rate at which subprime borrowers would default as housing prices fell and put them in negative equity situations. The same was true for other mortgage borrowers as well, for the United States had never experienced an extended period of time when the real price (i.e., the inflation-adjusted price) of owner-occupied housing had fallen substantially. When the fair value of any security cannot be compared to any historical norm at all, the security is p.r.o.ne to be priced on the basis of fear. This is what happened during 2008 in the market for mortgage-backed securities and collateralized debt obligations. The values of many of these securities were set at levels often 70-90 percent below their purchase prices of only a year or two earlier.

THE DEBT-DEFLATION SPIRAL TAKES HOLD.

Once the value of mortgage-backed bonds began to fall, fear cascaded through the world"s financial markets. Any bank, insurance company, hedge fund, or other financial inst.i.tution with a substantial portfolio of mortgage-backed bonds saw the equity of its shareholders plummet as these securities were marked down to values that were much lower than their purchase prices. In many cases there was no market for such securities at all. Consequently, other securities that had viable markets were sold in order to finance holdings of the mortgage-backed securities that had no market.

As the net worth of inst.i.tutions with substantial holdings of mortgage securities dropped, the value of their bond and short-term loan liabilities naturally was called into question. This was an especially dangerous turn of events because no one seemed to know which financial inst.i.tutions were about to take substantial losses on these mortgage securities.

Safety at any price became the byword. Deleveraging became the operational policy of financial inst.i.tutions. Banks refused to lend to one another or to their business customers. Corporations could not borrow in the commercial paper market. The normal business of financial intermediation ground to a halt as the demand for immediate loan repayment spiraled upward. This was the start of a cla.s.sic debt-deflation spiral, so feared by economists who study the business cycle. Such spirals begin when there is a sudden rush to sell a.s.sets to repay loans. This drives the price of a.s.sets downward, making it even more difficult to repay loans, thus spurring further a.s.set sales. The entire process, if left alone, will drive the economy into a depression from which it will be very difficult to recover. The Great Depression of the 1930s is the cla.s.sic example of a debt-deflation spiral.

LENDERS OF LAST RESORT.

As the panic of 2008 began to affect markets worldwide, central banks and government financial regulators stepped in. During the July-October 2008 period large numbers of government-financed lending programs were announced and implemented. If banks and other financial inst.i.tutions would not lend to one another, then perhaps they would be willing to lend to or borrow from the government or from the central bank. In this way central banks and national treasuries around the world a.s.sumed the role of financial intermediation that had been temporarily abandoned by the private sector. They had become the true lenders of last resort in the world economy.

Has government action halted the debt-deflation spiral in time to prevent a worldwide depression? As I write this in November of 2008 my view is that it has, but only time will tell. In this regard it is important to compare the events of 2008 with the events that accompanied the onset of the Great Depression in 1929.

Then as now there was a financial bubble whose unwinding caused bank failures and mortgage defaults. The big difference can be found in the governmental response to these developments. Government spending now is a much bigger part of the world economy that it was in the 1930s, and this makes fiscal policy now much more potent and able to cushion economic downturns. Of even more importance is the widely held belief that intervention to control the business cycle is appropriate, especially in downturns. In the 1930s few policy makers held this view, especially because they believed that adherence to the gold standard was essential to long-run prosperity.

Finally, central banks, especially the U.S. Federal Reserve, are now taking very seriously their responsibilities as lenders of last resort, of acting as financial intermediaries in times of crisis. This, after all, was the reason that most central banks were created. Moreover, the current Fed chairman, Ben Bernanke, is an expert on the policy failures that created the Great Depression and is determined to avoid them. If only for this reason, I think that things will turn out differently this time and that the United States and the world economy will recover relatively quickly from this financial fiasco.

THE CREDIT CRISIS AND THE CONTRARIAN TRADER.

It is unusual for any economic crisis to last as long as the panic of 2008 has done. It has been a financial crisis in several acts. The curtain first rose in July-August 2007 with the failure of two hedge funds sponsored by the investment bank Bear Stearns that invested in mortgage-backed securities. Each subsequent act of this terrifying play had its own bearish information cascade, which focused on a new set of financial fears and dangers. Each ended with a crystallizing event in which what had been feared became a fact. After a brief intermission of investor relief and market rallies, the curtain would go up on the next, even more fearful act. As this is being written, in late November 2008 shortly after the election of Barack Obama to the presidency of the United States, no one can be sure whether the curtain will rise yet again to reveal yet another unantic.i.p.ated financial disaster.

I have never witnessed so many intense, bearish information cascades during a 12-month period during my 40 years of involvement in the financial markets. As we shall see, these cascades were created and accompanied by many dramatic newspaper headlines and by an unprecedented torrent of bearish magazine covers.

As I pointed out earlier in this chapter, the conservative contrarian trader has only matched the performance of the buy-and-hold strategy during 2007 and 2008. As this is written, the conservative contrarian is awaiting a 1 percent upturn in the 200-day moving average of the S&P 500. When this occurs he will move from a normal to an above-normal stock market allocation.

In contrast to his conservative cousin, the aggressive contrarian has been far more active throughout the crisis. In the rest of this chapter we follow him as he reacts to the information cascades occurring during late 2007 and the first 11 months of 2008.

BULL MARKET TOP AND THE FIRST STEP DOWN.

The S&P 500 started its 2007-2008 bear market from a closing high of 1,565, reached on October 9, 2007.

The first subsequent indication that a bearish information cascade had begun was the headline for the November 8, 2007, edition of the New York Times New York Times. It read: "Markets and Dollar Sink As U.S. Slowdown Grows." I note that on the semiotic scale of bearishness this was a very mild headline. Why? First, it does not mention the stock market explicitly-note the use of the plural form markets markets. There was a first column subheading mentioning the Dow, but that same subheading also mentioned the prices of oil and natural gas. There was also a subheading mentioning that homeowners were feeling the pinch of reduced equity. The words pinch pinch and and sink sink convey only mild bearish emotions. Overall I would say that this was not a headline that indicated anything like a mature bearish stock market crowd in existence. It only shows that a bearish information cascade was under way. convey only mild bearish emotions. Overall I would say that this was not a headline that indicated anything like a mature bearish stock market crowd in existence. It only shows that a bearish information cascade was under way.

About three weeks later, the aggressive contrarian adopted a bear market stance when the S&P closed at 1,407 on November 26, 2007. That was the first time in nearly five years that the S&P closed at least 5 percent below its 200-day moving average. At this juncture the aggressive contrarian would a.s.sume a below-normal stock market allocation.

Seven more weeks pa.s.sed before a second bearish stock market headline appeared in the New York Times New York Times. In the January 17, 2008, edition, over two columns, the headline read: "Fed Chief"s Rea.s.surance Fails to Halt Stock Plunge." The use of the word plunge plunge and the explicit mention of the stock market make this a more decisively bearish headline than the one that appeared on November 8. The only semiotic consideration diminishing its bearish message is that the stock market is the object of the sentence, not its subject. and the explicit mention of the stock market make this a more decisively bearish headline than the one that appeared on November 8. The only semiotic consideration diminishing its bearish message is that the stock market is the object of the sentence, not its subject.

After the January 17 close, the aggressive contrarian would note that the S&P 500 was trading more than 10 percent below its 200-day moving average. If he were to judge that the bearish stock market crowd had grown big enough, this would justify increasing his stock market exposure to above-normal levels on the S&P close at 1,333 that day.

There was only one thing that might have caused the aggressive contrarian trader to delay increasing his stock market commitment at that juncture. He believed that a bear market was in progress. There was as yet only this single headline suggesting that a bearish stock market crowd had formed, and there was as yet no magazine cover commenting on the drop. This lack of evidence, despite a substantial drop in the averages during the preceding three months, would have made some aggressive contrarians defer action.

Only a few days later, on January 22, the situation had changed. The U.S. markets had been closed the previous day, Martin Luther King Day. But overseas markets were open. The headline of the New York Times New York Times read: "World Markets Plunge on Fears of U.S. Slowdown." This headline was very dramatic, spread across four columns and accompanied by several color photographs. One was a chart showing the previous day"s minute-by-minute drop in the Nikkei 225 index of the Tokyo Stock Exchange. The other showed a worried crowd of investors in India and turmoil on the floor of a Brazilian stock exchange. read: "World Markets Plunge on Fears of U.S. Slowdown." This headline was very dramatic, spread across four columns and accompanied by several color photographs. One was a chart showing the previous day"s minute-by-minute drop in the Nikkei 225 index of the Tokyo Stock Exchange. The other showed a worried crowd of investors in India and turmoil on the floor of a Brazilian stock exchange.

A semiotic interpretation of this headline reveals its very bearish quality. First, "world markets" is the subject of the sentence, which also uses the words plunge plunge and and fears fears to describe the situation. The headline appears across four columns and with color photographs. One photo shows a chart of the drop of the Tokyo stock exchange index. The others show worried and frantic investors. Overall, I take this headline as very convincing evidence that a bearish stock market crowd had formed. This was good reason for the aggressive contrarian trader to increase his stock market exposure, something he could have done near the opening of trading that day when the S&P stood near 1,280. to describe the situation. The headline appears across four columns and with color photographs. One photo shows a chart of the drop of the Tokyo stock exchange index. The others show worried and frantic investors. Overall, I take this headline as very convincing evidence that a bearish stock market crowd had formed. This was good reason for the aggressive contrarian trader to increase his stock market exposure, something he could have done near the opening of trading that day when the S&P stood near 1,280.

The next day"s headlines provided more evidence that a bearish stock market crowd had formed. "Fed, in Surprise, Sets Big Rate Cut to Ease Markets" read the headline of the January 23 edition of the New York Times New York Times. The Chicago Tribune Chicago Tribune chimed in with its headline: "Fed Jolts Stock Market." The previous day the U.S. Federal Reserve had cut the overnight lending rate by 75 basis points from 4.25 percent to 3.50 percent, and the stock market averages had responded by rallying from the low points they had reached near the opening of trading on January 22. The chimed in with its headline: "Fed Jolts Stock Market." The previous day the U.S. Federal Reserve had cut the overnight lending rate by 75 basis points from 4.25 percent to 3.50 percent, and the stock market averages had responded by rallying from the low points they had reached near the opening of trading on January 22. The Times Times" two-column headline stood next to a pair of graphs, one of which recorded the behavior of several stock market averages the previous day. It also appeared next to a news a.n.a.lysis by David Leonhardt ent.i.tled: "Worries That the Good Times Were a Mirage." The a.n.a.lysis opened with the sentence: "So, how bad could this get?"

If the aggressive contrarian trader had not already increased his stock market allocation to above-normal levels on January 17, he certainly would have done so on January 22 or 23. The headline material in his media diary presented strong evidence for an ongoing bearish information cascade, one that had already built up a substantial bearish crowd. The stock market had been dropping for three months, and the Dow and the S&P showed their biggest percentage drops in five years. Moreover, the Fed"s interest rate cut on January 22 was in this instance an example of a crystallizing event, something that serves to focus emotions in a single (in this case bearish) direction. Such events are generally closely a.s.sociated with market turning points.

The evidence for a bearish stock market crowd became even more definitive late in January with the appearance of several magazine cover stories. Two that especially attracted my attention were the covers of the February 4 issues of BusinessWeek BusinessWeek and of the and of the New Yorker New Yorker.

The latter was especially significant because the New Yorker New Yorker is a general interest magazine that rarely runs a cover related to the financial markets. Its February 4 cover depicted a worried Humpty Dumpty wiping his brow as he sat atop the New York Stock Exchange building on Wall Street. As we all remember from the childhood story, Humpty Dumpty is an egg-shaped fellow who shattered into innumerable tiny pieces in a great fall, never to be put back together again. From a semiotic point of view this is a very powerful and discouraging bearish image. is a general interest magazine that rarely runs a cover related to the financial markets. Its February 4 cover depicted a worried Humpty Dumpty wiping his brow as he sat atop the New York Stock Exchange building on Wall Street. As we all remember from the childhood story, Humpty Dumpty is an egg-shaped fellow who shattered into innumerable tiny pieces in a great fall, never to be put back together again. From a semiotic point of view this is a very powerful and discouraging bearish image.

The BusinessWeek BusinessWeek cover was less dramatic. Black letters on a green-lit screen announced: "Market Reckoning." The cover depicted a trader in shirtsleeves, his hands clenched to his head as he stared at the headline. cover was less dramatic. Black letters on a green-lit screen announced: "Market Reckoning." The cover depicted a trader in shirtsleeves, his hands clenched to his head as he stared at the headline.

THE BEAR STEARNS FAILURE.

Over the subsequent two months the stock market moved sideways, not dropping below its January low points but not rallying much, either. The aggressive contrarian would be waiting for the S&P to move 1 percent above its 50-day moving average, but this did not happen before another bearish information cascade took hold. During this cascade the aggressive contrarian would maintain an above-normal stock market allocation even as the S&P fell back down to the 1,256 level on March 17.

In its Sat.u.r.day, March 17, edition the New York Times New York Times headline read: "Run on Big Wall St. Bank Spurs U.S.-Backed Rescue." The Wall Street bank in question was Bear Stearns. Bear Stearns had achieved some notoriety nine months earlier on June 23, 2007, when the headline read: "Run on Big Wall St. Bank Spurs U.S.-Backed Rescue." The Wall Street bank in question was Bear Stearns. Bear Stearns had achieved some notoriety nine months earlier on June 23, 2007, when the New York Times New York Times headlined: "$3.2 Billion Move by Bear Stearns to Rescue Fund." Bear Stearns found it necessary to bail out a hedge fund it had sponsored that had gone belly-up because of losses from mortgage-based securities. headlined: "$3.2 Billion Move by Bear Stearns to Rescue Fund." Bear Stearns found it necessary to bail out a hedge fund it had sponsored that had gone belly-up because of losses from mortgage-based securities.

Evidently Bear"s exposure to mortgage losses was even more substantial than was evident in June 2007. The March 17 headline does not mention the stock market explicitly and so normally would not part of a stock market information cascade. But I made an exception to this rule here for two reasons. First, the headline mentions a bank run. This run was not one that affected depositors, but the emotional content is the same in either case. Worse, it was a Wall Street bank that needed to be rescued. The a.s.sociation of Wall Street with a bank run and a rescue makes this headline part of a bearish stock market information cascade. It provides more confirmation that a mature bearish stock market crowd exists.

The Times Times" headlines for March 17 and March 18 were of similar if less dramatic import. On March 17: "In Sweeping Move, Fed Backs Buyout and Wall St. Loans." On March 18: "Plunge Averted, Markets Look Ahead Nervously." These headlines are all a.s.sociated with a crystallizing event, the rescue (which was in fact a government-financed sale) of Bear Stearns.

More evidence for a mature bearish stock market crowd soon followed. The March 22 issue of the Economist Economist depicted a wall with a jagged crack running through it. The wall was embossed with gold lettering reading "Wall Street." The subheading read "A Ten-Page Special Report on the Crisis" in red lettering. Needless to say, a widely recognized crisis on Wall Street is generally a good buying opportunity. depicted a wall with a jagged crack running through it. The wall was embossed with gold lettering reading "Wall Street." The subheading read "A Ten-Page Special Report on the Crisis" in red lettering. Needless to say, a widely recognized crisis on Wall Street is generally a good buying opportunity.

The Weekly Standard Weekly Standard chimed in with its March 31 issue. This weekly magazine is devoted to conservative politics and opinion and generally does not pay any attention to financial markets. But this particular issue was an exception. It showed a black-and-white photograph of an older man dressed in a suit, tie, and hat holding an old-style ticker tape in his hand. The man is frowning, his hat is set back on his head, and his palm is slapped against his forehead. The whole effect evokes memories of the 1929 crash. The headline simply reads: "YIKES." chimed in with its March 31 issue. This weekly magazine is devoted to conservative politics and opinion and generally does not pay any attention to financial markets. But this particular issue was an exception. It showed a black-and-white photograph of an older man dressed in a suit, tie, and hat holding an old-style ticker tape in his hand. The man is frowning, his hat is set back on his head, and his palm is slapped against his forehead. The whole effect evokes memories of the 1929 crash. The headline simply reads: "YIKES."

FANNIE AND FREDDIE.

From its low point on March 17 at 1,256 intraday, the S&P rallied to a high at 1,440 on May 19. On April 1 the S&P closed at the 1,370 level, more than 1 percent above its 50-day moving average. This signaled to the aggressive contrarian that it was time to again reduce his stock market allocation to below-normal levels.

During April, May, and June 2008 the stock market stayed out of the headlines of major newspapers. It wasn"t the focus of any magazine cover stories, either. Nonetheless, when I read through my media diary for this period I am struck by the continuous flow of bad news about the housing market and the economy. But perhaps the biggest single story was the spectacular rise in crude oil prices, from $99 on March 4 to $147 on July 15. This 50 percent increase in crude oil prices was accompanied by a sharp increase on gasoline prices during the summer driving season in the United States. Moreover, this was only a part of a general increase in the cost of living for most Americans. All in all, this was a news background that investors found very discouraging.

The June 7 edition of the New York Times New York Times was headlined: "Jobs Down for 5th Month; Oil"s Rise Adds to Gloom." Note the use of the word was headlined: "Jobs Down for 5th Month; Oil"s Rise Adds to Gloom." Note the use of the word gloom gloom in this headline, a very strong indicator of the public"s mood at the time. On June 24 the Conference Board announced the June reading of its index of consumer confidence: 50.4, the lowest reading in 16 years; lower readings had been seen only twice in the prior 34 years. These two items ill.u.s.trate the tenor of virtually all media discussion of the state of the economy during the April-June period. An enormous bearish economic crowd had developed. Its themes were falling housing prices, tight credit conditions, imminent failures of financial inst.i.tutions, inflation, and increasing unemployment. Yet the stock market was still trading above its January low point! in this headline, a very strong indicator of the public"s mood at the time. On June 24 the Conference Board announced the June reading of its index of consumer confidence: 50.4, the lowest reading in 16 years; lower readings had been seen only twice in the prior 34 years. These two items ill.u.s.trate the tenor of virtually all media discussion of the state of the economy during the April-June period. An enormous bearish economic crowd had developed. Its themes were falling housing prices, tight credit conditions, imminent failures of financial inst.i.tutions, inflation, and increasing unemployment. Yet the stock market was still trading above its January low point!

The Dow and the S&P 500 started another decline from their highs on May 19. By early July both indexes had dropped below their January-March lows. Even so, the stock market stayed out of the headlines until July 8. That day the New York Times New York Times headlined: "Mortgage Fears Depress Shares at Two Agencies-Fears of Worse to Come." The story concerned the condition of two government-sponsored corporations, Fannie Mae and Freddie Mac, both responsible for financing home mortgages for U.S. homeowners. The stock market as a whole had become very sensitive to the fortunes of Fannie and Freddie, because their debt was held by so many banks and financial inst.i.tutions. Failure of Fannie and Freddie would result in an economy-wide credit crisis and economic contraction. From a semiotic point of view this headline conveyed extremely bearish sentiments. Note the two appearances of the word headlined: "Mortgage Fears Depress Shares at Two Agencies-Fears of Worse to Come." The story concerned the condition of two government-sponsored corporations, Fannie Mae and Freddie Mac, both responsible for financing home mortgages for U.S. homeowners. The stock market as a whole had become very sensitive to the fortunes of Fannie and Freddie, because their debt was held by so many banks and financial inst.i.tutions. Failure of Fannie and Freddie would result in an economy-wide credit crisis and economic contraction. From a semiotic point of view this headline conveyed extremely bearish sentiments. Note the two appearances of the word fears fears and the use of the word and the use of the word depress depress and the phrase and the phrase worse to come worse to come. A week later on July 15 the New York Times New York Times headlined: "Confidence Ebbs for Bank Sector and Stocks Fall-Lines Form at Lender." The story"s opening paragraph said in part: "[C]onfidence in the banking sector spiraled downward Monday." It went on to note that the shares of regional banks "plunged in one of the sharpest declines since the 1980"s." headlined: "Confidence Ebbs for Bank Sector and Stocks Fall-Lines Form at Lender." The story"s opening paragraph said in part: "[C]onfidence in the banking sector spiraled downward Monday." It went on to note that the shares of regional banks "plunged in one of the sharpest declines since the 1980"s."

These two headlines, a week apart, both concerned the stock prices of banks and financial inst.i.tutions. They indicated that a bearish crowd had developed in this sector of the stock market. It is important to keep in mind that financial inst.i.tutions keep the economy functioning. In a banking panic the prices of all shares, not just those of the banks, will fall. For this reason it seemed to me at the time that this was a buying opportunity for the aggressive contrarian trader. This was another bearish information cascade, and on July 14 the S&P had closed at 1,228, which was more than 10 percent below its 200-day moving average and a new low for the ongoing bear market. Here the aggressive contrarian had ample reason to increase his stock market allocation to above-normal levels. Moreover, the S&P had dropped for about two months since its last short-term high on May 19.

Magazine covers provided more evidence for the existence of a bearish stock market crowd. The July 7 issue of Barron"s Barron"s was headlined: "The Bear"s Back." It showed a cartoon of a ferocious snarling bear with its teeth bared. The July 14 issue of was headlined: "The Bear"s Back." It showed a cartoon of a ferocious snarling bear with its teeth bared. The July 14 issue of BusinessWeek BusinessWeek was even more significant. It was headlined: "Retirement Strategies for Tough Times" and showed a man and a woman trying to find their way through a maze. Of course the phrase was even more significant. It was headlined: "Retirement Strategies for Tough Times" and showed a man and a woman trying to find their way through a maze. Of course the phrase tough times tough times conveys a definite bearish sentiment. But of much more importance is the subject of the headline, retirement. When contemplating retirement from the workforce, people see themselves as being at the mercy of financial market fluctuations. When they start to worry about retirement, it is generally because the stock market has fallen enough to attract their attention and focus their fears. Remember that the low of the 2000-2002 bear market coincided with a July 2002 conveys a definite bearish sentiment. But of much more importance is the subject of the headline, retirement. When contemplating retirement from the workforce, people see themselves as being at the mercy of financial market fluctuations. When they start to worry about retirement, it is generally because the stock market has fallen enough to attract their attention and focus their fears. Remember that the low of the 2000-2002 bear market coincided with a July 2002 Time Time magazine cover story about retirement fears. magazine cover story about retirement fears.

The July 19 issue of the Economist Economist had on its cover a depiction of two tornadoes, which were sucking up currency, houses, and piggy banks (savings). It was headlined: "Twin Twisters: Fannie Mae, Freddie Mac and the Market Chaos." Tornadoes represent disaster, and the word had on its cover a depiction of two tornadoes, which were sucking up currency, houses, and piggy banks (savings). It was headlined: "Twin Twisters: Fannie Mae, Freddie Mac and the Market Chaos." Tornadoes represent disaster, and the word chaos chaos is about as bearish a word as can be used to describe markets. The July 28 issue of is about as bearish a word as can be used to describe markets. The July 28 issue of BusinessWeek BusinessWeek depicted a snake eating its own tail. It was headed, in red capital letters (the color of fear and danger): "How Wall Street Ate the Economy." depicted a snake eating its own tail. It was headed, in red capital letters (the color of fear and danger): "How Wall Street Ate the Economy."

As if to summarize Americans" feelings about the state of the economy, the Economist, Economist, in its July 26 issue, depicted the Statue of Liberty sitting and staring dejectedly at the New York skyline. The headline read: "Unhappy America." in its July 26 issue, depicted the Statue of Liberty sitting and staring dejectedly at the New York skyline. The headline read: "Unhappy America."

There were still other signs that an enormous bearish stock market crowd had developed. On August 3 the Conference Board released its latest consumer confidence report. For the first time in 20 years the majority of respondents expected stock market prices to decline over the subsequent 12 months. The bearish stock market crowd was accompanied by an equally bearish economic crowd. On August 3 the Gallup poll showed that 77 percent of Americans held negative views of the economy, while only 7 percent held positive views!

On August 28 the aggressive contrarian would have seen the S&P close at 1,301, for the first time since mid-July at least 1 percent above its 50-day moving average. As it happened, this signal occurred after the actual short-term high, which was on August 11 at the 1,305 level. At this juncture a move back to a below-normal stock market allocation was called for. It was hard to believe then, but worse was still to come.

THE CRASH: BANKRUPTCY OF LEHMAN BROTHERS.

In September the collapse of the Wall Street investment banks began and this time a worldwide panic enveloped the financial markets. The first sign of new trouble (and a new bearish information cascade) was the one-column headline of the September 10 edition of the New York Times New York Times. It read: "Wall St."s Fears on Lehman Bros. Batter Markets." Two days later the New York Times New York Times published a three-column headline: "Financial Crisis Reshapes Wall Street"s Landscape." It appeared that Lehman Brothers was on the verge of bankruptcy. Much to the surprise of Wall Street and the banking industry, the U.S. Treasury and the Federal Reserve refused to rescue Lehman Brothers and on September 15 the investment bank entered bankruptcy. published a three-column headline: "Financial Crisis Reshapes Wall Street"s Landscape." It appeared that Lehman Brothers was on the verge of bankruptcy. Much to the surprise of Wall Street and the banking industry, the U.S. Treasury and the Federal Reserve refused to rescue Lehman Brothers and on September 15 the investment bank entered bankruptcy.

The Lehman Brothers bankruptcy triggered a financial panic. The solvency of virtually every large financial inst.i.tution was now called into question. The venerable brokerage firm Merrill Lynch had suffered such losses in mortgage-backed securities that it had to be sold to Bank of America. On September 16 we had the first headline featuring stock prices as the subject of the sentence. In its September 16 edition the New York Times New York Times headlined: "Wall St. in Worst Loss Since "01 Despite Rea.s.surances by Bush." The next day the headlined: "Wall St. in Worst Loss Since "01 Despite Rea.s.surances by Bush." The next day the New York Times New York Times headlined more bad news: "Fed in $85 Billion Bailout Plan of Faltering Insurance Giant." The American International Group (AIG) insurance company was in danger of bankruptcy because of losses incurred on its issuance of credit default derivatives. Finally, on September 18 the headlined more bad news: "Fed in $85 Billion Bailout Plan of Faltering Insurance Giant." The American International Group (AIG) insurance company was in danger of bankruptcy because of losses incurred on its issuance of credit default derivatives. Finally, on September 18 the New York Times New York Times published a four-column headline: "New Phase in Finance Crisis As Investors Run to Safety." published a four-column headline: "New Phase in Finance Crisis As Investors Run to Safety."

Note that in only one of this sequence of headlines was the stock market itself the subject of the headlining sentence. So whereas a bearish information cascade was under way, I think the aggressive contrarian would have had reason to delay any decision to increase his stock market exposure even though the S&P was trading 10 percent below its 200-day moving average. More important, barely a month had pa.s.sed since the last short-term top on August 11. Generally, buying opportunities in bear markets develop only after the market has dropped for at least two months.

During the next two weeks the newspapers were filled with stories and headlines describing the U.S. government"s efforts to develop a plan for rescuing Wall Street and the economy. Things came to a head on September 29 when the first legislative rescue effort failed in the U.S. House of Representatives. The next day"s headlines recounted the event. From the New York Times New York Times we have: "Defiant House Rejects Huge Bailout; Stocks Plunge; Next Step Is Uncertain." The we have: "Defiant House Rejects Huge Bailout; Stocks Plunge; Next Step Is Uncertain." The Chicago Tribune Chicago Tribune that same day headlined: "The House Says No. Fear Grips Investors." that same day headlined: "The House Says No. Fear Grips Investors."

Clearly a very big bearish stock market crowd had developed, one even bigger than at the temporary July low point. But the S&P was in a bear market, not a bull market. In bear markets, history recommends waiting for two months or so to pa.s.s after a short-term top before increasing long positions in a bear market even when a bearish information cascade has developed sooner.

The next stock market headlines appeared on October 7, a total of 57 days after the August 11 short-term top and close enough to the two-month guideline to get the attention of the aggressive contrarian trader. The New York Times New York Times published a four-column headline, complete with photographs of fearful investors and charts of plunging stock prices: "Fed Weighs Bid to Spur Economy As Markets Plummet Worldwide." That same day the published a four-column headline, complete with photographs of fearful investors and charts of plunging stock prices: "Fed Weighs Bid to Spur Economy As Markets Plummet Worldwide." That same day the Chicago Tribune Chicago Tribune headlined all across its front page: "Crisis Goes Global," and helpfully provided inset photographs purporting to show fearful investors in various world stock markets accompanied by a down arrow labeled by that particular market"s percentage drop the previous day. The headlined all across its front page: "Crisis Goes Global," and helpfully provided inset photographs purporting to show fearful investors in various world stock markets accompanied by a down arrow labeled by that particular market"s percentage drop the previous day. The Tribune Tribune"s biggest contribution to this bearish information cascade came with its October 10 headline spread entirely across page 1 and accompanied by down arrows describing the market drops of the preceding seven trading sessions: "All Signs Pointing to Panic." The S&P reached an intraday low at 839 that day.

Starting on October 7 the aggressive contrarian would have been justified raising his stock market allocation to above-normal levels. The S&P was trading more than 10 percent below its 200-day moving average. An unprecedented bearish information cascade had built up a strong bear market crowd. And about two months had pa.s.sed since the last short-term top in this bear market. On October 6 the S&P 500 closed at 1,056, but closed much lower at 996 on October 7. Nonetheless, I think it is best to a.s.sume that the aggressive contrarian would have increased his stock market allocation to above-normal levels at the S&P 1,056 close.

So far I have doc.u.mented the September-October bearish information cascade solely through newspaper headlines. But an unprecedented avalanche of magazine covers did its part in building up the bearish stock market crowd. The first was the September 29 cover of Time Time magazine. It depicted a businessman headfirst in a hole with only his legs showing. The caption read: "How Wall Street Sold Out America." The September 29 issue of the magazine. It depicted a businessman headfirst in a hole with only his legs showing. The caption read: "How Wall Street Sold Out America." The September 29 issue of the Weekly Standard Weekly Standard was captioned "High Anxiety" and showed cartoon characters fleeing the New York Stock Exchange. The September 29 issue of the was captioned "High Anxiety" and showed cartoon characters fleeing the New York Stock Exchange. The September 29 issue of the New Yorker New Yorker showed a businessman talking on his cell phone while walking down Wall Street and about to fall into a manhole. The October 13 issue of showed a businessman talking on his cell phone while walking down Wall Street and about to fall into a manhole. The October 13 issue of Time Time showed a Depression-era breadline and was captioned "The New Hard Times." The October 13 issue of showed a Depression-era breadline and was captioned "The New Hard Times." The October 13 issue of U.S. News & World Report U.S. News & World Report showed a cartoon of part of a dollar bill with a likeness of George Washington wide-eyed. The caption read: "How Scared Should You Be?" showed a cartoon of part of a dollar bill with a likeness of George Washington wide-eyed. The caption read: "How Scared Should You Be?"

Finally, the October 20 issue of the New Yorker New Yorker featured on its cover a stunning cartoon of Death, dressed in a red robe and wearing a black-plumed red hat. He gripped a staff with a skull at its top, and held a chart on which a jagged red graph line depicted dropping stock prices. Beneath his gaze stood a group of agonized bankers and brokers, apparently bleeding losses in red from their eyes. Yikes! A fitting insight into and summary of the psychological tenor of the time! featured on its cover a stunning cartoon of Death, dressed in a red robe and wearing a black-plumed red hat. He gripped a staff with a skull at its top, and held a chart on which a jagged red graph line depicted dropping stock prices. Beneath his gaze stood a group of agonized bankers and brokers, apparently bleeding losses in red from their eyes. Yikes! A fitting insight into and summary of the psychological tenor of the time!

As I write this, the aggressive contrarian is still sitting with the above-normal stock market allocation he a.s.sumed on October 7 at the S&P 1,056 level. At its November 20 low close the S&P stood at 752, so he has suffered through a seven-week, 29 percent drop. He has underperformed the buy-and-hold strategy since early October. But another bearish information cascade has now developed in the New York Times New York Times" headlines. Its November 20 edition headlined: "Stocks Are Hurt by Latest Fear: Declining Prices." This headline conveyed only mild bearish sentiment; it covered a single column and used the verb hurt hurt instead of the more emotional possibilities like instead of the more emotional possibilities like plunge plunge or or plummet plummet. A much more emotional headline appeared the following day, though, spread across four columns and accompanied by a chart of the Dow: "Stocks Drop Sharply and Credit Markets Seize Up."

As we have seen in this and previous chapters, headlines like these are usually published within a day or two of a short-term stock market low. For this reason I think the aggressive contrarian would now be looking for an upward move in the S&P. The real question he must confront is the tactic he should use to restore his current stock market allocation to normal or to below-normal levels.

Normal bear market tactics would demand he wait for the S&P to close at least 1 percent above its 50-day moving average and then restore a below-normal stock market allocation. But there is an important issue that the aggressive contrarian must address at this market juncture. From its October 9, 2007, high at 1,565 to its current 752 low close on November 20, the S&P 500 has dropped 47 percent over a 12-month period. The bear market has thus far been above normal in extent and about normal in duration. What are the odds that the up move from the November 20 low at 752 is actually the first leg upward of a new bull market?

The strength of bearish sentiment about the stock market and the economy argues for the start of a new bull market from the November 20 low. But the aggressive contrarian currently has an above-normal allocation to the stock market and shows a substantial loss relative to his buy at the 1056 level in early October. In such situations I have always found it best to "play defense" to avoid losing too much ground to the buy-and-hold strategy. So I think the right choice here is to follow the normal bear market tactic by waiting for an S&P level close at least 1 percent above its 50-day moving average and then restoring a below-normal allocation the stock market.

CHAPTER 16.

Vignettes on Contrarian Thought and Practice A 1912 gem * * Humphrey Neill Humphrey Neill * * two great books on tape reading two great books on tape reading * * Neill"s contrary opinion writings Neill"s contrary opinion writings * * American"s love opinion polls American"s love opinion polls * Investors Intelligence * Investors Intelligence fills a gap fills a gap * * No Free Lunch No Free Lunch * * Garfield Drew and the odd lotter Garfield Drew and the odd lotter * * the finest book on speculation ever written the finest book on speculation ever written * * Paul Montgomery invents the magazine cover indicator Paul Montgomery invents the magazine cover indicator * * histories of bubbles and crashes histories of bubbles and crashes * * irrational exuberance finds its nemesis irrational exuberance finds its nemesis * * Robert Shiller Robert Shiller * * a contrarian looks at value investing a contrarian looks at value investing * * three pages from the value investor"s handbook three pages from the value investor"s handbook Every contrarian trader eventually constructs his own unique way of taking advantage of the market mistakes crowds make. In the preceding chapters I explained the methods I have developed over the past 40 years. But there is a lot more to say about the contrarian approach to markets than I have discussed so far. In this chapter I am going to try to fill this gap.

What follows is a sequence of short memos I have written for my own benefit over the years I have spent developing my approach to contrarian trading. These memos were written for various reasons. Sometimes I would come across a thought-provoking book and would then write a short review attempting to put it into a broader context within contrarian theory. Occasionally I would learn of a contrarian method that wasn"t explained in any book I had read and would write a short essay explaining its connection with my own approach. The following are several of these vignettes on contrarian thought and practice.

THE PSYCHOLOGY OF THE STOCK MARKET.

The Psychology of the Stock Market is the t.i.tle of a short book written by George C. Selden and first published in 1912. It originated from a series of magazine articles that had appeared a few years earlier in the is the t.i.tle of a short book written by George C. Selden and first published in 1912. It originated from a series of magazine articles that had appeared a few years earlier in the Ticker Ticker magazine. The magazine. The Ticker Ticker was founded by the legendary Richard D. Wyckoff just after the turn of the century and eventually became the was founded by the legendary Richard D. Wyckoff just after the turn of the century and eventually became the Magazine of Wall Street Magazine of Wall Street. Amazingly enough, this book it is still in print and available from Cosimo Cla.s.sics.

Selden describes in detail the ebb and flow of investor emotions and thinking during a typical speculative cycle. His observations are as relevant today as they were when first made nearly 100 years ago. I was particularly struck by this pa.s.sage on page 22: [M]ost of those who talk about the market are more likely to be wrong than right, at least so far as speculative fluctuations are concerned. This is not complimentary to the "molders of public opinion," but the most seasoned newspaper readers will agree that it is true. The daily press reflects, in a general way, the thoughts of the mult.i.tude, and in the stock market the mult.i.tude is necessarily . . . likely to be bullish at high prices and bearish at low.

Here is the genesis of the idea that investment crowds, especially in the stock market, can be detected by carefully tracking the content of the media. Over the next 100 years this idea would be developed in several different directions, each leading to a particular method for beating the market by leaning against the crowd.

THE G.o.dFATHER OF CONTRARY OPINION.

The torch lit by G. C. Selden was pa.s.sed to the man I think of as the G.o.dfather of contrary opinion, Humphrey Bancroft Neill (1895-1977). A wonderful 32-page biography of Neill appears as Chapter 5 in the book Five Eminent Contrarians Five Eminent Contrarians by Steven L. Mintz, which was published in 1994 by the Fraser Publishing Company of Burlington, Vermont. by Steven L. Mintz, which was published in 1994 by the Fraser Publishing Company of Burlington, Vermont.

Neill wrote three books, each of which is still in print and remains an outstanding contribution to contrarian theory and technique.

The first of these, Tape Reading and Market Tactics Tape Reading and Market Tactics, is probably the best single work on the technique of tape reading in print today. It was first published in 1931. In it Neill explains the methods a tape reader uses to evaluate and make deductions from the volume of trading a.s.sociated with stock price movements. (I should add that the best work on tape reading ever written is Richard D. Wyckoff"s Tape Reading and Active Trading. Tape Reading and Active Trading. This was published as part of his 1930s stock market course This was published as part of his 1930s stock market course The Richard D. Wyckoff Method of Trading and Investing in Stocks The Richard D. Wyckoff Method of Trading and Investing in Stocks. Sadly, this course is no longer in print. However, one can still purchase Wyckoff"s 1910 book, Studies in Tape Reading Studies in Tape Reading, which contains his early thoughts on tape reading.) Neill"s second book is The Art of Contrary Thinking. The Art of Contrary Thinking. It first appeared in 1954 and it is still his most popular work. In its first 46 pages Neill articulates his theory of contrary opinion. He explains it as a dialectical approach to thinking about markets and more generally about social and political affairs. One starts from a It first appeared in 1954 and it is still his most popular work. In its first 46 pages Neill articulates his theory of contrary opinion. He explains it as a dialectical approach to thinking about markets and more generally about social and political affairs. One starts from a thesis thesis, which is the current opinion of the crowd. The contrary step is then taken to the ant.i.thesis ant.i.thesis, which is a view in some substantial way contrary to the view held by the crowd. There follows the synthesis synthesis, in which one traces out the implications of facts that the crowd has overlooked. This results in an a.s.sessment of the extent and ways in which the crowd"s opinion could prove to be mistaken. In the book"s final 150 pages Neill develops his theory in a number of directions through a sequence of short essays. Stock market investors often find this book quirky because, while it offers much food for thought, it is not focused on the applications of contrary opinion to investing.

The Ruminator, Neill"s third book, is of much more interest to traders and investors. First published in 1975, it contains a number of short essays describing the contrarian"s take on stock market and economic events during the 1968-1973 period, described by Neill as a time of great emotional turmoil in the United States and around the world.

OPINION POLLS: WHAT DO YOU THINK?.

It is interesting to contrast Neill"s approach to contrary thinking to another that has become popular over the past 40 years. Neill emphasized the importance of a.s.sessing the crowd"s view by culling information from the print media. He often referred to the files he kept of newspaper articles, magazine commentary, brokerage firm recommendations, and the like. It is Neill"s approach for gathering information that I have taken in this book.

But it wasn"t long before the opinion poll supplanted Neill"s method for a.s.sessing the beliefs of the crowd. This development may reflect a peculiarly American trait. In his 1936 cla.s.sic, The General Theory of Employment, Interest, and Money The General Theory of Employment, Interest, and Money, John Maynard Keynes observed (section VI of Chapter 12): Even outside the field of finance, Americans are apt to be unduly interested in discovering what the average opinion believes the average opinion to be; and this national weakness finds its nemesis in the stock market.