We believe that the market has further to go on the downside.  The stock market would have to meet a few more requirements for us to at least move to a neutral stance before we hopefully can turn bullish.

The first requirement is for a "wash-out" event of public capitulation precipitated by major redemptions of equity mutual funds and massive selling of equities by the public, hedge funds, and the institutions that are forced to liquidate due to public redemptions. 

The second requirement would be for stocks to trade down to the levels that we would consider attractive values.  We have been updating the "Limbo, Limbo, How Low Can it Go?" article on the right side of our home page every few months, and it has recently been updated.  Ever since we authored "Limbo, Limbo" in early 2000 the stock market has never reached levels that we would consider attractive.  The article shows five different metrics to measure the valuation of the stock market-Price to Dividends, Price to Sales, Price to Cash Flow, Price to Book Value, and Price to Earnings. 

The third requirement for us to get more positive is for Housing Prices to decline to more normal levels of under 3 times median family income after rising to over 5 times median income in 2006.  This would require home prices that have already declined by 20% to decline by another 20%.  The deleveraging of the record debt will accompany the housing price decline.  We will only deal with the capitulation in this comment, but you should visit "Limbo, Limbo" to see how overvalued the market is except for the price to book metric. 

The last stage of panic selling is in the process of meeting our goal, but has not yet reached the level of massive capitulation that would be needed to counter the outrageous speculation that took place in the late 1990s and from 2003 to 2006 in both equities and home prices.  The equity mutual fund redemptions in 2002 did not come close to the liquidation we expected after the financial mania of the late 1990s and the latest redemptions in 2007 and 2008 have so far not reached the levels we would expect in order to be classified as enough capitulation to end the final stage of the bear market.

One of the best ways to measure the last stage of the bear market is to monitor the public's participation in the equity market through the net purchases and sales of equity mutual funds.  Thanks to the Investment Company Institute, such figures are readily available.  For example, net inflows into equity mutual funds during the first quarter of 2000 were far greater than in any other quarter in history.  As you know, this coincided with the peak of the financial mania.  Net inflows in the quarter amounted to $101 billion ($141 with foreign equities included), largely concentrated in the Nasdaq high tech and growth stocks that were the main targets of the blood bath that followed.  These purchases along with some additional buying throughout the year brought total equity mutual fund assets up to a record at the time of $4 trillion ($4.6 trillion with foreign equities) in August 2000.

History is replete with examples of massive herd-like public purchases at the peak of financial asset prices and emotional liquidations at the troughs.  A number of financial and economic studies have covered this topic from the tulip bulb craze in the 1600s to the crash of 1929.  Although culture, technology and financial instruments undergo great change over time, human nature remains the same and emotional highs and lows in financial markets are facts of life that never change.  A modern example is the early 1980s financing and marketing of oil and gas shelters from the drilling areas of Texas and the Gulf of Mexico to Wall Street where there seemed to be unlimited demand for anything to do with oil and gas.  This demand coincided with the peak in oil and gas prices in the early 1980s leading to heavy losses, bankruptcies, a crash in Texas home prices, and the necessity to bail out every sizeable independent bank in the state. 

Another quick example of public "irrational exuberance" was the lines of people around the blocks of downtown Manhattan seeking to buy gold and gold coins just as the price of gold was peaking in 1980 at over $870 an ounce.  The latest example, of course, was the recent purchasing of mortgages by Wall Street and packaging them for sale to all of their customers all over the world.  Time after time, it's apparent that the public and many institutions always buy heavily what it most recently missed, and subsequently liquidates with major losses.

Some may believe that the net liquidation of about $91 billion ($98 billion including foreign equity funds) of equity mutual funds from June to October 2002 represented enough fear and capitulation to qualify as the third stage of that bear market.  This liquidation, however, pales by comparison to the prior bear markets.  Total equity mutual funds (EMF) liquidation for the entire year of 2002 was only $25 billion ($26 billion with foreign), representing only a little more than 0.5% of the $4 trillion of total EMF assets.  To put this in perspective, there were 12 other years since 1970 where total outflows were much higher.  In fact, after the bear market of 1973-1974, every year between 1976 and 1979 recorded outflows between 10 and 12% of total EMF assets.  Furthermore, eight other years recorded net outflows ranging from 1.2% to 8% of assets.  This means that the net outflows in 2002 were only the 13^th largest on an annual basis since 1970-and this followed the greatest financial bubble ever.

Some may argue that stocks and equity mutual funds have much broader ownership now than ever before.  And 401 Ks are responsible for a lot of the wider ownership.  To us that makes the problem even worse and when the public panics near the end or at the end of severe bear markets, the more public ownership, the more people that are able to panic.

The fact that the public has come back into equity mutual funds with a vengeance over the bull market years of 2003 to 2006 with just under $300 billion of net purchases ($717 bn with foreign EMFs) is of even more concern to us since it is likely to make the final stage of eventual capitulation that much worse.  Total assets of EMFs of $4.2 trillion are just over the peak reached in mid-2000 of $4.0 trillion.  If foreign equity funds are included the total is now $5.5 trillion (with net purchases in 2007 of $93 billion) vs. $4.5 trillion in 2000.

If this global bear market is as bad as we think, we should expect redemptions of at least 10% of the total EMFs before it ends.  This would make the total net liquidations of domestic equity mutual funds of around $400 billion and if you include foreign EMFs the total would be about $550 billion.  So far (as you can see in the attachment) we have liquidated just over $135 billion of domestic EMFs and just under $105 billion if you include foreign EMFs.  Until the third stage of the bear market is complete, and the fear and capitulation become even more obvious, the market remains extremely vulnerable.

As many of our long-term readers know, we have been very negative on the stock market and economy ever since we first started writing these comments at the beginning of 2000.  We have tried to explain the way we see the financial environment even if we were hoping to be wrong the whole time.

 Lately, we have predicted that the severe U.S. recession we see ahead will spread abroad into a global recession and a global deflationary bear market for stocks.  On the other hand most investors believed that if there were a break in food prices, energy prices and other commodities the stock market would rise accordingly. They felt the pressures of inflation and corporate margins would tend to ease both here and abroad.  In the face of this almost unanimous feeling we also forecast that most commodities would decline as a result of the "demand destruction" caused by the global recession and that, combined with debt deleveraging, lead to a global deflationary bear market.  We attached the "Cycle of Deflation" chart (which we authored) numerous times over the past 8 years.  We will attach the chart to this comment and as you can see in the chart, the latest prediction we made was that there will be a race to lower rates worldwide and that the terms "competitive devaluation" and "beggar-thy-neighbor" will be terms used broadly over the next few year.  This started to become evident earlier today when the ECB, in a switch of emphasis, let it be known it was now more concerned about the lack of growth than the onset of inflation.   In our view this statement was meant to set up expectations of an imminent rate cut.

We never got the capitulation we expected after the market peaked in 2000 mainly due to the fact that the Fed lowered interest rates 14 times from 6.5% in 2000 to 1% in June of 2003.  The Fed maintained Fed Funds rate at the extremely low level of 1% for a year until June of 2004.  This loose monetary environment jump-started the housing market and prevented the stock market from undergoing a final capitulation. A new bull market started from the outrageously high valuation level of 26 times earnings at the time.  We understand that we looked foolish as the stock market rose from 2003 to 2007 accompanied by unprecedented valuations in real estate. 

The real estate bubble actually began as the stock market started down in 2000 and eventually rose to levels relative to incomes and rents that were twice the levels of the highest ratios in history.  Housing prices started to rise significantly in the mid- 1990s when the Clinton administration put pressure on Fannie Mae and Freddie Mac to increase their purchases of mortgages for low income borrowers.  Banks were also accused of "redlining", a term used to describe a policy of not providing enough mortgages to certain low income areas.  Regulators subsequently put subtle pressure on banks to increase lending for home purchases in low-income neighborhoods.  However, the boom really took off seriously in the early 2000s when Wall Street started packaging all these toxic mortgages and selling them to worldwide clients (who should have known better).  It was also spurred by mortgages featuring no down payment, no verification of assets and income, initial low teaser rates and outright fraud.  At one point the SEC allowed the top five investment banks to increase their asset-to-capital ratios from 12 to 1 to 40 to 1. Combine this with Greenspan lowering rates to 1% from 6.5% and keeping them there for a year as we described above.  He then encouraged new home buyers to get into these wild complicated mortgages that would reset at much higher interest rates.  We wrote about this in late 2003 when we did a special report called, "Real Estate-The Catalyst for the Deflationary Bear Market", available on the left hand side of our home page.  The home prices subsequently rose from record valuation metrics to twice the normal HIGH valuations over the next two years.  Doesn't that remind you of what happened to stocks in the late 1990s? 

The special report we wrote (again on left side of home page) "How We Got Into This Mess", was followed up with "How to Get Out of the Mess". How we got into this mess was described above. In our opinion, the bottom line of "How to Get Out of this Mess" is to let the free markets work to find a bottom without government intervention.  It concludes by stating that if the government gets involved to attempt to stop the housing market from finding a natural bottom it will only postpone the inevitable and may make it worse.

This brings us to the latest "Wall Street Bailout".  While the market has been rallying and declining on changes in the odds that congress will pass the Paulson plan, we think that the market will go down much further whether the bill passes or not.  After all, the plan in place, which now includes a bunch of "add-ons", will not help an extremely serious problem very much at all and we think that investors are seeing right through the "mirage".  (Furthermore the market only now is waking up to the fact that the real economy is in for a hard landing in any event.) The "Plan" only deals with the left hand side of the balance sheets (assets) of these financial companies' and leaves the left side (liabilities and equity) alone.  This means the government will buy toxic assets on the left side (assets) and leave the right side alone to fend for itself.  The bailout means that if the government pays the same or a little more for the toxic assets on their books, it will increase the cash available and decrease the toxic asset by the same amount.  This does not improve the stockholder's equity that is needed to encourage the bank to make loans and give relief for the credit crises we are in presently.  The institutions that are the weakest will sell the government their toxic assets but the increase in cash will not be enough to encourage the institution to make loans to consumers and businesses that are in desperate need for cash.

In addition the market today seemed to wake up to the realization that the economy is in for a hard landing no matter what happens to the Paulson proposal.  As a result of recently released negative data on consumer spending, autos sales, the PMI report and initial unemployment claims, a number of economists that had been in denial now concede that we are in a recession that is likely to persist well into 2009.  We previously thought that passage of even a highly flawed bailout plan would result in a rally.  That may still happen, but the prospects have dimmed significantly by an economy pulling in the opposite direction.   

Again, we honestly hope that we will be wrong about this highly negative assessment of the financial and economic environment.  Please let us know what we are missing so we can change our stance.