Dead Man Walking

It is, indeed, interesting that the market is showing signs of life. But don't put too much faith in any proclamation that the market has bottomed. It seems very likely to me that the DJIA will close out the year below 8000, and probably below 7400.

There is a popular notion that the market is ruled by greed and fear. As greed increases, the bulls gain control and the market rises. As fear dominates, the bears are out in force and the market falls. There are a couple of other parameters to this equation, however.

If you break the market into two distinct sectors, institutional investors and individual investors, it becomes apparent that the institutional part of the market is ruled by greed and caution, and the individual sector is controlled by hope and fear. The institutions, being in greater control by virtue of size and amount of capital, also are also privy to more information than the average individual. They therefore are not as susceptible to fear. They are greedy on the upside, and cautious, not fearful, on the downside.

Individuals are a very optimistic and hopeful lot. Their investment decisions are motivated more by hope and a belief that the "natural" state of affairs is a rising market. When the market falters and breaks down, their hope gives way to fear. Unlike the institutions which are very pragmatic in their decisions, individuals are more emotional, and in a down market they become paralyzed by fear. That is why so many 401ks get wiped out in a market such as the one we have been experiencing.

What does all of this have to do with my feeling that the market is destined to be much lower at year end? My prediction is based on a belief that the recent rally in the market has been driven not by a lot of buying interest, but rather a lack of selling interest. The ever-hopeful individual investor still wants to believe in this rally, while the greedy institutions are quite willing to oblige this fantasy - for a short while longer.

When you realize that the institutions, whose market commitments will always determine the market direction, are faced with a lot of "forced" selling between now an January, they have a vested interest in seeing the stock prices rise as much as possible before they put in their sell orders.

A simple way to accomplish this is to sit on the sidelines and let the small-money, the hopeful money, the imprudent money drive the market higher. By postponing their massive sales as much as possible, they are engineering a significantly higher market from which to extract as much as possible, and they are decoying the individuals into a belief that a real rally is under way. After a few more days of inaction, they will begin to put in their sell orders.

Since the institutions know when they are going to pull the trigger on their exodus, they might even be doing some buying in this bear market rally to capture some short term profits before the collapse. They are well positioned to fleece the small money on the way up before they shear them on the way down.

If this scenario plays out the way I think it will, we will rally the first part of this week. Then you will see a market that goes sideways for a few days, and then a decline will become obvious. At first it will seem like normal profit taking. After all, the pundits will say, it is perfectly normal in a rally for investors to claim some of their profits and take a look at new opportunities -- new stocks and sectors which may being showing leadership, etc.

Then the selling will ramp up to the point that it overwhelms the buyers, and we will see another precipitous decline, with the Dow undercutting 8000, and perhaps going much lower than that.

There are at least three reasons why heavy selling is in the cards for December:

1. The hedge funds have a lot more redemptions coming before January. The hedges are not anywhere near normalization yet. In the interest of disclosure, I have to state that this assertion is more hypothesis than fact. I do not have any figures on what reclamations are lurking. My gut feel is there are still quite a lot.

2. The mutual funds need to get their losers off of their prospectuses before the end of the year. And they have been holding lots of losers! It is a particularly cynical practice in the industry to hide a losing year or quarter by showing a raft of good stocks in their stable when a snapshot is taken of their holdings. Never mind that most of the quarter they were in losing positions, as long as the snapshot doesn't show these losers, they can actually look like they are well on their way to making money for their investors.

3. Year-end tax selling by many investors, large and small. There are many investors who have lost a lot of money this year, and the only way they can deduct those losses on their income taxes is to actually realize the losses. In other words they will be highly motivated to sell their big losers to establish their losses. When the year-end selling hits, the hopeful individuals will be caught off guard again. Their hope will diminish and fear will again dominate. They are being groomed right now to grow the market so that it can be more profitably harvested by those in control of the market.

At some point we will see a true capitulation (we haven't seen it yet). When we do see it, it will be unmistakable. There won't be anyone asking "Is this the capitulation?" because it will declare itself loud and clear. The year-end selling will cause the markets to collapse, and the worsening economy will almost guarantee that climbing up from the capitulated bottom will be long and arduous.

Hope is the denial of reality. It is the carrot dangled before the draft horse to keep him plodding along in a vain attempt to reach it. --Margaret Weis, Dragons of Winter Night