Man, It's Ugly Out There

Man, it's ugly out there... 'The most brutal market... in 30 years of investing'... The market gods are shooting the generals... Nowhere to go but down, down, down... Like a herd of wildebeests fleeing hungry lions... You're not Warren Buffett... A 'liquidity cascade' isn't as beautiful as it sounds... The bear market is upon us...

So much for the 'dead-cat bounce'...

In last Friday's Digest, I (Dan Ferris) told you to expect "a ripping bear market rally in our near future." But maybe I was wrong...

The dead-cat bounce hasn't happened – at least not yet. Since then, the bottom has continued to drop out of the markets...

The S&P 500 Index fell as much as 4% on Wednesday alone. And after sliding as much as 2.2% during the day today, the benchmark stock index finished about breakeven.

Still, it wrapped up a seventh straight losing week. That's the longest streak of weekly losses since 2001.

The S&P 500 is now almost 19% below its all-time high in early January. That's dangerously close to "official" bear market territory – a decline of 20% or more. (We'll get into that "official" description today.)

The Nasdaq Composite Index was down as much as 5.3% on Wednesday. And it lost another 0.3% today. Since briefly eclipsing 16,000 last November, the tech-heavy index is down nearly 30%.

Man, it's ugly out there.

I still believe a bear market rally will occur sometime soon...

That's what happens during bear markets. (We'll get into that today as well.)

But overall, it has been a rough few months. In fact, as our friend Jason Goepfert at SentimenTrader.com told his subscribers yesterday...

This is probably the most brutal market I've encountered in 20 years of publishing, 30 years of investing, and 80 years of data history. The 1930s were more consistently and more egregiously difficult, and maybe the 1970s could rival it. But in terms of value destruction and lack of alternative investments holding value, this will rank among the worst several months for investors ever.

One of the most knowledgeable market statisticians I know is comparing the current market to the 1930s. That tells you how bad it is out there right now – even if you don't realize it.

So let me make one thing clear before we go any further...

If the bear market rally I'm still expecting happens, be very careful about buying into it.

While I'm at it, let me clear up another even more important matter today...

I've told you nobody will even know if this is a bear market until long after it has started.

That's just how it is, I've reasoned. And I've even mentioned the oft-cited threshold of the big equity indexes falling at least 20% before it's an official bear market.

Then, a couple days ago, I read this post on Twitter from veteran trader Ed Borgato...

As soon as I read Borgato's message, I felt guilty.

I've been telling you we won't know it's a bear market until the 20% threshold. And yet, I'm personally trading as if we're already in a bear market. I'm much more interested in owning and recommending defensive stocks to our Extreme Value subscribers today.

The market action has been so crystal clear. I'm talking about all the down days, one after another, punctuated by days with 3% and 4% gains.

That's classic bear market action.

We don't need the 20% threshold to tell us that we're in a bear market. The evidence has been hitting us in the face for weeks.

All the speculative garbage has been murdered. Many tech stocks are down 50% or more.

Now, the market leaders are getting beat up. And every good trader knows, "They shoot the generals last."

By that, I mean stocks like Apple (AAPL), Amazon (AMZN), Meta Platforms (FB), and Netflix (NFLX) – former market leaders – are anywhere from 24% to 73% below their most recent highs.

In other words, the market gods are shooting the generals.

This is a bear market. I've been a fool not to think it. And I've been a fool not to say it to you. So let's consider that huge mistake fixed... I'll never make it again as long as I live.

Since this is a bear market, it's important to point out that the basic trading strategy everyone has been using for 13 years is dead. It always dies eventually.

That's when you find out that...

'Buying the dips' is smart until it's deadly...

Yes, investing for the long term is smart.

You've likely seen a multidecade chart of the S&P 500. Here's one starting the day after I turned 18 years old – November 19, 1979. (My birthday was a Sunday.) Take a look...

Sure, it falls significantly a few times. But since November 18, 1979, the S&P 500 climbed nearly 50-fold from its lowest point to its all-time high on January 3, 2022.

What a ride.

However, charts like this one have a hidden problem...

The chart makes it look like you can just buy every dip and be fine. But that isn't true.

The relentless mantra of "buy the dips" works until it doesn't. And when it stops working, it can be deadly.

Specifically, I'm referring to two items – one is visible on long-term charts, and one isn't...

The visible one is the fact that capital invested in stocks near big market tops can generate negative returns for more than a decade.

Except for a brief moment in late 2007, the market didn't eclipse its dot-com peak until 13 years later. Anything invested at the dot-com top was dead money for 13 years.

And the market didn't pass its 1929 peak until 1954. That's 25 years until $1 invested at the peak was made whole again. In the meantime, its value declined to as low as $0.11.

Now, I can hear the first objections already...

"But Dan, people don't really invest that way. If you keep investing all the way through the downturns, you'll earn great returns as you average in at much lower prices."

Really? Are you saying that most folks don't go "all in" at the top?

If you really think that way, you must be from a different planet. Going "all in" at the top is exactly how most folks behave in financial markets.

Oh, look... they did it again this time. As Bloomberg reported in November...

Investors have poured almost $900 billion into equity exchange-traded and long-only funds in 2021 – exceeding the combined total from the past 19 years – according to analysts at Bank of America Corp. and EPFR Global.

Let me say it again so it's clear... People poured more money into the market in 2021 than the previous 19 years combined.

That's the reality of how way too many self-directed investors behave.

It's no coincidence that it was the top, either. Everybody going "all in" on stocks is how tops are formed. And once they're all in... there's nowhere to go but down, down, down.

All the capital invested anywhere near the top will be wiped out...

In fact, a glance at the S&P 500's long-term chart shows that the dot-com bust took the index back to 1997 levels. And the financial crisis low of 2009 took it back to 1996 levels...

A decade or two of wealth evaporated from the market's many weak hands after fraying investors' nerves for two years. It's brutal. And it's happening again right now.

But again, I can hear the objections...

"Well, Dan, those moments of epic wealth destruction are just the bottoms on the chart. All you need to do is ride them out and keep buying and you'll be rich."

Yes, that's all you need to do.

You just need to be the bravest person among billions. You'll be just fine if you can do that. If you ride out the bear and keep buying, you'll average into stocks at lower prices. And then, as things turn around, you'll make plenty of gains.

That sounds really easy, doesn't it?

Unfortunately, the second item I mentioned earlier ensures almost nobody will do that...

And perhaps even worse, this item doesn't really show up on the charts.

I'm talking about "uncle points."

I've mentioned uncle points in the Digest before. But man, if there was ever a time to keep them firmly in mind, this is it!

An uncle point is the moment at which an investor can no longer take the pain of watching his investments fall. So he sells for a big loss rather than trying to ride out the downturn.

As humans, we don't like heavy burdens weighing on our fragile psyches day after day. We prefer the security and certainty of a big loss to the uncertainty of staying invested and risking further humiliation.

Hence, everybody has an uncle point. It's the point at which they simply must stop the pain.

You can see investors crying "uncle" in the volume surges on big down days leading up to big market bottoms...

Look at this chart of the Nasdaq Composite Index during the final days of the dot-com bust in the early 2000s. Notice the tall red volume lines that tended to precede the short-term bottoms heading into the ultimate bottom of the dot-com crash in 2002...

These red lines are investors selling out in a panic, all at once over several days.

They bought the dips as long as it felt good. And they kept doing it right up to the top of the most overvalued equity bubble in history.

Then, they panicked like a herd of wildebeests fleeing hungry lions right near one of the all-time greatest buying opportunities for U.S. stocks ever.

If someone had advised them to behave that way, they would've called the adviser crazy.

And yet, that's exactly what most folks did.

Yes, you can see the price action and the volume spikes on the chart. But you don't see all the investors in emotional turmoil.

Before I move on to my biggest, newest worry for equity investors right now...

Let me address one more objection I expect to encounter sooner or later...

At some point in the near future, I expect to hear, "But Warren Buffett is buying!"

This week, the Wall Street Journal reported that the Berkshire Hathaway CEO has been "deploying tens of billions of dollars over the past couple of months." Buffett increased his holding company's stake in energy stocks like Occidental Petroleum (OXY) and Chevron (CVX). He also boosted Berkshire's already massive position in Apple.

Let me ask you this, though...

Are you a 91-year-old with more money than you could spend in 50 lifetimes? Do many folks consider you the greatest living investor? And finally, do you also run one of the most robust financial fortresses on Earth?

Even if you can answer "yes" to the first question, you can't do that for the other two. After all, if you could answer "yes" to all three, you'd be Warren Buffett... And you're not him.

I bet Buffett can take infinitely more stock market pain than most living people today. He has been sailing through bear markets without changing anything for decades. If his personal fortune goes down 80%, he'll still be a billionaire.

Buffett doesn't use trailing stops because he doesn't need the money. But I'm guessing most folks reading this Digest don't have that level of wealth.

Personally, I have money I might never need. But that doesn't mean I have 25 years to wait after making the mistake of investing too much of it near the biggest market top of all time.

My cash position is bigger than ever right now. And it will stay that way until I start to see daylight at the end of what is so far a long, dark tunnel.

One little exception to not trying to imitate Buffett...

As I noted, he just bought some energy stocks. And in my mind, energy stocks are a reasonably good defensive move right now. So in that regard, go ahead... Do your best impression of a 91-year-old with more money than you could spend in 50 lifetimes.

Now, believe it or not, long periods of negative returns, uncle points, and buying because Buffett is buying aren't my biggest worries for investors today...

My biggest worry today goes by the picturesque name of 'liquidity cascades'...

The term conjures images of beautiful waterfalls. Or maybe you're visualizing a champagne fountain at a wedding reception.

Unfortunately, a liquidity cascade is not beautiful like those things. It's ugly... really ugly.

Rather than define a liquidity cascade, let's just remind ourselves of perhaps the most famous example...

On October 19, 1987, the Dow Jones Industrial Average fell more than 22%. It was the worst day in the 126-year-old index's history. And of course, it's known as "Black Monday."

Many folks blame the big one-day drop on so-called "program trading."

That's when computers would automatically buy or sell based on recent market action. They bought in a rising market and sold in a falling one. It's commonly believed that program selling spiraled out of control on Black Monday. And in turn, it caused the big drop.

But the thing is, other markets without program trading also declined. And the U.S. stock market wasn't the first one to break lower. As Swiss professor Didier Sornette pointed out in his seminal study, "Why Stock Markets Crash: Critical Events in Complex Financial Systems"...

Contrary to common belief, the United States was not the first to decline sharply. Non-Japanese Asian markets began a severe decline on October 19, 1987, their time, and this decline was echoed on a number of European markets, then in North America, and finally in Japan.

Whatever its ultimate cause, the uncontrollable spiraling on Black Monday in October 1987 is the essence of a liquidity cascade event.

It can happen on the upside, too... We saw that happen in the case of the "meme stocks." Some of them rose hundreds and hundreds of percentage points in a matter of days.

The folks at Newfound Research published a report on liquidity cascades in September 2020...

And I recently came across it. The title of the report is, "Liquidity Cascades: The Coordinated Risk of Uncoordinated Market Participants."

The research paper focuses on three commonly cited sources of market risk – accommodative monetary policy, passive investing, and the one-two punch of insufficient liquidity and increased leverage. It dives into some nitty-gritty details of each of those sources of risk.

Overall, the investment-research firm concluded that none of the three sources can explain extreme market action on their own. However, when combined, they can cause chaos in one market that can lead to "knock-on effects" in other markets. And as Newfound concluded...

When these knock-on effects reach the S&P 500, the entire market structure can begin to break down.

The researchers pointed out how markets have become vastly larger and more complex over the past several decades. Many more derivative products exist today that didn't exist before. And of course...

With greater complexity comes greater risk.

This idea strongly suggests the potential for liquidity cascades is greater today than it was in 1987. We're much more in danger of quick, dramatic, upward or downward price movements across whole markets that happen in weeks, days, or even hours and minutes.

That's why my greatest fear today involves the combination of interest-rate hikes, passive investing flows reversing from buy mode to sell mode, and record levels of leverage.

I'm worried that these three things will combine to generate an uncontrollable downward spiral of equity, commodity, and bond prices. And desperate investors will become more and more panicked in their efforts to raise cash and escape the risk of further losses.

What would this look like? Much worse than what has already happened this year.

It could include a day like October 19, 1987. Or maybe it would be a whole month like March 2020... though perhaps without the instant, snap-back market recovery.

I hope you can see why I'm mentioning uncle points and liquidity cascades in the same Digest...

A liquidity cascade can happen very quickly. It doesn't necessarily happen in a single day (or shorter), but it can.

My biggest fear is that it could happen so quickly that investors won't know how to react. Instead, they'll freeze like deer in headlights on a country road at 2 a.m.

They'll be so shocked that they won't know what to do. And they could lose everything.

I'm sure a lot of technical mumbo jumbo could explain why I shouldn't be so worried. After all, as humans, we love to find exceptions to every rule in order to sleep better at night.

And I'm not trying to scare you into selling everything you own today. I've never advocated that. The risk of missing out on years of compounding in great businesses is too great.

My purpose is the same as it has been for a long time. I want you to adopt my mantra, which I repeat relentlessly because human nature is to ignore such advice...

Prepare, don't predict.

Bear markets and extreme events like liquidity cascades are notoriously difficult to predict.

But as long as you hold plenty of cash (which you can raise by selling speculative garbage), some gold and silver, and high-quality defensive stocks... you'll do better than most folks.

And if a liquidity cascade occurs, with stock prices falling fast, using trailing stop losses to exit declining positions might mean booking losses... But it will also preserve the lion's share of your precious capital so you can live to trade another day.

In the end, I'm just trying to help you minimize the financial impact and emotional pain that can happen in bear markets. Because let's face it...

Whether the dead cat bounces or not, the bear market is upon us.

Doc's 'Playoff Beard' Is Growing

In the April 14 Digest, we told you about our colleague Dr. David "Doc" Eifrig's streak of 100-plus winning trades in Retirement Trader. It's nearing a new franchise record.

Related to that, Doc isn't cutting his "playoff beard" until the streak ends.

Five weeks later, we're pleased to report Doc's beard is still growing. Check it out...

While Doc hasn't closed any additional winning trades over the past month, the streak still stands at 116 in a row. That means he hasn't taken any new losses, either. And that's saying something with the S&P 500 down about 19% and the Nasdaq down around 30% from their highs.

Specifically, it says selling options on stocks you would want to own anyway – which Doc recommends in Retirement Trader – can give you more downside protection than regular buy-and-hold strategies. And you can collect "instant" cash with this strategy as well.

We expect Doc to close more winners soon. His most recent open recommendation is up nearly 7%. It's on track to close for a roughly 25% annualized gain next month.

With the markets down, fear has been high – and that's the essence of Doc's strategy. It's also why any investor should consider using it today...

If you're interested in learning more details, click here to watch or listen to this presentation from Doc. In it, he shares exactly how this "instant income" strategy works.

New 52-week highs (as of 5/19/22): Shell (SHEL).

In today's mailbag, one subscriber wrote in with a "real dose of inflation" from just one day of shopping. Do you have a comment, question, or story to tell? As always, e-mail us at feedback@stansberryresearch.com.

"Got a real dose of inflation while shopping today. Gatorade, up 29%. Gas up 8% in the last couple weeks. However, feed I buy at Tractor Supply is not stocked and available online only. I ordered the bag of feed at the store, for delivery to the store. The bag of feed was $29.99 and the shipping surcharge, for store delivery, was $30. I didn't realize you could get limo service for feed delivery. Why not use the truck that comes there every week anyway?...

"I will take my big truck, get 14 miles per gallon and drive a 60-mile round trip for that bag of feed when they tell me to come pick it up. Oh, and better stop for gas... Thanks for listening." – Paid-up subscriber Doug K.

Good investing,

Dan Ferris
Eagle Point, Oregon
May 20, 2022