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Richard Russell on the Markets

November 2, 2002

Most investors, and this includes most analysts, just don't know how bear markets work. Either that or they don't want to know. After all, when your assets are on the line, and probably more frightening, when your job is on the line -- there's one thing you want to hang on to? That one thing is HOPE.

I wrote a whole piece on HOPE and it's posted on the home page of this site. The essence of the piece is that hope is a killer when it comes to the stock market. What I suggest is that you substitute REALITY for hope. Anytime you find yourself "hoping" in this business, if you analyze your situation carefully, you'll probably find that behind your hope is a loss situation. You've done something wrong, and you're hoping the market will bail you out.

My suggestion, instead of hoping that the market will save you -- MOVE. Correct what you've done wrong.

A lot of people are hoping that the worst is over, and that this bear market is history. Unfortunately, it's not going to be that easy. The problem, at least the number one problem, is that stocks are still expensive. As I noted in a recent site, the new S&P "core earnings" for the S&P are $18.48. On that basis the S&P is selling for a ridiculous 48 times earnings. You want to be more conservative? Then take the S&P P/E as listed in Barron's at 33 times earnings. That's also ridiculous. The simple fact is that stocks remain hugely overvalued.

Bear markets don't end with stocks being overvalued. Bear markets end with stocks being undervalued. I've written many times that the only cycle that I believe in is not a timing cycle. It's a value cycle. It's the cycle from overvaluation (at or near a bull market's high) to undervaluation (at or near a bear market's low).

Everything else in this business is a matter of dealing with the action between these two extremes.

The simples and most fundamental concepts are the most difficult to understand. And the simplest and most fundamental concept in the stock market is the great swings from overvaluation to undervaluation and back to overvaluation again.

Why is the valuation cycle so difficult to understand, or I should say to accept? It's difficult because it goes against human nature -- it's counter-intuitive Dow wrote about it 100 years ago, and I'll repeat what Dow wrote for the benefit of new subscribers --

There is always a disposition in people's minds to think that existing conditions will be permanent. When the market is down and dull, it is hard to make people to believe that this is a prelude to a period of activity and advance. When prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one which make it unlike its predecessors and give assurance of permanency. The one fact pertaining to all conditions is that they will change.

There's a concept that was written a century ago and one that is just as true now as it was the day when Dow wrote it. And it's also just as disbelieved.

A bear market is a tragedy. It's a tragedy because it's relentless and inevitable. A bear market is a product and a result of man's fear and stupidity. A bear market is the antidote to a bull market. A bull market at its zenith is a product of man's greed and stupidity. Bull markets and bear markets both occur because people have short memories and because people, at least most people, never learn.

"OK, Russell, what are you leading up to?"

Simply this -- Investing and the stock market are a business. Hundreds of thousands of people are involved in the investment industry. And that means that there's a huge bias and comfort in remaining always bullish. Investors hate a bear market because a bear market means losses. Today we read that between the first quarter and second quarter of 2002 mutual funds worldwide lost 8.1% of their value. That's hardly going to make the millions of people who hold mutual funds happy.

We see the pain in the decline of margin debt on the NYSE. In March 2000 NYSE margin debt was $278 billion. The latest report for September 2002 shows that margin debt has collapsed to a new low of $130.2 billion. That's a decline of 53%.

Why the decline in margins? The decline is a record of traders being knocked out of the box. When traders quit, when they are losing, they exit the game. And as they exit the margin accounts on the NYSE decline.

Before this bear market is over, I expect NYSE margin accounts to be down around $30 billion or lower. I expect that they will be about 10% of what they were at the high.

In the meantime, the investment industry struggles on. Wall Street carries on. The idea is to survive, to get through this bear market intact, with a job, with some assets.

Every bear market is different. Each bear market has its own way of generating losses. Because the greatest and most speculative bull market in history ended on September 23, 1999, I expect this bear market to generate the greatest losses in US history.

I'm trying not to be pessimistic. I'm trying to be realistic. That's the way I see it. How do we survive this bear market? What do we do to come out as "whole" as possible. I wish to God I knew. I don't know because I don't know what lies ahead.

My guess is that almost every class and type of asset will be hurt. I've taken refuge in bonds and gold. Bonds because I think the Fed is going to drive rates down in Japan-like fashion. So far I've been right. But with the money that the bonds are throwing off I put into T-bills and gold.

Why gold? Because if this nation lapses into deflation, debt is going to be crushed, wiped out. People will be looking for something that is immune to bankruptcy. That something is gold, the only financial assets that can't be bankrupted because gold is pure money, cash. Gold has a 5000 year history of being accepted as real money. Nothing else qualifies. Nothing takes the place of gold.

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