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Wall Street Won't Tell You It's A Bear Market
by Stephen T. Mcclellan, CFA

We are in a bear market, but Wall Street will never admit it.  It is so emphatic in a bull market, but loath to address bad times.  I know the market is only off 10-15% from its October 2007 peak, but just wait.  I spent 32 years as a securities analyst on Wall Street, and unlike the current youthful generation of analysts, I experienced several major downward cycles.  The current economic and financial backdrop is probably the worst since the 1930s depression.  But it doesn’t seem like that if you listen to stock brokerage commentary, TV media or the government.

It is hard to keep track of all the bubbles, especially those that have not yet quite burst, such as oil and commodities, commercial real estate, consumer credit and stocks.  Busted bubbles are more obvious, but the degree and duration of the damage is still unknown — residential real estate, sub-prime mortgages and CDOs, debt derivatives, banking and brokerage system, U.S. dollar, federal budget deficits and spending, bond insurers, employment, GDP growth, etc.  The official inflation CPI reading in March was +4%, but the reality with all in, adjusting for the convoluted government numbers, is in the range of 7-11%.  And it will get worse.  Future inflation will be exacerbated by the ongoing massive federal bank, brokerage and other quasi-agency (Fannie Mae, etc.) bail-outs.

The economy runs in cycles; full recessions every few years.  The last real downturn was in the early 1990s; the one in 2002 was incomplete.  Recessions and stock market plunges have a cleansing effect, setting the stage for renewal and the next expansion phase.  The Fed cannot keep the system propped up forever.  It is running out of silver bullets.  Lower interest rates are not stimulating the economy. There is a pyramid built on huge debt leverage.

Derivatives are like the iceberg ahead of the Titanic: No one knows the dimensions beneath the surface.  We do know that credit default swaps amounted to $62 trillion (with a T!) and interest rate derivatives to $382 trillion (again with a T!) at the end of 2007.  Staggering!  When Warren Buffet acquired the General Re insurance company, he wound down that entity’s derivatives over a five-year span, losing $400 million in the process.  That was when the markets were normal, before the credit freeze.  The elimination of trillions in derivatives, some extending 30 years in multi-currencies and exchanges, may take a generation to complete.

The scary aspect of all this is that there is just so much we don’t know.  There are more things that can go wrong, and every month there seem to emerge unforeseen financial problems.  Most of this stems from too much debt and leverage.  Brokerage firms in the 1970s were not allowed to have debt of more than 12 times equity capital.  These days a ratio of more than 30 is the norm.  Mortgage, consumer, hedge fund and almost every other type of debt have multiplied several-fold over the last decade or two.

It took a decade in the 1930s to adjust for the excesses of the 1920s and for the economic downturn to play out.  During the Depression, the government initially hiked taxes and pushed trade protectionism, aggravating the economic problems.  We are hearing those themes again during the current political campaigns.  In the early 1970s it took three years and an overall 50% stock market decline to adjust for the prior extremes.  I was on Wall Street during that period and lived through it.  This time it is worse, given the excesses in the late 1990s and more recently during 2004-’07.  So it could take more than three years to even out.

Even during normal periods the stock market incurs regular slumps.  From 1926-2007 the S&P 500 index dropped three out of every ten years.  During bear markets there are numerous false rallies of more than 5%, a dozen or so for example during the 2000-2002 bear market.

Despite this sobering scenario, you won’t hear your brokerage firm or major TV stock market shows dwelling on any of these issues.  They are cheerleaders and promoters.  Wall Street is always in denial, eternally optimistic with a systemic positive bias.  An automobile dealer sells cars.  Brokerage firms sell securities.  Both generate revenue from transactions.  The favorable bias is an inherent aspect of the businesses.

In my book, Full Of Bull, I spend several chapters decoding the array of misleading and detrimental Street directives that are so counter to sound investment strategy:  Never take Wall Street literally.  Professional insiders know better.  The propaganda is evident in the nomenclature.  A falling market is a correction.  But a rising market is not termed a mistake.  Declining GDP or employment is called negative growth.  A recession is a contraction.

Stock investment ratings are similarly favorably skewed.  Even in today’s bad market there are less than 10% Sell ratings, more than 90% Buys or Neutrals.  Sometimes Outperform indicates a stock is expected to fall, just not quite as much as the other names in the sector.  An opinion shift from Buy to Neutral is a strong negative signal to unload the stock, in Street code.  Brokers rarely have the courage to use the gloomy “S” (Sell) word.  Earnings estimates are no different, almost always too optimistic.  In most cases, Street analysts take as their profit forecast the projection published by promotional, ebullient corporate executives.

Stock price targets, as published in research reports, are yet another overly positive bias.  How many times do you see downside, worst-case stock price possibilities highlighted in a report?  Never.  The Street is all about how much money you can make, the upside, not how much you might lose.

Wall Street is never focused on risk.  It is always about stock-price appreciation prospects, not about protecting capital, conservativeness — how much you might keep.  Even amidst a precipitous stock-price decline, such as in financials and home builders over the last 12 months, the Street focuses on “catching a falling safe,” that is, guessing the bottom for a purchase recommendation rather than avoidance.  Brokerage emphasis lists are all Buys, never Sell ideas.

No matter how negative the current market conditions or how uncertain the outlook, you cannot rely on Wall Street for objective advice on risk.   In view of the tens of billions of dollars in losses incurred by the Street with bad sub-prime loans and other debt instruments, it is hardly in a credible position to address risk.  Wall Street didn't manage its own risk; don't expect it to focus on yours.

©2008 Stephen T. McClellan, CFA

Stephen T. McClellan CFA
, is a former Wall Street investment analyst with 32 years of experience covering high-tech stocks. He spent 18 years as First VP at Merrill Lynch and eight years as VP at Salomon Brothers. McClellan has ranked on the Institutional Investor All-American Research Team for 19 straight years and on the Wall Street Journal Poll for seven years. He is in the Journal's Analysts Hall of Fame.

McClellan is former President of the Computer Industry Analyst Group and the Software/Services Analyst Group. He has been a guest on CBS, CNN, CNBC, and Wall $treet Week and has presented to many leading technology companies including IBM, Apple, ADP, and EDS. He is the author of the national best-seller The Coming Computer Industry Shakeout: Winners, Losers, and Survivors, and his work has also been published in The New York Times, Financial Times, Forbes, and other leading publications.

He holds an MBA in Finance from George Washington University and resides in San Francisco with his wife, Elizabeth Barlow, an artist.


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