I'm not going to pretend to know how to pick a bottom for stocks, but if we dissect the anatomy of a bear market we might understand why stocks markets eventually recover.

Photo:Walter_Rodriguez, Creative Commons, Flickr

Anatole Kaletsky, a columnist at The Times, recently wrote a brilliant piece on bear markets:

When we look back through history – or think about the underlying economics of business cycles – we realize that every financial crisis and bear market in the past has been a buying opportunity because we can see, with hindsight, that the world never did come to an end.

Kaletsky makes an important observation:

If everyone in the market knew that previous financial crises and bear markets always created buying opportunities, then a new bear market could never occur.

Overly simplistic? Logically correct?

But why do we still go through bear markets when everyone knows that past bear markets offered buying opportunities? Another important observation: We can only go into a bear market if potential buyers believe that the latest financial crisis was somehow different – and worse – than any that had gone before. Kaletsky adds:

If people believed that this was just an average sort of crisis, they would now be buying instead of selling, and there would be no crisis.

In other words, a bear market is only possible if there is a consensus that a financial crisis is significantly worse than ever before. And that is why we are currently in a bear market. A few examples of this psychology:

– George Soros said that this is "the worst market crisis in 60 years." George Soros also reacted to Black Monday in 1987 with a single chilling sentence: “This is 1929.”
– David Rosenberg at Merrill Lynch said, "we confess that we have been in the business for 25 years and have never – and repeat never – seen a cycle like this one."
– Alan Greenspan described LTCM in 1998 as the worst crisis in his 60-year working lifetime.
– Nouriel Roubini of New York University's Stern School of Business said that this is "the worst housing recession in U.S. history."
– Legg Mason's CEO, Chip Mason, said that credit markets are in the "worst state he has seen in his 47 yrs in the business."

This psychological trap will probably always be with us. The most experienced investors and bankers have careers that last about 30 years, a blink in economic history. "It is hardly surprising, therefore, that people are constantly amazed by each new cycle that comes along – and find it difficult to see it in historic proportion," says Kaletsky.

The near-term question: If bond insurers are bailed out, will credit markets recover? If credit markets recover, will investors then come to the realization that this is just an average crisis? If that is the case, a bottom for stocks might be around the corner.

The long-term question: If each successive crisis really is worse than the one before, a necessary condition for bear markets to occur, are we involved in a cumulative process that may one day approach an apocalyptic climax? That idea seems a bit far-fetched…

Photo:World Economic Forum, Creative Commons, Flickr