Analysts are struggling to handicap the outcome of inflation, earnings, and the odds of a recession, keeping Wall Street off balance as it tries to make sense of the rapidly changing financial landscape. As the bear market has worn on, bullish psychology has deteriorated and is increasingly being cited, including by us, as a contrarian positive for the future. The question is: are investors bearish enough to justify looking for a bottom? The low-water mark for investor sentiment is often marked by the bankruptcy, or “fall from grace,” of a previously unassailable market idol. Driven by a hubristic belief that their strategies would never suffer the dark side of risk, their falls were swift and merciless, leading to bankruptcy or jail terms. These spectacular failures have often marked the low point of major bear markets.
Market analyst Tom McClellan has called these moments the “burning Loach” (https://www.mcoscillator.com/).
McClellan was an Army reconnaissance helicopter pilot, and relates this story passed down by seasoned veterans. During the Viet Nam war “Loach” stood for light observation helicopter (L.O.H.) which were used to scout out targets so that heavy planes could deliver bombs as close as possible to enemy positions.
A “Loach” pilot had little more than his eyes and wits as weapons, and many of them got shot down. But they were often shot down right over the target, and so the smoke from the crashed helicopter came to mark the spot where the 500 mph planes would want to be. “The target is marked by the burning Loach” came to be a part of the pilot’s lexicon as a result.
The corollaries in the financial markets are all too easy to find, and it is their timing that provides food for thought today. In 1994, Orange County, CA filed for bankruptcy because its treasurer had overextended his wrong-way bets on the bond market. That bankruptcy marked the bottom of the bear market in bonds—it was the burning Loach.
In 1998, hedge fund Long Term Capital Management famously made huge bets on Treasury bonds that went against them, bankrupted the firm, and required a Federal Reserve bailout of their big bank lenders. It was the burning Loach for that move, marking the low just prior to the internet boom.
Even the “Lehman Moment” has become part of our parlance, referring to the 2008 low marked by Lehman Brothers’ collapse and the start of the Fed’s heretofore radical policy of quantitative easing (money creation).
Can we now add to this list of burning Loaches that of cryptocurrency king Sam Bankman-Fried and the epic collapse of his crypto empire? Like the Loaches before him, Bankman-Fried (or SBF to his friends) flew too close to the sun. Having ridden the crypto boom to its highest peaks, he was even dubbed the “J.P. Morgan” of the crypto industry when he bailed out other peers who were beginning to crack under the weight of rising interest rates and a profound bear market in cryptocurrencies themselves.
Like Icarus’ wings of wax, SBF’s empire melted away in a flash, sending him crashing to earth. Leverage, duplicate ownership of assets, and perhaps some fraud have been his undoing. Bankman-Fried’s net worth peaked at $26 billion and was estimated to be $10.5 billion in October 2022. However, on November 8, 2022, amid his firm’s solvency crisis, his net worth was estimated to have dropped 94% in a day, easily the largest one-day drop in the history of the Bloomberg Billionaires Index. The full impact of this collapse on financial markets is not yet clear.
SBF embodied the promise and righteous optimism of cryptocurrency adherents, and it would be hard to find a more messianic figure for this moment in financial history. His fall fits in with examples of burning Loaches of the past. So should investors view this as the beginning of the end for the bear market?
To answer this question, we encourage investors to look at what the financial markets are doing, rather than what someone forecasts they should be doing. And the message from our indicators has fodder for both bears and bulls.
The most significant positive to favor the bulls is the recent buy signal from the daily NYSE advance/decline (a/d) line. This buy signal occurred in early November as the Dow index rallied 1200 points in a single day on a report of moderating inflation. This was a very emotional event, so it remains to be seen what sort of staying power this buy signal has. The a/d line also gave a buy signal in July, but this soon reversed itself and moved lower.
Interestingly, the a/d line’s chart is clearly defining the point-and-figure “major trend,” the 45-degree downward sloping line. A principle of chart analysis is that the more times a chart is turned back by the trend line, the stronger the trend line is. Unfortunately for today’s investors, that direction is down. So it is crucial to the bull’s case that the a/d line breaks this cycle of lower lows and lower highs. We’re not there yet.
Fortunately, the trend becomes clear using the p&f approach, and gives us a context to judge whether SBF’s burning Loach marks a bottom. That is, if the a/d can keep rising and get through the downtrend line, it would indicate a long-term bullish approach is justified. Another downturn below the trend line, though, means investors should prepare for more downside risk.
The recent rally evident in the a/d line has pushed stocks up to “overbought” levels, which implies some sort of pullback to relieve buying enthusiasm is likely in the coming weeks. During the bullish QE era, pullbacks from overbought levels were an opportunity to “buy the dip,” a strategy that has been fraught with risk during 2022’s bear market, as garden variety corrections have become more dramatic declines. We welcome this change, however, as it helps to deflate the bullish complacency of recent years and lays the groundwork for the creation of genuine values in the stock market.
The well-recognized elephant in the room is, of course, inflation and its corollary, interest rates. It is safe to say that Wall Street has become obsessed with the direction of Federal Reserve policy and seems to be overreacting with euphoria, or despair, to each new data release on inflation.
There is no question that we are in a new interest rate era, one where inflation is calling the tune for central bankers. Wall Street, having gotten accustomed to artificial, ultra-low interest rates, is now panicking over their rise. But this “new era” is simply a return to the way financial markets operated prior to 2009, when interest rates had some realistic relationship to inflation.
Given the sea change in the bond market environment, perhaps we should look for a burning Loach among sectors most sensitive to rising interest rates. That candidate may turn out to be the $125 billion Blackstone Real Estate Income Trust (BREIT), which shocked Wall Street this month by unexpectedly limiting withdrawals following a surge in redemption requests. Investors suddenly are clamoring to get their hands on cash amid concerns over the health of the commercial property market. This is reminiscent of the mortgage-backed Bear Stearns hedge funds that ran into trouble in July 2007, also limited withdrawals, and presaged the bigger problems which resulted in the original Lehman Moment in 2008.
It would be easy to dismiss BREIT as an isolated incident but for the fact that, as of this writing, another large REIT has also put the gates up. Starwood Real Estate Income Trust announced it would be limiting redemptions after cash requests spiked last month. Taken together, are these two developments painting a picture of rising stress in the real estate market, and a “run on the bank” by investors eager to get their cash out before it’s too late? It is too early to tell how serious a message these developments represent, but bear watching for further trouble.
To that end, we encourage investors to keep their eyes on the bond market for clues to the future. A simple indicator is the chart of TLT, a long-term Treasury bond ETF. This is a price chart of bonds, and remember, bond prices fall as interest rates rise, and vice versa. Currently, this chart is on a p&f buy signal (i.e. bond prices rising). Like the NYSE a/d line, it has given a buy signal within the context of a clearly defined down trend. The message is that there are some near-term positives coming from the bond market, but the bearish “major trend” has not reversed yet.
We may have seen the burning Loach for this bear market cycle. At the very least, the list of candidates is growing longer by the month. If a dramatic financial failure transpires in the months ahead, investors should consider that it may mark the end of the bear market rather than its continuation.