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Bears Locate a Template for a Crash

Doug Kass

"History repeats itself, first as tragedy, second as farce."

-- Karl Marx

In order to understand the possible future course of equity prices, it is helpful to call upon history.

Today's opening missive asks two questions: Are the conditions underlying the strong market advance over the last year similar to any other time in history? If there is a historical precedent to today's market conditions and prices, what could this portend for 2007?

Based on the recent (2006-07) trends in domestic equities, emerging market equities, interest rates and volatility indices, there appears to be a clear parallel to a past period. Specifically, these four factors leading to the present seem best compared to January 1994.

Although equities are hitting record levels (the S&P Index has climbed in 12 of the last 13 months) and everything is coming up booyahs as disbelief has been virtually suspended, should the market relationships hold to the pattern of the first quarter of 1994 in the first quarter of this year, the investment implications should be worrisome.

Strong parallels exist between today and the markets 13 years ago in 1994.

• U.S equities were making highs in January 1994.
• Emerging markets were rising parabolically into 1994. The Hang Seng index rose from 3,000 in 1990 to 12,500 in early 1994 while Mexico's IPC climbed from 700 to 2,900 in the same interval.
• In December 1993, complacency was copious. The VXO had declined from about 35 in 1990 to under 10 by year-end 1993.
• Bonds experienced a sharp rise in value as yields declined in 1990-1993. The 10-year U.S. note rose from about 84 and peaked at 106 in the third quarter of 1993. By January 1994, bonds were already beginning to falter.

A two-month drop of nearly 10% in the S&P 500 Index began at the end of January 1994. The emerging markets collapsed -- Hong Kong's market fell by a third and Mexico by an even greater amount. The bond market got schmeissed -- by year-end, the 10-year U.S. note had fallen 20 points, correcting the entire gain of the previous three years. Finally, the VIX fell back to 1990 levels, climbing from 9 to 24 in only two months.

To understand what could happen in 2007, it is also helpful to understand what conspired fundamentally back in February 1994 to take the world equity and U.S. bond markets down, and the volatility indices up. On Feb. 4, 1994, the market was spooked by a surprise hike in interest rates by the Federal Reserve. The mortgage markets went into a tailspin as bonds collapsed in price and rose in yield.

The already leveraged financial landscape was almost immediately littered with financial accidents: Orange County (California) went bankrupt and a venerable Wall Street firm (Kidder Peabody) collapsed, for example.

I can posit a number of similar developments in February 2007 that could result in history repeating itself, such as a surprise Federal Reserve rate increase, sovereign debt defaults (yesterday I mentioned Fitch's downgrade of Ecuador's debt), more aggressive moves by China to slow its economy, a financial accident in sub-prime lending or in the derivative markets, etc.

(Speaking of potential market-busting catalysts, it is interesting to note that the Chinese stock market dropped by 4% yesterday -- the largest one-day drop in seven months. Moreover, a Chinese official issued the government's first explicit warning about an overheated stock market by warning banks "to prevent personal loans from going into stocks.")

Facing the Future With the Past

Henry Ford wrote that "history is bunk" and Percy Bysshe Shelley (who was married to Mary Shelley, the author of Frankenstein) wrote "fear not the future, weep not for the past," and they both could be right. Nevertheless, I have always invested on the basis, as Karl Marx writes, "that history repeats itself" or as Pearl Buck wrote, "one faces the future with one's past."

To be sure, although there's a strong parallel between early 2007 and early 1994, it is less clear when a correction might take place in 2007. For now the burden of proof lies squarely on the ursine crowd because those who invest/trade at the "Altar of Momentum" are firmly in control.

However, the near panic to the upside in some of the more speculative fringes of the U.S. equity market suggest to this observer that the end of the market rise might be at hand -- sooner rather than later. Some of those stocks include:

Gambling stocks (Las Vegas Sands(LVS), Wynn Resorts (WYNN));

Brokerage stocks (Goldman Sachs (GS), Merrill Lynch (MER), Lehman Bros. (LEH));

Publicly traded exchanges (NYSE Group (NYX), InterContinental Exchange (ICE), Chicago Mercantile Exchange (CME));

And steels (Allegheny Technologies (ATI), U.S. Steel (X)).