The Bubble of Bearishness, Part 2: Banks

Because credit standards were extremely lax from 2005 to 2008 and we are in the midst of one of the worst recessions in recent history, there will be some significant credit defaults. At this point, however, the majority of defaults are with respect to assets that one expects a bank to own, but no one has taken the time to evaluate the actual types of assets instead the term "toxic" is broadly applied.

Imagine that someone was reviewing your household balance sheet. Whether it is your brokerage account or your 401(k), he or she would see that you were down 38% in 2008 but would not know your actual investments.

The natural reaction would be that you own something very "toxic," when in fact, you simply owned the S&P 500, which most investors are expected and even encouraged to own. Your problem is that you own it in a very bad environment. So, we wound up with an environment in which financial institutions were significantly penalized by the market for owning exactly what they are expected to own. They simply owned these investments in a deteriorating environment.

Fear, the "headline tape" and misguided calls for nationalization fueled the negativity on top of legitimately bad fundamentals, which created the perfect storm for the bubble of bearishness. The price action only fueled the hysteria. The more stocks went down, the greater the conviction for nationalization.

As a result, buyers almost entirely retrenched throughout the market and stepped away. Bears were shorting into a one-sided tape with only sellers and no buyers. If the banks were going to survive, then valuations for a long-term investor were actually compelling. The key word was "if."