Fasten your seatbelts

Source TheAge

Over time, the volatility of the stock market exceeds the capacity of traders to absorb losses. In other words, very few people actually make money trading the stock market through entire cycles.

In the wake of the biggest one-day rout since the 1987 crash, this reality will brutalise any punter intrepid or foolish enough to have waded back in for a spot of bargain hunting during the few days.

Over the long-term, shares perform better than the other asset classes, bonds and property, but short and medium-term trading is a big boys' game. And so it is that the bear market now appears to be entering its "capitulation" phase where people simply chuck their hands in the air and walk away. Institutional volumes drop away too.

To those who have lambasted this reporter for being excessively bearish this year - and apparently talking the market down (which entirely exaggerates our significance in the universe) - it may be useful to know that we cut our teeth in this journalism caper in the bear market of 1990. It was not until every last punter was a bear and believed the market would not recover for years ... that it finally did.

This left a stark impression of the herd mentality, and of the notion of capitulation. In the aftermath of an abortive expansion into the US market Westpac had been decimated by the deepest losses in Australian corporate history, the stock was on its knees in the $2 range amid speculation the bank would go under, market sentiment was unbearably morose, and somebody began building a stake in Westpac.

The mystery buyer was finally outed as Kerry Packer. He picked up a 10% holding and launched a tilt for a couple of seats on the board with henchman Al Dunlap. They failed. Packer sold out way too early - but still made $100 million.

It should be kept in mind that the share market began recovering when Australia fell into the recession of the early 1990s. Since that time the market has been broadly in upswing. The dotcom bubble was just that, a bubble, and the subsequent bull-market by far the biggest in history.

This time around, sadly, the level of consumer debt is far greater.

Meanwhile, the bad news came thumping in last night on both sides of the pond. We won't reiterate here. Fed chairman Ben Bernanke was sufficiently concerned that he foreshadowed the need for greater market supervision by government in managing asset price bubbles.

Bernanke is a champion at shutting the gate after the horse has bolted, though a good deal of the blame for this mess can be directed at the abject failure of his predecessor Alan Greenspan to supervise interest rates for the long-term.

And in a prelude to further state intervention Bernanke noted that the US faced a "very serious too-big-to-fail problem". "There are too many firms that are in some sense systemically critical".

The big fear is bonds. Will the US bond market crack? Throughout this crisis there has been a pattern. When the Dow has been strong, bonds have weakened. When the Dow has been weak, bonds prices have ticked up in the "flight to quality".

The US bond market is the biggest market in the world and the 30-year treasury bond has hovered near its all-time highs - or all time low yields, as bond yields are inverse to price.

Bonds have been in a bull-market since the early 1980s when the yield peaked at 15%.

If the US bond is destined for the mother of all sell-offs - to use a tired old term - the world is in for the mother of all "dislocations" - to use a euphemism.

In the last seven trading days the 30-year bond has been sold down from 122.50 to 114.50, off a low of 113.80.

The Fed can control short-term rates but the fate of the big bond may be out of its hands, especially since China owns more than $1 trillion of them and the Arabs probably more.

If the rate spikes up so do the costs of long-term borrowing for the US Government. This, at a time when the deficit is spiralling towards $US1 trillion this year (some commentators are tipping $US2 trillion) and government debt - and this is before the ocean of household debt - is 70% of GDP and rising.

As GDP is contracting and fiscal policy expanding, the outlook is not pretty. Who will buy the bonds? The oil producers will. China and the rest of the world may not. The US Government will pull out all stops to protect the primacy of its bellwether asset, the long bond, and defend its dollar at all costs.