The economy
It is dangerous to try to forecast the stock market based on a forecast for the economy, for two reasons. Firstly, major turns in the stock market almost always occur well in advance of major turns in the rate of economic growth. In fact, it is normal for both economic growth and earnings growth to remain weak during the first 6-12 months of a new bull market. Secondly, the stock market influences the economy. For example, if the stock market embarked on a new bull market now it would enhance the prospects for the economy next year.
My medium-term bearish view on the stock market is therefore not based on a view that the economic growth rate is about to tank. However, my views on the economy do add weight to my bearish stock market view. Also, I think the stock market bulls are falling into a huge trap by assuming that the economy and company earnings are going to grow fast enough over the next year to validate current stock prices. Such an assumption makes no sense.
In October of 2001 I was quite bullish about the prospects for the US economy as far as the coming year was concerned. At that time the consensus expectation regarding economic growth had been 'ramped down' due to the devastating events of September-11, but I was optimistic because some of the most reliable leading indicators of economic growth were signaling a recovery. However, I pointed out that a rebound to, say, 3 percent economic growth, would not prevent the stock market from tumbling during 2002 because valuations were simply way too high and had to come down.
Today, the same reliable leading indicators are, unfortunately, not painting a rosy picture of economic growth over the coming 12 months. In fact, based on current trends in leading indicators such as money supply growth and the Weekly Leading Index calculated by the Economic Cycle Research Institute, there is a distinct possibility that the US economy will be back in recession by the second quarter of next year (as is always the case, though, the recession won't be officially identified as such until several months later). So, rather than assuming that the economy will be stronger next year than it was this year, it actually makes more sense to assume the opposite and plan accordingly.
Valuation
Stock market bulls are relying on a strong rebound in the economy and company earnings next year to validate their view that current valuations are reasonable. However, as far as I know there has never been a case where the stock market has made the transition from bear to bull as a result of a sharp recovery in earnings. Before a major bear market can end, valuations must first become low based on current business conditions.
The problem, at the moment, is that valuations are still closer to what I would expect to see at the top of a major bull market than at the bottom of a major bear market, despite the huge declines in stock prices over the past 2.5 years. For example, the average dividend yield of the stocks in the S&P500 Index is presently around 2 percent versus a historical norm of around 4 percent. Based on current valuations there is not only no chance that a new long-term bull market could begin at this time, there is also no prospect of even a 1-2 year cyclical bull market.
Sentiment
Despite the drubbings suffered by the major stock indices since the bear market began in 2000, most people remain optimistic with respect to the return on investment they expect the stock market to provide over the next several years. However, bear markets only ever end after the vast majority of investors have thrown in the towel.
Towards the end of a bear market there is invariably either widespread panic or a total lack of interest. Widespread panic results in a selling climax, that is, a short period where a "get me out at any price" attitude dominates the market. A selling climax can shorten a bear market by shaking out all the likely sellers in a small amount of time and, from a longer-term perspective, can therefore be considered bullish (unless, of course, you happen to be fully invested when the selling climax occurs). The alternative is that prices just continue to move steadily lower, with the occasional rally acting to rejuvenate hope, until a point is eventually reached where almost everyone has lost interest in the market.
There has not been a genuine selling climax and most people remain intensely interested in the stock market, so sentiment is not indicative of a market that has already reached, or is close to, a major bottom.
Over the past few months the OEX Volatility Index (VIX) has drawn a lot of attention because it has moved to levels that have typically been associated with important bottoms. However, many other sentiment indicators did not confirm the VIX's superficially-bullish message. As such, while we were comfortable trading the April-May 2001 and September-December 2001 bear-market rallies from the 'long side', we considered the July-2002 and October-2002 lows to be opportunities to take profits on short positions rather than as opportunities to initiate long positions.
The rally that began on 10th October has had a lot more to do with the actions of performance-chasing fund managers and a mistaken belief that the famous "4-year cycle" has bottomed, than on sentiment having reached the bearish extremes normally seen near major bottoms.
Current Market Situation
Almost all the gains in the S&P500 Index since its intra-day bottom on 10th October occurred during the first 4 days of the rally. In fact, last Friday's closing level for the S&P500 was only 1.6% above its 15th October closing level. So, the aggressive buying by performance-chasing fund managers over the past 4 weeks combined with all the recent 'good news' has done virtually nothing for the overall market, although there have certainly been pockets of extreme strength.
The upshot of the above is that this is definitely not a market where it pays to wait for confirmation of strength or weakness before entering a trade. Certainly, anyone who waited for the July lows to be breached last month before 'shorting' the market would have lost money and anyone who waited for confirmation of the October rally before 'going long' would barely be breaking even at this time.
Taking this a step further, it will be an obvious confirmation of strength if the S&P500 closes above its recent high. This is especially so since the run-up to around 925 on 4th November was a test of the 11th September peak, making the Greenspan-inspired jump to around 925 on 6th November a 'test of a test'. If the market now moves decisively above the mid-920s it would create a lot of excitement and almost certainly lead to some further short-term gains. However, we suspect that such an upside breakout would result in a surge that would end within 2 weeks, and perhaps even within 2 days, of the breakout occurring, after which the bear trend would resume.
Similarly, entering the market on the short side following an obvious future confirmation of weakness would also be unlikely to pay large dividends for anyone other than the most nimble of traders. For example, it is quite possible that the October-November rally has ended and the next 'bear leg' has already begun. However, by the time the market definitively confirms this view it will probably be too late to 'short'. This is because it is often impossible to differentiate between a normal pullback within a continuing uptrend and the early stages of a new downtrend. The difference between the two might only become apparent with the benefit of hindsight (e.g., after the market drops to a new low for the year).
Further to the above, your view of what the market is going to do must be based on more than just the confirmations of strength and weakness that are obvious to anyone looking at a chart (which, these days, is pretty much everyone).
What to do?
There will continue to be opportunities for traders to move in and out of the market and I do my best to identify these opportunities at www.speculative-investor.com, but longer-term investors should keep their stock market exposure to a minimum. I do, however, continue to like some of the precious metals stocks and am very bullish on gold taking a 6-month view.
Steve Saville
Hong Kong
November 11, 2002
Regular financial market forecasts and
analyses are provided at our web site:
http://www.speculative-investor.com/new/index.html