Printer Friendly Version      Email this Article

Preview of 2002: Mega-Market Meltdown
By Brady Willett & Todd Alway
Despite economic recession, hints of deflation, deep cuts in capital spending and what is sure to become the mother of all inventory gluts, the outlook for the U.S. economy is bright. 

However secure the above argument may seem, so long as the economic negatives are regarded with less than the same open mindedness as the positives, it is difficult for objectivity to emerge.  To be sure, current accounts make it appear as if people with common sense are in the minority these days.  Rather, meaningless slogans and "hope for the best" optimism dominate "analysis" of the near future.  In fact, amongst this investing herd, where serious research is conducted at all it is limited to post 1950 history books and meaningless short term economic reports: Auto sales ballooned in October, housing sales exploded in November, and consumer confidence rebounded sharply in December.  These things spell out that happy days are here again, don't they? 

Unfortunately, even short term measures can be tarred with a pessimistic brush: the broader economy should still post negative growth in 4Q01, corporate earnings even for automakers will be pitiful, and the layoff tally continues to climb.  Of course this is to say nothing of longer-term demand cycles, but one step at a time.  Yes, the reality of economic hardship can be romanced into higher stock prices, but should this be the case?

Stock Market
Following September 11 it did not take long for the markets to bottom (Sept 21).  Even as disastrous economic numbers have since trickled in, this rally has miraculously held.  In light of these deteriorating economic indicators, the question for Wall Street has naturally become why has the rally happened.  It is not a question of whether the rally should have happened (it being a perfectly efficient market, after all), only why it occurred to begin with.  Given the need for continued trading volume, it would be unseemly for Wall Street to ask the question which might kill the goose that laid the golden egg.  Accordingly, while economists have dusted off their post 1950s texts to figure out when the recession will end, investors have been engaging in a similar selective historical analysis to justify the stock market boom: since 1950 bad news, without exception, has turned out to be good news 3 months, and 6 months afterwards.

Whether or not the Dow and related equity markets can continue to emulate this upward trend until March 2002 is uncertain. However, what is known is that history dates back further than 1950.  With this in mind, is it out of investigative convenience that the three depressions in the 1800s, and the great depression of the 1930s are ignored today?  Perhaps… 

Mega-Market Trends
Analysis of the roaring 1990s is often compared to previous 'new economy' type markets.  However, rarely is such a comparison made to the aftermath of each era.  For example, one of the more prominent bulls of the late 1990s, Ralph Acampora, published a book back in 2000 entitled The Fourth Mega-Market, Now Through 2011.  He notes that the three previous 'Mega Markets" were:

1) 1877-1891
2) 1921-1929
3) 1949-1966

What should be remembered is that even if we are/were in the fourth mega market, as Ralph says, the end result of previous 'mega markets' has been, in two out three cases, 'mega depressions'.  To note: there was no textbook depression following 1966, but severe losses in stock prices and a deep malaise in Western economies nonetheless.

As such, it should be remembered that when previous 'mega markets' unwound they typically lasted much longer than normal bear markets. Furthermore, the economy went through anything but a normal recession during these periods.  Rather, years of slumping economic performance was the norm.  Using Mr. Acampora's dates, the charts following the two 'mega markets' during the last 100 years are as follows:

"The year 2002 is going to be a range-bound market with the averages moving sideways"
Ralph Acampora

When considering that 2000, and 2001 were both write-offs, a simple question deserves to be asked: Do Mega-markets stagnate for years on end?  Ralph?  Any comment?

Unfortunately, history suggests that the markets are set for dire straights for many years to come. This is especially significant when considering that the Dow is currently off of its record high by a mere 15% after being down 33% on September 21. No other comparable market in history has ever dropped so little after rising so greatly.

Furthermore, and despite recent stock price stagnation, very few previous markets were as richly priced as today's.  As such, calls for a continued stock market rally seem to be the result of the continuance of the MM mentality rather than solid fundamentals.  It is certainly possible that the market could continue to rise, but this is something which is extremely unlikely given the current condition of corporate earnings and economic growth.  Yes, even MM's are hinged upon positive economic and corporate earnings results.  Loosely mind you, but still hinged.

Prior to the 1990s the markets rarely maintained an average P/E of +20.    Moreover, during previous recessions/bear markets the average P/E often slipped well below the historical average of 16.  Today a reading above 30 is commonplace.

In this regard, the so called bear markets of 2000 and 2001 appear to have done little to change mega-market trading.  Done little to return the markets to historically reasonable levels. Put simply, a historically 'normal' P/E sees the S&P 500 hovering around 600.  Given that the S&P is at 1,154 the markets remain anything but normal.  Furthermore, the relationship between stock, and bond yields has not yet shown signals that we are in an entrenched bear market. Rather, bond yields remain four times that of stock yields (anything but normal). Question is, will things ever become 'normal' again?

There are various reasons why the basic valuation instruments are sitting near records even while economic growth has been, and should continue to be, less than spectacular. Perhaps the most fundamental reason is because more capital is chasing the investment instruments that the markets offer.  In other words, demand for stocks outstrips supply.  Consequently, prices rise until this disequilibria abates – sellers catch up to buyers.

In this regard, one specific investment vehicle appears responsible for facilitating overvaluation and maintaining market optimism.  Mutual funds. Not unlike how the roaring 1920s saw the proliferation of investment trusts, and the 1960s of mutual funds, so too has the most recent market been made possible, in part, by the rapid expansion of mutual funds.  However, does a similar demise of yesterday's mega-markets await fund holders today?  Perhaps...

As we enter 2002 the fund industry is slowly loosing momentum. To be sure, in March 2000 total mutual fund assets stood at $7.1 trillion while today they sit at $6.9 trillion. This may not seem like an incredible differential.  However, when combined with the fact that year-over-year (Nov) less than 200 new funds have been created, this is big news.  As we pontificated back in September 2000, the slow down in mutual fund creation and overall wealth are important themes to take notice of.

Unlike the case of the 1930s or mid 1970s, today's market faces an additional demographic disequilibrium which threatens to create a new long-term barrier against the development of a new sustained bull-market.  The unfortunate consequence of this is that stock averages may not rebound into a long-term growth phase for at least a generation:  Why?  Because fund exposure has been on the rise for nearly 20 years, and if outflows do not likewise take 20 years to transpire the pressure on financial instruments will be phenomenal. Think of it this way: fund buyers have been lapping them up for two decades in order to prepare for retirement.  Given demographic trends and lifestyle expectations, the outflows which will be necessary to sustain the baby-boom generation upon retirement, when taken concurrently with the exiting from the labor force of this significant segment of the population (and consequent decline in the investment of earnings into the funds), it appears likely that there will be a sustained outflow of capital from the equity markets into basic consumption.  Question is, when exactly will such outflows develop?  Moreover, will such outflows be undertaken during a period of market calm, or during instances of panic?

Mega-Market Hope
As the stock markets begin to dump their mega-market dressings into the hamper, there is the hope that the Fed will arrive to do the laundry.  In fact, this, if anything, is what separates yesterday's MM failures from today's MM malaise: the contention that the Fed can resolve the issues binding the economic slow down, and unravel a new platform for growth. 

However, with the markets pricing in an earnings rebound in 2002, and stellar growth rates beyond, it is up to the Fed to produce.  In this regard, bull market commentary has once again left objectivity at the wayside and entered the room sprouting mega-market mantras: interest rates are at 40 year lows, the Fed has cut rates 11 times in a row, the money supply is providing liquidity, and Greenspan believes the long-term productivity advances remain.  To be sure, none of these topics tackles stock market 'overvaluation', attempts to explain why consumers are searching for bargains rather than spending wildly, or the effect of business keeping a strangle hold on capital spending.  No, what is offered is hope for the mega-market to live on, a wish that investments in mutual funds by Americans will grow rather than decline in the years to come, and a dream that America is not like Japan, not like Argentina, and most certainly not like any America before.

2002 Forecast
We believe that during these times of intense mega-market malaise the prudent investor would do well to remain highly liquid, and have some holdings in hard assets (Eagles, and Maple Leafs).  That said, pecking at those companies with long-term appeal should always be a consideration when value, and valuation unite.

Buying U.S. equities doesn't necessarily mean that we are optimistic that the U.S. stock markets will rally this year. We are not.  Rather, if those stocks we do like drop we will applaud the opportunity to buy more shares at a cheaper price.  This is what being liquid essentially means: being able to jump on opportunities when they arrive. 

With this in mind, we don't expect the markets, and most stocks for that matter, to perform well in 2002.  Quite frankly, the markets have priced in an economic rebound before one has arrived.   Consequently, assuming that one does arrive, this leaves stagnation rather than growth as the logical direction for the market.  On the other hand, assuming that a rebound does not occur (and there are many reasons to believe that it will not), this leaves a deep drop as the likely destination.  Investors that own any stocks outside of select areas (gold/silver, hard assets with dividends) should be prepared for their portfolio to take a hit. 

Just as Americans flocked to automarkets late in 2001 to pick up great automobile buys, so too should the prudent investor be ready when similar 'cheap' buys present themselves in the equity markets. Ironically, as the markets have rallied since September 21 more investors have gained enthusiasm.  This is illogical. The next time GM raises their prices, see how many buyers are clamoring around the auto-yard yelling 'I have to buy now the price just went up!" 

We remain as bearish as ever, and one day foresee the Dow clinging to 5,000, and the Nasdaq battling at 1,000. Moreover, we envision less than 45% of households being involved in equities, then 40%, 30%, perhaps as low as 20%.   Obviously whether or not this will occur next year is beyond the realm of our knowledge.  Nevertheless, the longer term repercussions of over investment in the 1990s and overly optimistic expectations today remains.  The Fourth Mega Market meltdown is upon us.

"Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time.  When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn"
Federal Reserve Chairman Alan Greenspan  – Feb 26, 1997

January 7, 2002

http://www.wallstreetwishlist.com