25 YEAR STOCK MARKET TOPSell, Sell, Sell
In December 1981, I scooped Wall Street by predicting a grand cycle (10-20 year) bull market in stocks. Since that time, the DJI has gone from 800 to 12,000. Here in January 2007, I am predicting that this grand cycle bull has come to an end. A 10-20 year bear market in stocks (as represented by the DJI and S&P 500) is about to begin. Rough price objectives are 6000 DJI in nominal dollars and an 80% decline in real dollars. If you own stocks, then sell, sell, sell.
Cause and Effect
I have achieved a dramatically successful record in analyzing stocks over the past 30 years by practicing the scientific approach, by which I mean studying the cause and effect relations which govern stock prices.
The cause of the vast majority of major term (2-4 year) stock moves is the bond market. In the 19th and early 20th centuries, normal (earnings) yield for good quality stocks was 8%. Normal (real) yield for high quality bonds was 5%. This 8:5 ratio held for long periods of time and almost certainly reflects certain basic value judgments of our society (with stocks receiving the higher yield due to their greater risk).
What causes a major stock market move is that the U.S. Central Bank the Federal Reserve) adopts a policy toward interest rates. If the Fed lowers (short) rates, then this will cause a lowering of long rates and will disturb the 8:5 ratio. For example, the Fed came into existence in 1914 and immediately lowered short term interest rates from 6% to 3%. For the sake of easy calculation let us say that long rates fell from 5% to 2½.
This immediately disturbs the 8:5 ratio (changing it to 8:2½). Investors can now get a much better yield on stocks than on bonds; they sell their bonds and buy stocks. This selling of bonds and buying of stocks continues until the 8:5 ratio is reestablished, say by a stock yield of 4% (4:2½ = 8:5). If there is no change in stock earnings, then this can only be accomplished by a rise in stock prices, and indeed at this time the DJI doubled over a 2 year period.
Fear and Greed
The idea that major term stock moves occur because of emotions is a popular theory on Wall Street. You have undoubtedly heard that investors buy because of greed and sell because of fear. This has some validity on the intermediate term (several months), but it does not work on the major term. All you have to do is to look at a cyclical group, like housing or autos, and you will find that their P:Es are below the market average at tops and above the market average at bottoms. If people were wildly optimistic at tops, they would give these cyclical groups higher P:Es; vice versa at the bottoms.
Adherents of the fear-greed theory can always tell us after the fact that a certain period was a time of intense greed or enormous fear. But they can never tell us at the time. This is because their theory is all wet.
The Great Grand Cycle Bull Market of 1982-2007
Stocks have moved up from 1982-2007 because bonds have moved up from 1981-2005. This in turn was caused by a fall in short rates from 16% in 1981 to 1% in 2004 (nominal). In effect, we had 23 years of Fed easing.
It should be noted that there is no long term uptrend in (real) stock prices. Stock yields have to maintain a long term relationship of 8:5 with bond yields. For stock prices to continually go up, bond yields would have to continually go down. This can not happen without an artificial event: the easing of the Fed. Indeed, we have good indexes of stock prices from 1885 (the earliest Dow index) to 1932. And during this time stock prices were flat. In 1933, the Fed got the legal tender power, and it has been easing for most of the past 74 years.
The great grand cycle bull market was interrupted on occasion, but the cause was usually a temporary Fed tightening. The Fed tightened in 1983, leading to the bear trend of '84. Then it tightened again in 1987, leading to the October crash. Minor Fed tightening in 1990 and 1994 caused mini-bear markets.
The Fed tightened in 1999, causing the bear trend of 2000. This was then extended by the World Trade Center attack of 2001 and the brewing of the Iraq war in 2002. (The collapse of internet stocks from their overinflated bubble prices in 2000-2002 made the bear market seem worse than it was, but the majority of stocks were not hurt badly at this time, and the Value Line index (not capitalization weighted) showed that most stocks were still in their grand cycle bull trend.)
Why Should the Fed Tighten?
Some might argue, why should the Fed ever tighten? If easing makes stocks go up, then why not always ease? Then stocks would go to infinity, and we would all be millionaires.
Unfortunately, the principal way that the Fed eases is by creating money. This is sort of legalized counterfeiting. Creating money does not create real wealth for the country. It just makes prices go up. Right now the Fed is tightening because of the commodity pendulum.
In a simpler time, the Fed would ease for a few years. It would create money, and 1-2 years later consumer prices would rise. This changed with the Kennedy tax cut of 1963. Since 1963, commodities have been swinging wildly and have become a much more important factor in consumer prices than they used to be. Also, commodities take a long time to respond to the forces of supply and demand. They only respond to the Fed's creation of money after a 10-20 year time frame.
After the big commodity upswing of the 1970s, commodities were overvalued, and they went down for 20 years. This undercut the rise in consumer prices and made "inflation" look tame. So the Fed was able to keep easing. Now, however, commodities are extremely undervalued. In 1999, their real value was half that of 1971 (which was the previous most undervalued point for commodities in American history). That is why they are rising explosively. This is feeding through into consumer prices, and Bernanke cannot figure out why the CPI is going up so rapidly.
But it is not necessary to debate what the Fed ought to do. It is only necessary to observe what the Fed is doing. Most Fed watchers are so up close to events that they cannot see the forest for the trees. Take the recent tightening as an example. There were two important sell-offs in the T-bond market as investors tried to discount a Fed tightening, mid-2003 and spring 2004. Yet the bond market made its (second half of a double) top in mid-2005 about a year after the tightening started. And the stock market continued to climb for another year-and-a-half beyond that. If these Fed watchers had cared a bit less about the news of the moment and a bit more about the cause and effect relationship which governs stocks, they had a great deal of time to get bearish.
There is an old saying that they don't ring a bell on Wall Street (to signal a market top). But in fact this saying is wrong. They do ring a bell on Wall Street. Bonds go up, and that makes stocks go up. When bonds go down, it makes stocks go down.
In the last bear market (2000-2002), there was a 15 month lag between the bond peak (Oct. 1998) and the stock peak (Jan. 2000). Taking 15 months after the recent bond peak (Sept. 2005), we would be led to expect a stock peak circa Dec. 2006. Add the fact that New Year's Day is often an important turning point, and it is easy to conclude that the one-day reversal of 1-3-07 may have been the grand cycle top of this stock market.
Keep an eye on commodity prices, and you will realize that the Fed has to keep tightening. But in any case the Fed will give you plenty of warning. You can make money rapidly in (stock) bear markets, and it is a lot more fun to make money when everyone else is losing.
January 14, 2007
Howard S. Katz was one of the early gold bugs of the late '60s and '70s, turning bullish on gold in 1965. His favorite gold stock, Lake Shore Mines, went from $3/share to $39/share over the course of the seventies (sold at $31). Katz turned increasingly skeptical about gold as it mounted its final rise in 1979, and he called the top after the close on Jan. 21, 1980 (with gold at $825.50/oz.). Katz traded gold in and out during the '80s and '90s and once again turned long term bullish in Dec. 2002. His thoughts on commodities, stocks, bonds and real estate are available in a letter entitled The One-handed Economist and published every two weeks giving specific advice on trades in stocks and futures. This letter is available (both electronic and paper copy) for $300/year with a 3-month trial for $100. Send to: The One-handed Economist, 614 Nashua St. #122, Milford, N.H. 03055. (Include both electronic and mailing address.)
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