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The Stealth Market Collapse: What is Really Going on is That the April Turning Point is Here

April 23, 1999

Never in the past 71 years has there been a week like last week (week of April 12) which saw the Dow set five consecutive record highs at the same time the S&P 500 Index declined for four consecutive days and key stocks like IBM and Wall Mart declined 10%. And, to top it off, market breadth was positive, reflecting more advancing issues on the NYSE than declining issues. Volume on the NYSE was over 1 billion shares two days in a row, a feat accomplished on the NYSE on only one other occasion: October 28, 1997, the day the mini-crash ended in the U.S. at the start of the Asian economic meltdown. Last week's trading action, then, underscores a trend lately: that technical divergences and volatility are the greatest in decades.

So, why is this happening? And, how could the Dow and S&P 500 have been making steady record highs even as the general stock market has been in a bear market for exactly one year? To understand why, first look at our chart and our special analysis section detailing our Money Flow Indicator. This indicator helps reveal a so-called stealth bear market that has been in force for the past year--a bear market in a large majority of stocks responsible for the underperformance of 70% of mutual funds, money managers, and individual investors even as the Dow makes record high after record high. It is important because it contains implications that all traders and investors should now before making their next decision. According to our work, this divergence would last only until April 1999, as we have been forecasting, and we are there now.

Second, as this article will reveal in a moment, only a select few -- very few stocks in the major benchmark stock indices and averages are responsible for the record highs in the averages. Read on to find out what is really happening beyond the record run to Dow 10,000+, why we feel it is so important.

Consider the following regarding the present state of the market: We have been calling for an important April turning point this year, one that our research strongly argues will ultimately lead to a U.S. market meltdown within the context of a financial panic cycle at the end of the bull market. Research shows that investors have a tendency to panic at regular intervals, a difficult concept for many to swallow but, yet, the tendency is there in the history of the many financial panics that have hurt investors this century and last. We wish it weren't so--that investors seem to have to periodically hurt themselves from time to time by throwing caution to the wind and bidding the prices of stocks, or gold, or real estate (whatever the current bubble is) too high--ultimately causing just what they fear: a collapse and selling panic. Our work strongly argues that this panic will happen this year, and that it may even have begun this past week. The 10% plunge in IBM, Wall Mart, and other key stocks this past week is typical of the way the way these panics sometimes begin. In fact, skeptics of this theory of regular financial panics might ask: if no financial panic is likely, then why were these key stocks down 10% even as the Dow set five consecutive record highs, and why are Internet stocks fluctuating sometimes by as much as 30% or 40% per month? This kind of volatility is a sure symptom that the market has become the gambler's arena our Forecast '98 report had indicated it would, and is a symptom that investors have thrown caution to the wind and are bidding stocks up and then selling them off (after reaching as high as 500 P/E multiples in some cases) with no regard for fundamentals.

Volatility of this kind has historically occurred at (or along the way to) market tops. So has an investment "bottleneck," a situation that occurs when less and less stocks are participating in the final rally due to investor and money manager unwillingness to give up on the bull market. Consider this report by the New York Times published last Friday in an article entitled, "Why S&P 500 Leaves Many Funds In The Dust":

*In the 12 months ended Jan. 31, almost 70% of stock mutual funds underperformed the S&P 500

*Fund performance has deteriorated steadily since 1993 when almost two out of every three funds actually beat the index

*Astoundingly, just five stocks -- Microsoft, America Online, Citigroup, MCI Worldcom, and American International Croup -- accounted for 52.7% of the performance of the S&P 500 Index in the first quarter, according to Leah Modigliani of Morgan Stanley.

*Even more astoundingly, in the first quarter the top 18 stocks accounted for 100% of the S&P 500's 5% rise. This means that the remaining 482 stocks added nothing to the index's return, according to the article. 55% of the stocks actually lost ground during that period.

*Performance is not the only thing that changes the value of indices like the S&P 500. The makeup of the S&P 500, used as a benchmark by 97% of U.S. money managers, keeps changing. Research by Wells Capital Management in Minneapolis shows that since 1994 the S&P 500 has become dominated by that it calls "new-economy stocks," those in health care, technology, telecommunications, financial services, and consumer services companies. "While such companies made up roughly 60% of the index in 1994," the Times article says, "they made up almost three-quarters of it at the end of last year."

*"At the same time, 'old-economy stocks' -- those in energy, transportation, utilities, industrials, and basic materials -- make up far less of the index than they did in 1994. Companies in these industries accounted for 16 percent of the index recently, down from almost 30% in 1994."

*The result is a shift in the S&P 500 away from stocks "forged in the undustrial era and into companies created by the technology revolution." Paulsen says that most of the names being eliminated from the index are old-economy names, those being added are new economy names.

*Last year a record 48 changes to the 500 stocks in the S&P 500 Index occurred. Neither the S&P Midcap 400 Index, and the S&P Small-cap 600 Index, by contrast, have changed over as much as the S&P 500 Index.

*The old-economy stocks have declined somewhat in both indices, but not as significantly as their drop in the S&P 500 Index.

*"Few investors realize how much indexes change from year to year. Their makeup shifts for two reasons: the performance of the stocks that are in an index and the additions and deletions made to the index by its administrators."

By contrast, the Dow Jones average is calculated differently. It is a price-weighted average, so the more the higher priced stocks move the more the average moves. Money managers typically do not weight their portfolios by the composition of an index or by how often the stocks in that index are changed over. As a result, the only strategy left in a mature market characterized by a bottleneck-type advance is to rapidly rotate from industry sector to industry sector. This approach, used by the many money managers the bull market has picked up over the years, has increased in velocity to the point where, according to the sector rotation system utilized by our Bull And Bear Enhanced Portfolio, money managers are having to abandon sectors before they pay off as they attempt to rotate out of rapidly-weakening sectors into other sectors before further selling hits. This is a period during which mutual fund switchers should be in money market, until the appropriate signal comes that warrants a switch to a bear fund like the Rydex Ursa fund, strategy for which was designed and executed by yours truly and is now used in the Bull & Bear program for fund switchers. The Ursa fund strives to move inversely to the S&P 500 Index. In light of all these facts, our expectation is that the U.S. stock market is in trouble, that investors and money managers are hanging onto "The Old" too long, and that the situation will deteriorate into a full-fledged bear market in the indices and its associated financial panics that typically characterize the post-bull market environment during which everyone attempts to get out of the pool at the same time. Our Forecast '99 report describes the exit of The Old and the coming of The New, and what it all means for investors this year.

We certainly do not need a bear market or a financial panic for any reason, and we especially do not need a collapsing market environment for a Bull and Bear program or a research advisory service to succeed since we can play both sides of the market, rotate sectors, or otherwise make do with a raging bull market. Therefore, we report this negative outlook for the market with a great deal of regret. Yet, at the same time we understand that we would be remiss if we failed to report what our combined technical and fundamental approach is saying at a critical time like this (that includes the breakout of a major war, the potential effects of which are analyzed in great detail in our latest issue of The Global Market Strategist®).

It is always possible that we are wrong, or that the market somehow salvages its poor underlying condition and manages to move ever higher. However, as one might imagine, this is highly unlikely without alternating between the bull and bear cycles, and humanity is likely on the verge of learning the same lesson yet again--the lesson that our grandfathers and grandmothers learned, that our brothers and sisters in Asia and other areas of the world learned in 1997 and 1998, that the market is cyclic, that caution cannot be thrown to the wind, and that it is not a gambling table. And, above all -- whether or not one's opinion is that investors are gambling -- we must remember that one's investment dollar is just that--an investment dollar, to be diversified or concentrated in the various investment markets available, not just in stocks. View contents of April issue of The Global Market Strategist®.

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