Ned Davis: An Advisor's Advisor

05/27/2005 12:00 am EST

Focus:

Ned Davis

President and Senior Investment Strategist, Ned Davis Research

Perhaps the highest compliment I could offer Ned Davis is that as eager as individual investors were to listen to his speech in Las Vegas, so too were many of the professional advisors. Here, we share some of his thought-provoking insights.

"There are a lot of conflicting indicators right now. People tend to want to be bullish or bearish, but if you look back, about 35% of the time the market stays in an 8% range. There are a lot more periods of sideways action than most people believe. We’ve had that sideways action for much of the past year, and it’s really not that uncommon. It often happens after a bubble and a bear market, where we see the market go sideways and correct its excesses before the next move. I think we are in one of those post-bubble aftermaths where there is going to be a lot of neutral action.

"Meanwhile, the Federal Reserve is raising interest rates. My primary view on the stock market is that unless there’s a lot of evidence to the contrary, we don’t like to fight the Fed. The Fed has raised rates eight times already and has promised that it will raise them some more. We have found in the past, once they have raised rates three times in a row, in almost every case, there has been a bear market. I would add that there are some potential ‘offsets’ this time. The Fed is raising rates from extraordinarily low levels of 1%. Yes, that was extraordinarily low. And they have been raising them in very small steps. That’s also a positive. In addition, while the Fed has been raising short-term rates, long-term rates have been going down. The short rates are bearish for the market, but the long rates are keeping the market together.

"But if the Fed continues to tighten, the market will pay a price. And it’s not just the market. I don’t know a single economist or Fed member who is looking for a recession. But the record, if you go back and look at previous periods of successive rate increase and Fed tightening, there have been 16 prior cases since 1919. And in 14 of those 16 times, the economy did go into a recession. And those recessions began about 411 days after the third increase in rates or as we called it, the third step up. So these signals tend to be very early. But the record is not good. For now, my guess is that the market is going to stay in this neutral trading range.

"Inflation is really the key here to watch. I think it’s a lot broader than just oil; a lot of commodities have gone up and I think that’s the area to watch right now. Gold is a good indicator to watch. We would also focus on the Commodity Research Bureau. If it goes through 325 (the old high was 323 in March) we will have a real inflation problem and the Fed would have to continue to tighten. If the CRB drops below 280, which was a major support level, that would be a sign that the Fed stepped too much. At that point, they might feel they’ve tightened enough and gotten to a neutral place and can pause. If that happens, I think the bull market will get a second wind.

"We did a study and broke bull markets into different periods, and found that in the first third of a bull market, historically, non-dividend-paying stocks beat dividend-paying stocks in the S&P 500 by about 6%. And that happened in this cycle as well, despite the change in the tax laws. But in the final third of bull markets, the dividend-paying stocks beat the non-dividend-paying stocks by 6.8%. We think we’re late in the bull market, and therefore, we really like dividend-paying stocks such as utilities, energy, and healthcare.

"When the Fed dropped interest rates to 1%, and kept them there for a very long time, almost anything looked attractive. For companies that were able to borrow money at 1%, there were plenty of places to lend it out at 4% or 5%. That's why General Motorswhich makes 90% of its earnings through its finance arm was able to earn $3.6 billion last year, and now expects to not earn anything this year. This also drove a lot of people into the housing market, where very low cost financing set off a housing boom. Overall, the ability to borrow at 1% and lend at 5% led to  a lot of speculation. I don't know how big a problem this could be. I do think GM highlights a really interesting situation and as rates rise we will find that there are similar problems in the economy. It might prove to be a problem with hedge funds, and it may be a problem facing the housing market if the Fed has to continue to ratchet rates up."

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