Be Flexible in 2008

01/31/2008 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, president of InvesTech Research, says Fed rate cuts and the presidential election cycle could lead to a market turnaround later this year.

If we are in a bear market, then we're only in the fourth month (since the market peaked on October 9th). Only two of the past 15 bear markets have ended in less than six months, [although] over half of the bear markets since 1940 have ended in less than a year.

That means we should prepare for a possible buying opportunity by the second or third quarter of this year-if our key indicators start to turn bullish. And remember, this is a presidential election year, and [Federal Reserve chairman Ben Bernanke] is already promising more aggressive easing. (He delivered on his promises with two big cuts that drove the federal funds rate down to 3%-Editor.)

One concern we had in October-November, as the subprime crisis spread to broader credit markets, was the possibility of a "crash scenario" if the stock market started falling too far, too fast, so soon after the October peak. As we showed at that time, precipitous declines are what turned the 1929 and 1987 bear markets into market crashes.

Fortunately, we are now past that "high risk" period, and as inept or ineffective as Fed policy may [have seemed], the ongoing series of discount rate cuts clearly had a stabilizing influence on the rate of descent.

Looking ahead, there is a firm historical basis for that old adage "Don't Fight the Fed" -but 2008 could prove the exception. While Fed intervention is usually strong medicine, the washout in housing and the spreading problems in the mortgage markets are far from over, and signs of an economic slowdown or recession are increasingly apparent.

We believe that monetary action has averted any possibility of a stock market crash, although it will not prevent further losses if Wall Street is in a bear market. Another fundamental development that is difficult to ignore (and therefore should not be) is the positive fact that 2008 is a presidential election year, [from which we draw the following conclusions]:

1. Since 1940, 81% of presidential election years have seen gains in the Standard & Poor's 500 index.
2. Also since 1940, only one presidential election year (2000) has seen over a 3% loss in the S&P 500.
3. Even in three of four other presidential election years that saw the start of a bear market (1948, 1956, 1968 and 1980), the S&P 500 finished the year with a gain.
4. If October was the final peak in the bull market, it would be only the second time in 87 years that a bear market began in the third year of an election cycle.

So, we head into this year of uncertainty with our defensive strategy and allocation still intact, but with a bias toward flexibility. We're not holding our breath in hopes of a reversal to a bullish outlook, but we are open to the possibility and watching for changing evidence.

Subscribe to InvesTech Research here.

Related Articles on MARKETS