Time to Err on the Side of Caution

05/16/2007 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, advises investors not to succumb to euphoria as the Dow sets new records, and to be aware of the risks in the economy and market.

As the Dow Jones Industrial Average crossed the 13,000 level for the first time [in April], Yahoo! Finance conducted a poll on which target the DJIA will see next: 14,000 or 12,000? Almost 2/3's (62%) of respondents answered DJIA 14,000. If you've ever believed there was value in being a contrarian, this might be a good time to be more cautious.

This bull market is already 1.5 years longer than the median bull market life span of the past 75 years. To last through the end of next year (and the 2008 election), it will have to become the third longest bull market in history. (And remember, this is already the second longest period in history without a 10% correction.)

So, although our technical models in breadth and leadership are holding steady and not yet signaling a bear market, we would prefer to err on the side of caution.

The monthly survey from the Institute for Supply Management (ISM) shows another sharp rebound in the number of purchasing managers reporting higher prices at this earliest stage of the manufacturing cycle. Meanwhile, another inflation timing model from Ned Davis Research has also taken a noticeable turn for the worse.

Conversely, with economic growth slowing in the first quarter to the slowest pace in four years, the Federal Reserve isn't about to raise interest rates right now. In our opinion, this unwinding of the housing boom has a long way to run. Private residential construction growth has turned negative to a point that has triggered or accompanied a recession in every instance of the past 40 years.

Yet the inventory of unsold homes has hardly budged. One reason is that high inventories usually require years to resolve, and this one will likely be no exception. When starting at record high levels, don't be surprised if this unsold inventory is still working its way lower three or four years from now.

Over the past 80 years, corporate earnings have averaged a fairly consistent 7% growth channel: Even through recessions, economic booms, and decade long expansions like the 1960s or 1990s, that 7% growth has held constant. So, with corporate earnings now above that long-term channel, the next year or two could hold some significant (and unpleasant) surprises for investors.

And we think investors speculating in China with the intent of taking profits after the 2008 Beijing Olympics conclude will find themselves a day late and a (lot of) dollars short! Bottom line, we see a lot of risk-even outside the housing sector-between now and next year's election.

Our best advice for the next 12 months: step softly, and carry a comfortable cash reserve.

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