A Bear with a Silver Lining

11/29/2007 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, sees signs of the Bear, but tempers his forecast with a few positive characteristics.

Since the DJIA first hit 14,000 on July 19, there have been 19 days with over a 100-point DJIA gain and another 17 days with over a 100-point DJIA loss (of those losses, 12 days have been over 200 points). That averages at least two 100-point moves every week. Such volatility is not normal.

In our view, a combination of three factors is contributing to this. First is the level of hedge fund participation-which the Dallas Federal Reserve estimates at 33% of stock market volume, and over 50% of trading volume in distressed debt. These guys are born, bred, and bound to panic! A second factor adding to volatility is the historical fact that correctionless bull markets are not the safest markets. Without washouts along the way, the internal pressure builds-again raising the odds for a bear market or panic.

At 56 months, this is the second longest period in Wall Street history without a 10% correction (on a closing basis) in major blue chip indexes. At the time immediately prior to the 1987 Crash, the stock market was also experiencing the second longest correctionless bull market. And for any overly confident bull out there who doesn't think that investor exuberance or speculation isn't a little over the top in this 6-year bull market, just look at Margin Debt as a percentage of GDP. The parabolic rise of the past year makes us nervous. as does the absolute level, which isn't far below the peak of the high-tech bubble of the late 1990s. One historical conclusion seems obvious-when Margin Debt starts to unwind, it always seems to result in a bear market.

There could be a silver lining, even if a bear market has begun. First, remember that almost all the bigger bear markets-including 2000-02, 1973-74, and 1929-32-started from lofty levels of overvaluation. In other words: extreme overvaluation = extreme risk. That is not the case today, with the S&P 500 trailing P/E ratio less than 20% above historic norm. So we think the downside S&P 500 risk in a bear market would be a moderate 20-30%.

Likewise, we don't see high odds of any bear turning into a lengthy multi-year torment for investors, like the 2000-2002 bear that lasted over 2? years. The median bear market duration (where half are shorter and half are longer) is 1.3 years-much shorter than the average bull market duration. So either way, we could see a great buying opportunity before the end of next year.

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