Stack on Stocks

05/21/2004 12:00 am EST


James Stack

President, Stack Financial Management

Jim Stack is equally adept with fundamental and technical analysis, with a focus on both growth and value. But it is his unequalled expertise as a market historian that makes him so successful as a forecaster. Though long, here is a must-read analysis of his outlook for the market.

"Last year at this conference we were 80% invested and we were very bullish. Today, I do still believe that a bull market is in place, but I think it's going to be a more selective bull market for the remainder. I think some sectors out there have already topped out and I think there are risks going forward as we go through the election and into 2005. It has been a very profitable year over the last 12 months and I think there are still profits on the table going forward. If you were at this conference last year, the headlines at the time were about terror alerts and the deficit. Remember deflation, the lack of job growth, and no post-war pick up in the economy? Insiders were on a selling spree. We had SARS and Mad Cow disease affecting the markets. You had every imaginable reason to stand aside. That's quite typical as bull markets have a characteristic of climbing that wall of worry. What you have to do is separate out the real worries versus the danger flags.

"Regardless of whether you are bullish or bearish, these are not normal times and the reason is that four years ago we popped a valuation bubble on Wall Street. We went into a generational bear market. It was a huge bear market, with NASDAQ losing close to 80% and the biggest bear market in the S&P 500 Index since the 1930s. There are residual effects when you pop a bubble. And t he potential exists for more damage going ahead. If we look at all of the recessions since WW II it takes about a year-and-a-half for corporate earnings to get back up to their previous peak. But here we are almost four years after the peak in corporate earnings and they are not back up to where they were. They are not projected by S&P to get back up there until March of next year. So again, this shows the severity of the impact of this generational bear market. We are still trying to recover from that. Meanwhile, the Fed undertook the most aggressive easing in its 90-year history and it was that aggressive stimulus that has helped put the stock market back on more stable footing. Also offsetting the market losses has been the run-up in real-estate prices. 

"Now let me put this bull market in perspective. In terms of duration, this bull market is just 1-1/2 years old. The median life of all bull markets since the late '20s is 2.6 years. If this bull market has already ended, then this is the shortest bull market in 50 years. If you look in terms of size, form its absolute depths 18 months ago, this bull market is up almost 50%. But again, if this bull market is over, then it has also been the smallest bull market in 50 years. So at least from a historical perspective, the odds are that this bull market still has some life to run. It still has some upside potential and still has some duration of course unless we just saw the shortest and the smallest bull market in 50 years. The good news, at least in my perspective, is that I do think we have more profits ahead.

"Let me now step back to the bad news. This economic recovery is already over two years old. The recession in the 2001 ended in November of that year. The medium length of all the economic recoveries over the past century-that is from when one recession ended to when the next recession began-is 3.1 years. That means if we are 2-1/2 years into this recovery, so the odds are also there that we are in the latter half of this recovery. The other point I want to make here is that most investors I think have a misconception about economic recoveries and it has been created by the decade of the 1990s and 80s. I think these expansions were an aberration, helped by the fact that we had interest rates coming down from extremely high levels in the 1970s. I think what we are looking at in the decade ahead is going to be more frequent economic recessions and more frequent bear markets. Don't count on a bull market lasting ten years- chances are, it's not going to do that.

"We are at the time of the point of economic recovery at which good news may not be good news if it starts forcing the Fed to raise interest rates more than expected and faster than expected. So that is the major danger going forward- the fact that the economy is booming and that we are seeing the kind of imbalances that often develop in the latter half of economic expansions. You are starting to notice these imbalances on the store shelves and in the headlines. Coffee prices are going up, dairy prices are heading up. Everything from tires to food to gas at the pump. Inflation is very real, it's just not showing up in the Consumer Price Index yet. The economic recovery that we are in is the first coordinated global recovery in 25 years. The last time that all the major economies all fell into recession at once, you'd have to step back to 1974. What happened in the latter half of the 70s as all the economies came out of recession together? The demand for commodities went up, particularly oil. The same is happening today.

"Inflation pressures are also spilling over into the weakest area of the economy, which is the manufacturing sector. One factor causing me the greatest concern right now is the percentage of purchasing managers of the nation's factories that are reporting higher prices. The purchasing managers of the factories are kind of at the leading edge of the whole manufacturing cycle. When they are seeing higher prices, that means they are going to have to be raising prices and it means you are going to see higher prices. This index is now at the second highest level in 20 years and the sixth highest level in 50 years. Almost invariably, it has meant that if interest rates are not already rising, they are going to be rising. So unless we get a surprising cooling off in the economy and the manufacturing sector, you are going to see higher inflation.

"How close are we to a bear market? I think this year, 2004, has several positives going for it- one of them as trite as it may sound, is that it is an election year. Election years historically are very stable ones for the market. It's very, very rare to see a bear market in an election year. The third year of the cycle, the year before the election year, is generally the most profitable. The election year is not as favorable but still the second best of the four years on average with almost a 10% gain. There is only one election year since WW II that has seen the S&P lose over 3%. That was in 2000 with the popping of the bubble when the Fed raised the discount rate four times. So history is in our favor that we are not going to see some kind of a fearful collapse or sharp bear market develop, at least until after November's election.

"I think the second positive that this year has going for it is the fact that we have a Fed that is dragging its feet. This Fed is acting late and that means that the monetary stimulus is still great out there. Odds are very high you won't see a rate hike between the August 10 meeting and election. That means there are two potential rate hikes, June 30 and August 10. In most cases, one or two rate hikes do not kill a bull market. The problem we have today is that this is perhaps the most anticipated rate hike in Wall Street history. Everyone knows it's coming. You can't have inflation at 3% and have short-term interest rates down at 1%. You can't do that forever. Remember all the stimulus comes in the year before the election so that by the time you get into the election year, the economy is starting to overheat. Very often the Fed does have to raise rates in election year, just not in the two months before the election. So what this means is that the gloves very often come off after the presidential election and if the Fed is behind the curve in tightening, we could see some larger rate hikes, particularly if those same imbalances and same commodity pressures exist as we are seeing today.

"What happens if the Fed raises the discount rate on June 30 by 1/4 point? Chances are, nothing. One discount rate hike very seldom causes a severe bear market and in most cases you will continue to see some healthy market gains at least in the first three months and perhaps six months after that first rate hike. Unfortunately the first rate hikes normally don't end there. Usually the first rate hike is followed by more rate hikes. In fact there have been only two occasions in the past six years where the Fed has raised the discount rate and stopped after one. Once they started raising rates, in seven out of eight cases, short-term rates rose over two percentage points in 18 months. I think this bull market can weather the first and perhaps second discount rate hike. I don't think it can weather seeing short-term rates go up two or three percentage points. I think that could bring the bull market to its knees and that's why I am nervous looking ahead into 2005.

"So any strategy for the next 12-18 months has to allow for the possibility for a new bear market and/or recession next year. Over half of the recessions, since the Federal Reserve was created, started in the year after a Presidential election. One of the reasons is because every president, whether it's an incumbent or new one stepping into the White House, knows if you are going to have any bad news, get it out of the way in that first year of the term so that by the time you are running for re-election four years later, you'll be climbing out of the recession, consumer confidence will be rising and the market will be rising and hopefully you will be reelected. It is no coincidence that over half the recessions start in the year following the presidential election.

"T-bond yields at 5.5% have moved into what we consider a warning threshold. There is nothing magical about this level, it's just that if the 30-year T-bond yield keeps rising, then it means that the bond market is tightening for the Fed, and that is not good. It means that the real-estate market is going to be thrown a curve. If 30-year bonds start moving toward 6%, then starting shifting more of your portfolio to a higher cash position. It's a simple guideline. But if you follow it, I think it will help keep you out of the worst trouble ahead. I think any strategy has to be a safety-first one in the year ahead. Emphasize as much on managing the risk in your portfolio as you would going after the best profits. If you do nothing else, just don't lose anything big in the market. Bull markets are great, but it's not what you make in a bull market that counts- it's what you still keep after the bear market does its damage."

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