McMillan: Short to Long

01/06/2006 12:00 am EST

Focus:

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Larry McMillan is a expert in sophisticated options strategies for advanced traders. Here, however, he offers an excellent 2006 forecast that is easily accessible for both the novice and sophisticated investor, covering his short, intermediate and long-term outlooks.

"Without wasting a lot of time, this is the thesis for my 2006 Outlook: since 2006 is the mid-year between Presidential elections, it will likely be a bottom. And, for it to be a bottom, the market is going to have to go down to make that bottom. Hence, we’re bearish in that we’re looking for a decline into a solid trading bottom sometime later in the year (probably the fall, if seasonal patterns hold).

"There are other reasons to support that outlook. But before getting into that, it should be pointed out that we don’t normally recommend long-term (one year or longer) trades, so in that respect, this discussion is academic. However, some of our intermediate-term forecasts align with the longer-term ones, so that should be of use.

The Long Term

"For a number of years, we have been forecasting a wide trading range of sorts: a series of bull and bear marketswith potentially increasing severity on the bear side. The ‘next’ bear market after the 2000-2003 market has yet to emerge. However, the market has been unable to advance much since the end of 2003, either. We continue to stand by this ‘trading range’ scenario even if the narrowness of the range is far smaller than we had envisioned. It’s just too soon after the last roaring bull market for another to start now.

"Given the fact that after the huge bull markets of the 1920s and the 1960s, the market stagnated for 25 years and 16 years, respectively, we would not expect to see another super bull market in stocks until sometime in the next decade. This should mean that trading rather than ‘buy and hold’ will be the better strategy. The current rally in the S&P 500 has retraced a good portion of the 2000-2003 bear market. For Fibonacci fans, that retracement is currently 65% near one of the ‘standard’ retracements. The index has made another new recovery high with its latest push upward since October, 2005. That alone should be enough to keep the market from collapsing immediately.

"Markets tend to repeat their cyclical moves which is why cycles are followed in the first place. In past years, we’ve presented a case that the current market might mimic the 1966-1982 period, in which a series of rallies to the 1000 level were followed by bear markets, and then more rallies, etc. The trading range pattern was wide and volatile, and eventually led to the 1982 breakout to the upside. We still think that this pattern could repeat itself over the coming years.

"Another market that has seemingly been ‘ahead’ of the US markets for some time is Japan. Since their market peaked about ten years before ours did, and since their market was into its big bull phase about ten years before ours was, one might say that Japan leads the US by ten years or so. While it might not be possible to pinpoint the time frame exactly, it is evident that the Nikkei has led the S&P dating back into the 1960s. So, if the Nikkei bottomed in 2003and if it leads the US by ten years—t hen that would project a US bottom in 2013. The last bear market in Japan was the worst, but now that market is experiencing its strongest rally since the 1980s. So perhaps the worst is over, after 13 years from peak to trough.

"One other historical note may be of interest: the Dow first hit the 100 level in the 1906, but struggled for over 18 years before punching on through, in 1924, and setting off the Roaring 20s bull market. In a similar fashion, the Dow first hit 1000 in 1966, but it was 16 years later before it broke out and decisively left the 1000 level behind. The next round number in the sequence, 10,000, was first touched in 1999. A similar period of hiatus would indicate that this current market won’t be able to break and decisively leave the Dow 10,000 level behind until perhaps the year 2015 or so.

"So, how does this history really apply to the current markets? One can never be certain, but by all past indications, this market has not yet fulfilled its ‘stagnation’ period. Fundamental analysts and most people you see on TV will always tell you that the market is going up, but in reality it doesn’t always go up. These long stagnation periods can be very devastating especially for those espousing the buy-and-hold strategy.

The Intermediate Term

"Our definition of ‘intermediate term’ usually encompasses three to six months, but for the purposes of this report, we’ll extend that out to the next year or so. The gist of it is that we are seeing overbought conditions in many of our big-cap market indicators. Moreover, the NASDAQ market has already given sell signals. So, once the new year begins, the market may find itself confronted with heavy selling just as it did in 2005.

"Note that we are not making this potentially bearish forecast because we expect 2006 to be like 2005 but rather because sentiment indicators (put-call ratios and $VIX) and breadth oscillators are turning bearish. As usual, though, we require confirmation from prices. In the case of QQQQ, the market has already broken down, but the S& P chart will not break down unless it closes below 1250.

"Many studies have recorded the long series of bottoms in mid-year Presidential elections. Nearly every one of those years produced a decline into a bottom even 1986, which didn’t include any particularly large declines, save a single-digit correction in August-September. But, as we said at the beginning of this article, we expect the market to have to decline into the 2006 bottom. Given the tenuous state of the indicators at the current time, that decline could begin soon.

"How far down could it carry? In the bear market phases following super-bull markets, each successive low is usually slightly lower than the previous one. This was true in 1968-1970-1974 and, for the Japanese market, similar action occurred (see chart, page 2). That would mean that the 2002-2003 S&P 500 bottom near 770 could be tested. That almost sounds impossible, given the current diminished level of volatility of the stock market. Hence, we think that target is too extreme.

"We are looking for a declining market into late next year. Say it lasts ten months. Moreover, volatility is very low right now. It will rise during a bear market, but starting from this low level, it might not equal the levels of other bears at least not right away. Based on historical precedents of volatility, from the current S&P 500 level of 1260, we would estimate a decline to about 900. While that may seem eye-popping right now, those figures are actually quite mild.

"In summary, we look for a decline in 2006, extending until late in the year. After that, things should improve as the mid-year bottom of the Presidential Cycle takes hold. If the decline is typical of past declines, the S&P 500 index will suffer a setback of between 300 and 450 pointsfrom its current level of 1260. A less severe bear market would produce a smaller decline of 185 to 300 points, but to make that assumption would be somewhat contrary to recorded history. The more severe decline is much more in line with the history of bear markets even short-lived ones. Bolstering these mathematical projections is the fact that sentiment is stretched to the extreme. Could we be wrong? Of course. That’s what makes a market!

The Short-Term

"On a short term basis, the S&P 500 index has held above the 1250 support level. This is perhaps the most important single fact that can be stated about the current state of the market. As long as that support holds, there will be no serious decline (unless it comes from a much higher level at a later time). What is most pressing right now is that 1250 level. If it gives way, much lower prices could result. But without a breakdown below 1250those, one cannot be bearish on the index. However, the deterioration of the indicators makes it look like we are very late in the bullish cycle.

"Within this timeframe, we note that our studies are showing several drug stocks on the ‘buy’ side, so we are going to recommend the purchase of calls on the Pharmaceutical HOLDRS (PPH ASE)a tactic we’ve used before with some success. Our specific recommendation for options traders is to buy PPG February 70 calls at a price of $2.20 or less. If bought, stop yourself out on a close below 69. These HOLDRS combines take advantage of our buy signals in Abbott, Merck, and Pfizer especially the latter, where the put buying has been out of control."

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