An Historian's Perspective

01/06/2006 12:00 am EST


James Stack

President, Stack Financial Management

Using an understanding of market history, Jim Stack has developed one of the industry's leading records in forecasting the market's future. Here, he applies his fundamental and technical skills to assess the current bull market and its prospects for the coming year.

"Of the 14 bull markets in the S&P 500 Index over the past 75 years, fewer than half (six) lived beyond three years. The good news is that most of those that made it through three years, did manage to extend another full year (six out of seven). However, this statistic hides some unpleasant facts: in most cases where a bull market's fourth year provided decent gains, there was either an interim recession or market decline that set the stage for solid fourth year performance. And the one exception that didn't was 1987- a year that was not worth celebrating.

"Overall, we don't like the current investment odds. On a scale of 1-to-10, with 1 being the worst time to invest and 10 being the best, we would only rate this market 3-4. And the only reason we give it that high a score is because of stability in bond yields and market breadth. If not for these two factors, we'd drop our rating to 1-2.

"In 2003, the fears of deflation quickly dissipated once the Federal Reserve's massive easing finally took effect. Never before in Fed history had we seen 11 discount rate cuts in 12 months. But it did overcome the effect of wiping out $7 trillion on Wall Street. Unfortunately, it may have created an even bigger exposure ahead in real estate. Personally, we hope the real estate excesses-or regional bubbles, as the Fed calls them- are deflated over an extended period of years, without a lasting impact on the economy.

"Yet it's not the lofty prices, but the high debt, leverage, and illiquidity that present the greatest risk of a severe decline. In our opinion, such an event in real estate-with widespread defaults at both the consumer and lender level- is the one scenario that could trigger a deflationary accident in the US. As a result, one of our main concerns for the bull market in stock is that we believe this housing cycle has peaked.

"Meanwhile, with 13 interest rate hikes under its belt, Fed policy would have to be called 'unfavorable' or outright bearish. The outlook for the bond market has also deteriorated. In fact, our Bond Advanced Risk Index is at its most dangerous level since the 1987 crash. That index is warning of a potential upturn in long-term bond yields in the months ahead. If that occurs, then chances are that Wall Street's bull market is over.

"As we head into 2006, the headwinds that we warned of last January continue to increase. Our technical indicators are starting to show a breakdown in leadership, if not in breadth, and much of the current economic prosperity is riding on the overextended consumer, and a potentially ugly housing bubble. Nonetheless, until our models turn more decisively bearish or yields rise into the danger zone, we'll continue to give this bull market the benefit of doubt- but not without a sound defense in place.

"With our bullishness tempered, our allocation has become more defensive. Our portfolio is currently 70% invested with 13% in international funds, 16% in resource stocks, 9% in value securities, 22% in growth investments and 10% in a bear market fund. The remainder of the portfolio (30%) is held in short-term Treasuries or a money market fund. So for now, be patient, stay conservative, and remember that this is not the time to swing for home runs."

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