(v. 5, i. 1  1/10/03)

Edwards pdf           Schaeffer pdf           Hays pdf

Global Strategy Weekly
More on Plan B
By Albert Edwards

The nature of the Fed’s role as guardian of the punch-bowl has altered. It is 2am. The party has wound down. The guests are sloshed and want to get home. Yet in one of those Nightmare On Elm Street moments, big-Al has bolted the door and is now dunking the struggling guests heads into the punchbowl. 

  • We note the increasingly open discussion among policy makers about the range of policy options available in any move to Plan B – i.e. the use of unconventional policy measures to revive flagging economies. We believe the policy menu described by Fed Governor Bernanke in a recent speech will almost certainly have to be utilised sometime next year. Our own Taylor rule for US interest rates suggests that the US Fed will run out of conventional ammunition sometime in the middle of next year.
  • Elsewhere an increased appetite to engage in more aggressive conventional measures is becoming apparent. In the eurozone the review of the twin pillars of ECB policy is expected to bring about an explicit upward revision to the inflation target. In addition, the difficulties we foresee in the French economy next year are likely to see the establishment driving a retreat away from the doomsday fiscal and monetary straitjacket which the eurozone has imposed on itself.
  • In Japan, recent comments from the Finance Ministry has led the market to believe that competitive devaluation is being considered as a supplemental policy option (or natural consequence of a increasingly aggressive monetary expansion). Competitive devaluation (and trade tension) was always likely to occur as the Ice Age bit home, as countries fought to export their own domestic deflationary pressure.
  • The identification by the Japanese MoF, in a recent Financial Times article, of China as a major contributor to the global deflation threat and their aggressive exhortation for a Yuan re-valuation is all symptomatic of the increasing desperation that will surround the 13 December 2002 Global Strategy Weekly

The advent of a new US economics team coupled with the Fed’s “Bernankel” speech has also raised the possibility that the US might also now engage in devaluation if the going gets tough economically over the next year. Re-election is President Bush’s main priority after all. His father found to his electoral cost that a stagnant economy more than outweighs the impact of any military victory overseas.

Of course, not all countries can devalue their way out of deflation. But whoever is committed to highest degree of monetary laxness will probably win the fight. It also helps if one starts off with a huge current account deficit as the US does. Yet while the US talks the talk, other people have started to walk the walk. Central Bank “intervention” to push the dollar up has been running at an incredibly high pace over the last six months (see chart below). Eyeballing the reserves data quickly, it looks as if China and Japan may be slugging it out in the foreign exchange markets as well as in the pages of the FT!

Source: Thomson Financial Datastream

The US has had enough of importing other people’s deflation. It may have been an appropriate policy at the height of the boom to curtail inflationary pressure, but is darn right stupid now. According to our foreign exchange strategist, Jesper Dannesboe, there is growing evidence that the Asian central banks have begun buying the euro in large quantities, perhaps in response to the realisation that the US authorities will increasing resist any dollar re-valuation (see FX Navigator 12 December). In contrast to the US authorities, the ECB will, most likely, see a rising euro as validation of their policies and welcome the move in its early stages! It is not even wholly certain who has the call for intervention in the eurozone if (when) any upward move is to be resisted (we believe it is the Econfin which instructs the ECB).

Devaluation is strictly speaking more of Plan A (conventional policy measures) as is further fiscal stimulus. And indeed, why turn to Plan B if Plan A seems to be working. Indeed US bank lending is running at a rip-roaring 13% annualised rate over the last six months (see chart below), almost the fastest nominal rate of growth for 30 years (and certainly the fastest in real terms).

Huge purchases by the commercial banks of Agency paper has buoyed lending activity (see chart below). Banks are clearly playing the yield curve, but prefer the higher carry from Agency paper over Treasuries. Bank lending to the private sector is running at a less hectic, but still rapid 9% annualised pace, due mainly to mortgage refinancing activity. Hence if the US banking sector is still in good shape and spewing out credit, why would the authorities need to move from Plan A to Plan B. The simple truth is that more debt in an Ice Age environment is not really the solution. Debt is the problem.

If we have returned to Austrian-type economic cycles, then the solution to deflationary pressures caused by an investment boom may not be to boost aggregate demand, but to embrace the recession and cut away aggregate supply. (This has been the ongoing debate in Japan over the last ten years, but it is now a global issue.) But in the absence of higher inflationary pressure, a recession to purge the excesses and imbalances of the bubble years is right off the policy agenda. The US embrace of the free market model is clearly only a very partial one.

The need for further adjustment to the excesses of the bubble years is most clearly seen from a stalling out of the correction of the private (corporate and household) sector-borrowing requirement without it moving into substantial surplus – as would normally occur (see chart below). Many investors see this return to balance in a positive light and that the adjustment process is complete. But if the payback to the bubble is in any way proportionate to excesses accumulated during that period, there is plenty of retrenchment still in the pipeline.  

The corporate sector financing gap has started increasing again because the profits recovery has stalled (see chart below). Contrary to what many believe, the corporate sector is still piling on the liabilities, not paying them down.

We have not even seen a debt/equity swap occur as we saw in the early 1990s (see chart below). Corporates have been hoping the cycle will bail them out. It hasn’t. Corporate retrenchment is again the order of the day as sub-trend growth spills into deflation which in turn spills into disappointing profits growth. Continued high debt loads in this environment are a killer.

As to the US Household Sector, despite the huge appetite to take advantage of low interest rates to refinance their debts, it should not go unnoticed that the decline in net wealth has nevertheless led to the predictable rise in the household saving ratio (see chart below - saving ratio inverted). This means that the consumer is in a cautious, not a “throw caution to the wind” mood. 

US household wealth (incl housing)/income ratio and the saving ratio (inverted and with 6 m mav)

Despite the Fed’s attempts to force more debt on the economy to prevent the adjustment to the bubble years, consumers are clearly taking a more cautious line of their finances than the Fed might have hoped. Indeed Dallas Fed Governor McTeer explicitly stated that although the consumer needed to retrench ultimately they (the Fed) did not want it to occur any time soon! Lord make me virtuous, but not yet.  

We view more private sector debt in the current environment as a burden and a potential source of future instability, not the solution to the problems inherent in the Ice Age. The rapid snap-back in the improvement of households debt/net wealth ratio recently, may leave the consumer rueing that they allowed debt to accumulate as rapidly as they did as a % of income over the bubble years (see chart below). 

Nor will rapid household income growth bail the consumer out. Despite further tax cuts, we expect post-tax income to grow at an extremely slow pace over the next few years in our view, more in line with the low nominal 1% growth in the wage and salary bill (see chart below and our US economist, Kevin Logan’s recent weekly Declining wealth, rising debt: a consumer spending trap, 6 December 2002) 

In a deflationary environment, debt sticks. But as the Fed tries to keep the balls in the air a while longer (or heads in the punch-bowl) and fights the Austrian cycle, their need to flip-over to Plan B may be increasingly close.  

The situation in the US housing market is critical. Recent data shows house price inflation abating and the fear is that this asset class also begins to feel the icy deflationary feeling that the rest of the economy has already felt. Most worrying of all, with the recent wave of re-financing, households now hold a record low of equity in their houses (see chart below). 

It is salutatory to compare the US’s record high 44% mortgage share of household real estate value with the UK. Gearing is fine as long as asset values hold firm – as we found out in the UK to our cost in the late 1980s and Japan, Hong Kong and Germany is finding now! The comparison with the current UK housing bubble (which of course will all end in tears) is bracing. In the UK, the mortgage share in the housing stock is a measly 28% --close to its 10 year average. 

So where we end up is with the world authorities realising the end-game for the Ice Age is getting closer. Trade tension and competitive devaluation are just par for the course in this environment. Attempts to deal with the deflationary threat by boosting aggregate demand via getting the private sector to heap on even more debt are ultimately doomed to failure and the alternative - embracing the Austrian Cycle and hence the recession to cure the deflation - cannot be countenanced by the policy makers. 

Hence the alternative - private sector debt default via the creation of higher inflation - will increasingly be embraced. Inflation burn off of debt is, after all, what happened at the end of every cycle over the last 40 years. That is why Plan B will need to be adopted along with increasingly aggressive conventional policy measures such as the abandonment of all pretence of fiscal restraint. 

The crisis we see unfolding early next year in the equity market with decisive new lows reached alongside the increasing prospects of insolvencies in the banking and insurance sector will force the authorities hand, quicker than if they were just watching the on-creep of deflation itself. On clear articulation of a move to Plan B in the US we will seek to participate in what we expect to be a V shaped equity recovery. And although this may ultimately prove to be another bear market rally (depending on the effectiveness of the measures implemented) any equity rally is likely to make the four 25% bear market rallies to date, look like minor hi-cups.

Bernie Schaeffer: My 2003 Market Forecast
1/3/2003 9:30:47 AM

When I discuss the "fundamentals" with investors or the media, it is often with the caveat that "I'm not a fundamental analyst." My late and much-lamented dad, Jack Schaeffer, might respond, "Are you bragging or complaining?"

In fact, there is not much for fundamental analysts to brag about these days. During my appearance on the November 15, 2002 edition of Wall Street Week, I discussed (using WorldCom as my example) the fact that fundamental analysis provides no inherent exit strategy. It is thus fully exposed to the "death-spiral" process whereby, as a stock declines to lower and lower depths, it is deemed more and more of a "value" by the fundamental analyst. The terrible price action is almost always followed by a "deterioration in the fundamentals," at which point some (but not all) analysts will jump ship. But not before severe (and in many cases fatal) damage has been sustained to the portfolios of their followers.

Wall Street Week host Geoffrey Colvin responded that many would say this problem was due to "conflicted analysts," and unfortunately we then moved on to another topic. Here's my belated response to Geoffrey. This is not a "conflicted analyst problem." It is a "fundamental analysis problem." The tenets of fundamental analysis are inconsistent with the tenets of controlling losses, which guarantees that this approach (and the investors who follow it) will lose big money in a bear market.

But will fundamental analysis make big money in a bull market? Not necessarily, as often a fundamental analyst will jump off a rising stock because his or her price target has been achieved or the stock has become too "richly valued." In other words, the effect of fundamental analysis is often to cut profits short while at the same time allowing losses to become open-ended. Is this the exact opposite of the formula for success in investing? Yes.

So I may be bragging a bit when I disclaim being a fundamental analyst. But I also have a complaint – mostly with myself – when I make such a statement. Because in developing my market forecast for 2003, I realized that in many ways, the fundamentals are important to me, though not in the traditional sense.

I refer to my approach to investing as Expectational Analysis®. Much of this approach has to do with sentiment analysis, along the traditional lines of taking a contrarian approach when investors are excessively bullish or excessively bearish. I deem excessive bearish sentiment in the context of strong technical price action to be particularly compelling as a contrary indicator, and I found this to be the case throughout most of the bull market of the 1990s. Similarly, excessive bullish sentiment in the context of weak technical price action is also a compelling contrary indicator, and I've found this to be the case during the current bear market.

But while the process of superimposing an analysis of investor sentiment atop technical analysis can provide a very powerful timing tool, there is more involved in my Expectational Analysis® approach. And this "more" has to do with my approach to the fundamentals, which is a two-step process. First, I try to develop an objective view of the economy and corporate earnings in terms of where we are and the spectrum of future possibilities. Note that my goal is not to "forecast" economic growth or earnings growth, but to focus on a realistic assessment of the possibilities. Allow me to digress for a moment. Fundamental analysts love to smugly assert that it is impossible to forecast future price action from past price action. In other words, technical analysis is built on impossibility. I'll defer the defense of technical analysis for a future column. But here's part of my reply to those smug fundamental analysts. It is impossible to forecast the future direction of the economy and corporate profits. The best one can do is to develop a number of potential scenarios, assign some probabilities to them, and move on.

I chuckle when I hear an economist or analyst forecasting GDP growth down to the tenth of a percent level for four quarters out, and then disclaim that "if we go to war with Iraq or if there is a terrorist attack on American soil, all bets are off." Much obliged. And while we're at it, all bets would also be off if the dollar collapsed, if the real estate bubble popped, if the consumer retrenched and stopped spending, and if business investment was totally unresponsive to zero interest rates.

My purpose is primarily to illustrate the folly of "single point forecasts," but also to illustrate that such forecasts tend to be "best case." Why? First, because most "wild card" events that can seriously affect such forecasts tend to have a negative impact. And second, the vast majority of the forecasters are employed by firms whose interests would be best served by a strong or improving economy and a bull market. "Whose bread I eat, his song I sing."

So what's the next step in my Expectational Analysis® once I develop my "spectrum of future possibilities" for the economy and corporate earnings? I compare this spectrum to the prognostications of the community of economists and analysts who make the traditional single-point forecasts. If I find the aggregation of these single-point forecasts to be excessively optimistic, my conclusion will be that the market, whose current price reflects these forecasts, is vulnerable to disappointment. And if I find these forecasts to be excessively pessimistic (this does happen – but mostly during bull-market periods), my conclusion will be that the market could benefit from positive surprises.

Let's now move on to my outlook for 2003.

Fundamental backdrop
We all know the bullish case for the economy and the market in 2003. The economy is beginning to recover, the most recent Fed rate cut will help solidify this recovery, the Fed's "reflation" commitment will successfully head off potential deflation, price/earnings ratios (albeit based on tenuous 2003 earnings-growth estimates and the inflated "operating earnings" still accepted by Wall Street) are reasonable, and profit margins are improving. Productivity growth remains high. Dividend and other federal tax relief is on the way. Liquidity is impressive, what with all the money that has fled to bonds and to money market funds and with the Fed running the dollar printing press 24/7. The stock market is extremely unlikely to decline for four consecutive years, and the third year of a presidential term is always bullish for the market. The unspoken assumptions are that overseas wars will be brief and relatively painless and there will be no terrorist attacks of significance on American soil.

What are some of the flies in the above ointment? Per James Grant, the S&P P/E ratio thought to be "reasonable" is currently about 50 based on "core earnings" (defined by Standard & Poor's as excluding such goodies as gains on pensions and including options as an expense). As for other measures of market valuation, Bianco Research (by way of Grant's Interest Rate Observer) reports that the ratio of total market cap to GDP is currently just over 100 percent. While this is down from the all-time high of 183 percent at the 2000 market peak, it compares unfavorably to a figure of 81.4 percent on the eve of the 1929 market crash. GDP growth unquestionably decelerated in the fourth quarter of 2002, so there is little economic momentum as we move into the New Year.

Year-over-year corporate profit growth was a mere five percent in the third quarter but is expected to be +12 percent in the fourth quarter and to accelerate further in 2003 despite the recent deceleration in GDP. Sequential earnings barely budged from the second quarter to the third quarter. Earnings are being "grown" due to "cost cutting" – read "layoffs" – as opposed to top-line revenue growth. The Fed rate cuts have done little to stimulate the economy but have done much to put the consumer deeply in debt and stimulate a potential real estate bubble, both of which are serious threats to continued heavy consumer spending. Weak holiday season sales might be a first indication of a weakening consumer. "Reflation" could help touch off a major plunge in the dollar and a massive outflow of foreign money from U.S. financial assets. Dividend tax relief may get swept aside as the continuing tide of corporate layoffs fuels additional anger toward those who are "rich" and those who have jobs. And any stimulation from tax relief on the investment front may be more than offset by tax increases and spending cuts from cash-starved state governments. If the market can rally for five consecutive years (1995-1999), why is it so improbable that it decline for four? And war and terrorism can paralyze the economy if they escalate dramatically.

So there you have it. A potential economic recovery in 2003 on one hand and numerous risks to that recovery on the other hand. So how are the economists sifting through these various potential scenarios – this "spectrum of future possibilities" – in terms of their forecasts for 2003? The answer turns out to be quite simple. Of the 62 economists polled in the December 30, 2002 issue of BusinessWeek in their annual economic survey, exactly two are forecasting negative corporate earnings growth in 2003. In addition, each of these 62 economists was asked to forecast GDP growth for each quarter in 2003. Of these 248 quarterly GDP forecasts (62 times 4), exactly zero predicted negative economic growth. Let me rephrase this for additional emphasis. Not a single one of the 62 economists in the BusinessWeek economic survey for 2003 believes that the U.S. economy will experience a single down quarter. And finally, quarterly economic growth in 2003 is expected to proceed in a smooth upward progression, beginning with +2.7 percent for the first quarter (which is likely to be a good deal higher than that for fourth quarter 2002) and ending with +3.6 percent for the fourth quarter.

At this point, you don't need me to conclude for you that the economic forecast for 2003 underlying today's stock prices is biased in the extreme toward the best case. Nor do you need me to further conclude that under these circumstances, the market is vulnerable to being punished should this best-case scenario not materialize. What's more, the market is vulnerable to being mangled beyond recognition in the event of a worst-case scenario.

Does this mean that the best-case scenario (or a reasonable facsimile) cannot or will not develop? No. It simply means that the potential rewards in terms of stock price appreciation in 2003 under the positive economic scenarios are modest compared to the potential risks in terms of stock price depreciation under the negative economic scenarios. Despite this negatively skewed reward/risk ratio, Wall Street and the vast majority of the mutual fund management community are more than willing to make the bullish bet for 2003 with your money, just as they were in 2002, 2001, and 2000. Are you?

Technical backdrop
The importance of utilizing long-term charts and long-term moving averages for gaining the perspective needed for forecasting has never been greater, as the heightened market volatility in recent years has substantially increased the "noise" component for the shorter time frames. And speaking of noise and volatility, set forth below are the major rallies and declines in the Dow Jones Industrial Average (.INDU) for the period 2000 through 2002.

Does the above period strike you as a "devastating bear market," or just a "rollercoaster" characterized by "bookend" rallies and declines? Of course, the mathematics of cumulative gains and losses are such that gains and losses that are roughly equal over time will bottom line to a net loss. This effect plus the "unanswered" 7.8-percent decline at the end of the period were sufficient to produce a cumulative loss of nearly 30 percent.

Now check out the monthly chart below of the .INDU since 1995 with its 10-month and 80-month moving averages. Note that the 10-month moving average has been in a steadily declining mode since early 2001, and how the monthly .INDU closes have become more and more consistent below this trendline. Note also how the 80-month moving average is rising from below, and how the index's decline in September 2001 was contained on a closing basis at this longer-term trendline. But the 80-month was broken on a closing basis in July 2002, and since August 2002 it has not been penetrated to the upside even on an intra-month basis. Note also the "compression" of the declining 10-month and rising 80-month as the trendlines began converging until they ultimately crossed in December 2002. The .INDU rally in early December failed right at this critical juncture in the 9000 region.

My conclusions from this chart? We are mired in a very serious bear market, and despite all the volatile upside bounces, the bulls have not only failed to take control but are steadily losing ground in their battle with the bears. The failure by the .INDU last month at the convergence of the two long-term moving averages was extremely compelling technically, and it foretells yet another downside leg that is likely to take out the October 2002 lows.

Is this technical scenario set in stone? By no means. Technical analysis merely provides a road map of past price action that can be very helpful in forecasting future price action. So the best I can say is that the odds favor a continuation of the bear market. I can't quantify these odds, but I can quantify the point at which the technicals will improve significantly. Should the .INDU rally above 9000 and its 10-month and 80-month moving averages, and should the 10-month moving average begin to flatten and then turn to the upside, the .INDU would emerge from its bear market mode. But unless and until this occurs, the "trend that is your friend" – whether or not you want such a "friend" – is to the downside.

In addition to the road map provided by this chart, it is also extremely helpful in establishing a context for investor sentiment. When (as now) we are in a clear bear market, investor sentiment is expected to be bearish. To the extent that such sentiment can instead be interpreted as bullish or hopeful, the conclusion is that the bear market has not yet bottomed. More on this in my next section.

Why, you might ask, am I focusing here on the Dow Jones Industrial Average? For two reasons. First, it is the "headline index" that most investors use as a proxy for "the market." And second, the .INDU has outperformed other major indices in recent years to such an extent that it is not out of the question to refer to a .INDU relative-strength chart as a "bubble."

Below is a chart of the 14-year relative strength of the .INDU compared to the S&P 500 Index (SPX). For the past 20-plus years (including a period that predates this chart), the .INDU's relative-strength line has fluctuated above and below a mean relative strength value of 100. So at its current value of 125, the .INDU is 25 percent higher relative to the SPX than its "norm." Must the .INDU revert to its mean, and, even if it does, must this occur in 2003? No and no. But it is clear to me that the .INDU is the most vulnerable of all the major indices, and that it is likely to "lead" the next market leg down. And on this next leg down, it would not be unreasonable to expect the .INDU to give back half of its current excess relative to the SPX, which would amount to as much as 1,000 points of additional .INDU downside.

My final chart is that of the U.S. Dollar Index (DX/Y), monthly from 1988 to date with its 10-month and 80-month moving averages. After my discussion of the comparably situated .INDU chart above, it should come as no surprise to you that I see the technical picture for the dollar as both dire and dangerous. And there would be nothing nice in store for the U.S. financial markets following a sharp plunge in the dollar in 2003.

Sentiment backdrop
Bear markets persist when sentiment is hopeful and they end when all hope is gone.

I can think of no better illustration of this principle than the following quotations from The Plungers and the Peacocks by Dana L. Thomas, the best book ever written on the history of Wall Street.

"Many astute traders had accurately called the turn in 1929. During the summer (of 1929), the market looked extremely perilous to them and they withdrew, converting substantial paper profits into cash, taking shelter just in time from the hurricane. Then, still using their heads and following the time-tested maxims of classic trading strategy, they reentered after the (October 1929) crash, buying stocks at 'rock bottom' levels in anticipation of the expected rally … These were skilled professional traders, wise in their lore of the market, an astute minority that had accurately estimated the situation only a few months previously – and now (in late-1930) they too were being destroyed by a market that simply refused to act according to any historic pattern or rational line of behavior."

"Edwin Lefevre, a veteran financial writer who had been covering the Wall Street scene for thirty years and was personally acquainted with many of the top operators, conducted a survey in 1932 to find out just how the boys who had guessed right in 1929 were doing. Time after time he ran across men who had bought cheap stocks in 1930 and sold them at tremendous losses in 1931."

"In the summer of 1932, the stock market once again displayed its perverse penchant for doing the absolutely unexpected. Just as the majority of pundits failed to guess the top in 1929, so now they were unable to guess the bottom. Suddenly, without the slightest warning, when business was at its worst, when everybody was overwhelmingly bearish and there seemed to be no hope, the market started upward again. The low point of the decline was reached on July 8, 1932. The next day, stocks began to rally and within the next sixty days the averages shot up 90 percent in the quickest, sharpest, most precipitous climb in history."

So the majority of pundits failed to guess the top in 1929 and couldn't guess the subsequent bottom. Fast-forward to today. Clearly, the majority failed to guess the top in 2000. So is there any reason to think they'll be any more proficient in calling the ultimate bottom of this bear market? For further background, let's take a look in the table below at the results of The BusinessWeek Market Survey since 1995, when the venerable business magazine began polling upwards of 50 market strategists for their forecasts for the next year.

If you need convincing about the adages that "Bull Markets Climb a Wall of Worry" and "Bear Markets Decline on a Slope of Hope," just review the table above. The forecasts ahead of the four bull market years (1995-1999) were all well short of the actual result. Ignoring the transition year of 2000, the forecasts for the two bear market years (2001 and 2002) have been well in excess of the actual result. In fact, the more deeply we've moved into the bear market, the more aggressively bullish the forecasts have become.

Dissecting the data from the 2003 forecast a bit, we find that of the 65 prognosticators with Dow forecasts, 25 saw the Dow closing out 2003 above 10000 and just five saw the Dow below 9000. This is a remarkable statistic, given that the Dow was in the 8500 area when these forecasts were being developed. And how many of these 65 saw a declining Dow for 2003 – a close below 8500? Three.

The "Slope of Hope" (a term first coined by Bob Prechter) is not only alive, it is alive and kicking. Expectations for the market in 2003 are simply too aggressive, and they become even more out of line when considered in the context of the questionable fundamentals and the weak technicals.

Once again, this does not mean that the market cannot or will not be higher by yearend 2003, or that a monster rally will not occur this year. It simply means that the bull trade is still too crowded, which drastically lowers the odds that a final market bottom will be achieved in 2003. At what point will the odds be strongest for a bottom? To borrow from Dana Thomas, "When business is at its worst, when everybody is overwhelmingly bearish and there seems to be no hope."

Conclusion
I expect 2003 to be another bear market year.

I do not rule out an extension of the rally that began on the first trading day of the year through the end of January. If this rally occurs, it is likely to be a major fake-out that will result in an avalanche of money flowing into equities at just the wrong time.

I expect the bulk of the damage to have occurred by mid-year or shortly thereafter, with a potential Dow low in the 5800-6000 area.

I look for a rally beginning in the second half of the year that could take the Dow back above 8000, but only if the Dow first takes out the October 2002 lows and trades down to at least 6500.

I see Nasdaq and the techs as being the least vulnerable to a first-half slide and the Nasdaq potentially posting a gain of up to 50 percent for 2003. I am most bullish on the small- and mid-cap techs – the "single-digit midgets."

I see the biggest cap names in the Dow and the S&P as being most vulnerable to major declines. Many of these stocks have attracted "safe haven" money due to their large capitalizations and liquidity and the illusion of safety. But I see these names as being "first out" of institutional portfolios on the next market leg down. These include Pfizer (PFE), 3M (MMM), Procter & Gamble (PG), Citigroup (C) and General Electric (GE).

Overall, 2003 is likely to be a very tough year for heretofore "safe" or "quality" assets – mega-cap stocks, the dollar, and bonds. I suggest "thinking speculatively" – not with all your capital but with a portion of your funds – by investing in low-priced tech stocks and gold stocks (see below).

I continue to believe that all investors should have at least 10 percent of their portfolios in precious metals stocks. Gold has broken out to the upside technically and will be the beneficiary of the Fed's "reflation" push and potential dollar weakness. And investor enthusiasm on gold remains muted, with gold funds accounting for a smaller than average percentage of sector fund assets.

Morning Market Comments January 3, 2003       www.haysmarketfocus.com

The Year Ahead--2003
The Decade Ahead—2003-2013
by Don R. Hays

Year-Ahead Overview:

Psychologists tell me that very few people, much less than 10%, will continue to pursue something if they have been rejected three times. After one rejection or rebuke the majority will be able to persevere, will believe it is just a one-time anomaly, but the second failure begins to weed out the majority. But three rejections is the kiss of death that totally defeats almost everyone’s enthusiasm for pursuit of a goal or an ideal. Nothing dictates this year’s year-ahead market projections that seem to be flowing out of every mouth in the investment world like this psychological principle. Look at the economy. The economy has been measured to grow for the first three quarters of 2002 at an annualized rate of 3.4%. The 30-year average has been 3.1%, so 2002’s economic growth was above average. The unemployment rate, even after moving up on what many believe was a one-month aberration to 6%, is right at the level that Alan Greenspan consistently told us through-out the first 10 years of his tenure as head of the Federal Reserve to be the "full-employment" rate. Even at this peak level of unemployment for this economic cycle, it is still slightly under the 30-year average. But the stock market has ignored this economic recovery, and has produced its third straight year of negative performance. Hence, the three down years of stock market performance is definitely biasing these year-ahead projections to a very negative interpretation of the improved economic conditions.

History certainly tells us that the "stars" are lined up to produce a very favorable market in 2003. In other words, the seasonal November to April tendencies, coupled with the third year of the Presidential election cycle, has never produced a down year in the last 50 years. Historically measuring from the market troughs of the "second" year, i.e. 2002, of the historic Presidential election cycles to the peak of the election year, i.e. 2004 shows the average gain has been 60% + in the last 50 years. It has not produced one loss in any of those periods. This is not just one of those random types of similarities, but coincides with the time frame that the Administration is always doing everything in its power, and that is a considerable power, to make the voters feel happy and comfortable. So typically in these periods, it is easier for the economy, corporate earnings, and favorable tax policy to make the headlines to help cheer the potential voter. If you don’t believe me, just read this morning’s paper at the new Bush proposals. This is in sharp contrast to the typical first two years of the Presidential election cycles, when the presiding Administrations try to get all their tough acts completed, and are not politically motivated to make any special attempt to put a favorable light on news and events. That has certainly been the case for the last two years.

But not withstanding the very favorable seasonal juncture that we are entering, as I resist the natural skepticism generated from the last three years of negative performance in the market and just look at the facts, I see a very good year facing us. I expect the economy to gradually gain strength as the year progresses, with a combination of capital expenditures and inventory replenishment finally coming in to spur the economy. Yesterday’s ISM composite, in an almost exact correlation to the emergence from the 1990-91 recession, was a good example of what I am expecting. This economic strength is expected to show a growing strength throughout the year, as capital expenditures, and the Y2K technology hardware and software replacement "echo" kicks in. But since the stock market always looks ahead, I believe that the strongest part of the market rally will occur well ahead of the strongest economic quarter of the year—the fourth quarter. In fact, the market seems to be poised to rally almost right out of the January 2, 2003 starting gate. I believe the majority of stock market performance for the year will be produced in the first six months, with the last six months starting a more volatile digestion of those initial gains.

The stock market is the world’s best barometer to measure all factors that influence our well being and national character. So why didn’t it rally last year, as the economy rebounded from the recession of 2001? The answer, of course, was a huge abundance of other items ranging from the Terrorists attacks and threats, corporate malfeasance, and corporate earning concerns. The extent of these cross-currents was as severe as anytime since the 1974 calamities that were severely affecting the U.S. and the world. The cross-currents have certainly not disappeared, but in most cases are declining in their shock effect. We now face a new year, after three years when investors have scurried to the safety of the sidelines. As a result, they have built up a treasure chest of $2.8 trillion dollars in savings accounts alone. $469 billion of that has been added in just the last 12 months.

Bull markets are renowned for climbing a "wall of worry," and with that huge potential buying power now shivering on the sidelines, any good news (and return of optimism) will start this money starting to seep back into the investment arena offering the most attractive potential return. Historically, that has been stocks, especially if purchased from periods when the fear has driven stocks down to extreme lows. With today’s historic low yield being offered by the fixed income markets, i.e. t-bills and money market, stocks are the most attractive of any time in at least 30 years on a comparative valuation.

In this initial 6-month rally, I expect the stock market to move back to the approximate levels where they were at the end of the first quarter of 2002. That would produce an increase in the Dow Jones Industrial Average of 24.7%, 30.4% in the S&P 500, and 38.2% in the NASDAQ Composite. I expect the stocks and sectors that were impacted  the most in that 2002 decline to experience the greatest gains, which means the telecommunication, information technology, Utilities, and healthcare to be the best performers.

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That is my overview of the next 12 months, but it doesn’t even move the needle on a meter to measure the really important story that is unfolding as we start this year. There has only been two other times in American history that come close to comparing with today’s view of the tomorrow’s outlook for the U.S. and probably even more so for the world. So now let’s start from the beginning and look at where the market is right now, giving a few little particulars, but then trying to expand that if time allows into the outlook for the next decade.

As you can see, the traditional mirror image, if it continues to unfold as I expect, has an almost perfect time horizon on the right side of the head as the left side. In fact, the left hand side, from the left shoulder to the head took 53 days, and the right side took 56 days. You can readily see that the right shoulder did not, or at least has not yet, come down to the same level as the left shoulder. That is not uncommon, and in fact if my desired resolution comes about, this higher level is a sign of strength about the ensuing rally. The indices that have the highest right shoulder in relation to the left shoulder are showing the greatest potential for the next six months, which also helps to explain the higher targets for the NASDAQ over the Dow and S&P indices.

Of course, one day doesn’t make a trend but it happened almost perfectly on schedule, and was explained by the very strong release yesterday from the ISM manufacturing composite. If you remember my explanation for the reverse head and shoulders, this is also exactly on script. In other words, the worst news is always at the left shoulder, and the highest selling volume occurs there as well. The news at the head juncture improves slightly, but not actually an improvement showing growth, but more of a moderation of the worsening news. Even though the indices make lower lows at that head juncture, the number of stocks making new lows and the volume decreases from those levels reached at the left shoulder. But finally at the right shoulder, in an environment with extremely low volume the catalyst that finally lifts the market off the shoulder is the first hint that the economy (or the crisis of the moment) is being lifted somewhat. It is not universally accepted by all, in fact most doubt the staying power, but the market knows and takes off with vigor. The lift-off from the right shoulder HAS TO HAVE increasing volume, and build as the rally takes off. 

Let’s take a look at the economic indicator that sparked the rally yesterday, and in particular pay attention to the comparison with the action in the lift-off from the 1990-91 juncture that led to the longest economic recovery in history. It also led to a stock market that produced 300% gains in the next 8 years even by the stodgy old Dow.

This very widely watched survey of the supply managers of manufacturers, is nothing more than confirmation of the "inventory replenishment" that I have been projecting, and also has already been measured in surveys from New York, Philadelphia and Chicago for the last two months. But let’s go back and review the 1990-91 example. I remember well the amazement of us all in that 1990-91 period when the fear of corporate managers and the struggle to get productive, as they didn’t have the prior high inflation to help boost their revenues, produced the lowest inventory to sales ratio in history. It was 1.56 to 1. Well fast forward to the fears produced in the wake of the huge cross-currents of 9-11, an even lower inflation rate, and the intense scrutiny being placed on corporate managers to produce honest results. In the latest month, the inventory to sales ratio dropped to 1.33, totally eclipsing that bare-bones inventory levels of 1991. 

So in 1990-91 they remained bare-bones in their inventory until finally they woke up one morning and found sales were slowly growing and they didn’t have anything to put back on the shelves out front. They really turned it on, and you can see after a very volatile action in the ISM composite it went to new highs as they scrambled to restock. The faint line on the graph shows the volatile monthly action. Now, once again, fast forward to yesterday’s release. We are not including it, but the new orders part of this survey soared to 63.3, one of the highest readings in history. This same exact similar trend is occurring in the unemployment insurance claims.

It is not part of this story, but more of an excuse I guess, but you can vividly see how the economy was already improving before 9-11 changed the world. That event immediately changed the economic environment, and drove a huge new wave of cut-backs and freezing of new capital expenditures by the world’s corporations. I believe history will show that 9-11 was the most important event to get the world purified (certainly not perfect, but a far better condition than the greed induced period prior to that.) This new purity and transparency on U.S. (and world) corporations is setting the stage for a much better investment future, as the world (and especially the U.S.) gets ready to capitalize the growth and spread of capitalism in the world in the next decade.

While the headlines are moaning and groaning about Christmas sales, quietly in the back pages I read this morning that last minute and post Christmas shopping surged last week. I also got a report that gift certificates made up 15-20% of all purchases in the pre-Christmas season, and those sales are not measured in the retail statistics until actually redeemed, so that is a huge potential that changes the overall perception once the final statistics all get counted. I have not been expecting a block-buster Christmas this year, but believe even a moderate one will put the heat on replenishing the historically low inventory levels. Yesterday’s ISM report was some confirmation of that, and I expect that to only topple the next domino.

What is the next domino? It is the huge potential when the postponed capital expenditures from the last three years begin to kick in. They have been postponed as one crisis after another has caused fears of the Apocalypse. But we now have the end of major software service support of old product coming up, as well as old and outdated hardware that has been pushed far over the recommended replacement time-line.

So here is my time-line. So far the consumer, with improving real wages and low interest rates, has kept this economy on track. That is not about to stop. They have been increasing their savings rate and now have $2.8 trillion in savings accounts alone. But we are already seeing some increase in capital expenditures, and just like the inventory replenishment cycle, it enhances the next phase of economic recovery. With a huge backlog of outdated technology, the improving cash flow is now going to encourage a much faster cycle of capex than today’s 3-times defeated economists and corporate mangers can envision in today’s state of defeatism.

That’s important, of course, but that doesn’t even begin to compare with the real economic enhancer that the next decade is going to produce from the spread of Democracy and Capitalism. Every new job will produce a new consumer that will produce a new job. The U.S. consumer has kept the world afloat during this tough period of transition for the world that began when the Berlin wall came down in 1989. But now it is blossoming out all over.

Of course, the easiest example to illustrate this is China, but look at South Korea today in relation to even 15 years ago when they still had the threat of big money from Communist Soviet Union and China keeping North Korea on life-support. Look at Cuba who is opening courting the U.S. in Castro’s old age. Neither of those examples are yet perfectly solved and transformed into Democracy, but rebels in Argentina and Iran are certainly pushing the envelope, and this is only the beginning. I am almost amused by the reaction and intense fear of everyone about North Korea. Of course, it is scary of what they could do in a suicide crisis attack, but look behind the veil of public opinion.

Guess who the South Korean’s are turning to for help in diffusing this situation--China. Good old Capitalism. China is absolutely dependent on the U.S., and their huge support of North Korea in the past is now about to show that egotistical monster that is the ruler of North Korea that the monetary spigot will dry up totally if they don’t get back in line. This is also the "behind the scenes" reason for Castro’s new kinder and gentler attitude. In front of the cameras and their people, they are not going to start cozying up to the big old successful former enemy Uncle Sam, but behind the scenes they see the handwriting on the wall.

China will be the headline generator in this next decade’s historic economic recovery. The U.S. consumer will be almost a non-event, as the 180 million working population of the U.S. will have a hard time stacking up against even the 20 million new Chinese workers that are being added every year to their working force. Today’s news of the Citigroup’s new purchase of a bank in China is the beginning to a trend. In the next decade, the U.S. will be the country that furnishes the capital, or at least leads the consortiums, to keep this amazing economic expansion on track. That, plus the technology leadership as the five waves of technology explodes out of the embryo that has been in the gestation phase for the last 50 years. This explosion of technology will include massive changes in personal computers and telecommunications. These new combination wireless phone/computers are just a small example of the evolution. In 10 years I suspect I’ll be dictating this into my computer if the miracle wave of bio-genetics can keep this old man ticking. And that computer will be in my shirt pocket. The last two waves, alternative energy and nanotechnology are developing much faster than even I imagined when I first started talking about this emerging phenomenon back in 1995. Recent headlines are revealing why the Arab countries had better make as much on their oil reserves in these next few years as they can, because alternative energy is really going to start catching on the next three years.

So let me get to the time-line again. Inventory replenishment produces a real step-up in manufacturing production for the next six months, capital expenditures and the Y2K echo kick in much faster than expected by the second quarter of this year. The European economy lags badly until April and May, but the strength in the euro will keep the ECB on the ball for the first time, and their short-term rates and tax policy and work rules will take a sharp turn in the next year toward economic growth—pro business. They will be struggling to keep up for the entire decade since they have so much entrenched socialism, but they have no recourse. It is either change or totally die, and that is not an option.

China will allow their currency to float this year, and that will be another big step in their efforts to succeed as a capitalist country. They have huge problems to overcome, but just like the U.S. Presidential election cycle, I expect the new regime in China to do the tough things early in their regime, and that means reinforcing their very weak state banks, (the Citi-group announcement is the first step in my opinion), closing unprofitable state run corporations as private corporations soak up the excess workers, and producing an international currency with no artificial supports.

But the key date for China’s real coming out will be 2008 in my opinion, as they host the Olympics in Beijing. They can’t wait until 2007 to light the fire, however, so I expect their government to do the tough things this year, and draw closer and closer to the new consortium of the U.S., the U.K., and Russia. 

My crystal ball for the world’s economy depends heavily on the U.S. recovery this year and next. It then will get a boost from Europe in a couple of years, and then China will really kick in by the time Bush’s second term begins in 2004. That kicking in of China’s real growth spurt will be like a turbocharger to the world’s economies.

Now here is the one projection that I expect will get the most barbs. But I have never seen such universal scorn being heaped on Japan’s chances of survival, and for some strange reason their Nikkei Dow has outperformed the S&P 500 in the last 12 months. And in the heat of the worst press clippings, the Nikkei Dow has produced a triple bottom in the last three months, with the interday lows making slightly higher lows. I find this intriguing. I also find it intriguing that almost every Japanese government leader is encouraging a weaker yen, and it simply won’t weaken. Does the market know something? Is this the best contrary indicator?

I’m going to guess that the answer is yes. So as a very powerful incentive, maybe the next two years will also see the Japanese finally escaping the death grip of their LDP party, and get their bank problem written off, releasing the huge savings potential of the Japanese consumer. This would be icing on the cake. I’m not betting on this one yet with real money, but urging you to keep an open mind on this important part of the globe.

Okay, that takes care of the next year, and the next decade, so I guess all I have to do for the next 12 months is worry about the next day or two. I’ll see you on Monday my friends. I consider it a real honor to have you take the time to read my market projections, and my wish is that they help in some small manner to separate the wheat from the chaff.

I’ll see you again on Monday morning. Cheers!!

Reprinted with permission.