Downside Risk Extremely High
Although the historic financial bubble of 1998 to 2000 has burst, the market continues to struggle and the
imbalances built up through the boom period have not been corrected. These imbalances include a highly
overvalued market, a glut of capacity (particularly in technology), record indebtedness, an extremely low
consumer savings rate and an unsustainable trade deficit. In this financial and economic environment the
turmoil in accounting, the troubles in Japan, and the virtual bankruptcy of Argentina are not isolated
occurrences to be blithely explained away. They are symptomatic of a burst bubble that is only in the early
stages of being unwound. Even now the majority of investors remain complacent and act as if they are still
more afraid of missing the next upturn than they are of losing a significant portion of their savings in a
deep and prolonged bear market. In our view the market will make a major bottom only after the vast
majority give up and throw in the towel. Bottoms are made in an atmosphere of gloom and despair when
most are no longer heavily invested in equities. That is not the case today.
Since March 2000 the market has made a series of lower highs and lower lows, the textbook definition of a
major downtrend that is still in force. The late September 2001 low was lower than the March 2001 low and
the recent January rally top was lower than the May 2001 rally high. During the long period of above
average market returns from 1982 to March 2000 investors came to believe that such returns were normal,
and that to make a fortune one had only to buy and hold. Those days, however, are rapidly fading into the
past. One day investors will wake up and realize that the S&P 500 at its close today was at same level as in
March 1998, almost four years ago. That’s virtually no return except for meager dividends over a four-year
period, much less than the compounded rate of return of cash equivalents over the same time span.
The bulk of the recent rally was accomplished in the first few weeks of the move. At its close today the S&P
500 was back at a level first reached on October 17. In our view this is a classic rally top and the current
risks are extremely high.
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