Decision Point Alert
By Carl Swenlin
November 16, 2002
decisionpoint.com
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LONG-TERM MARKET ENVIRONMENT
This section articulates our view of the long-term structural elements
affecting the economy and stock market. It is included in each issue of our
weekly commentary, although it is only changed or adjusted infrequently as
our opinion changes.
Secular Bear: We are in a secular bear market unlike any seen in the
last 70 years. Even the most experienced professionals will find that much of
what they thought they knew is wrong and does not apply to the current
environment. So-called valuation models have been rendered useless because
interest rates are so grotesquely low, not because stocks have become
attractive values. Beware of the universal reference to "operating earnings".
They are artificially enhanced, deceptive, and do not reflect the true
financial condition of any company.
Investor Psychology: There has been a major reversal of investor
psychology. During the bull market, investors were ignorant of risk and
thought they were invincible. That innocence is gone forever, replaced by
fear, pessimism, and despair. This generation of investors will never again
be capable of another extended round of irrational exuberance. Never.
Bearish Technicals: Because the long-term trend is down, technical
analysis rules now favor bearish resolutions of chart patterns over bullish
resolutions by roughly 70%. Bullish setups are more likely to fail, and
bearish setups are more likely to execute as expected. More often than not
resistance will turn back rallies, and support will fail.
High Valuations: The bear market should last until current extremely
high valuations have been corrected, probably to an undervalued extreme of
S&P 500 P/E of around 10. Historically such corrections have been
accomplished by price declines, not an earnings recovery.
Housing Bubble: After stocks, the second area in the economy where
valuations have reached irrational levels is housing. Whether there is a
bubble is not determined by the fact that people are still buying, rather it
is determined by a sensible assessment of value. In many areas one can rent a
house for half of what it costs to buy one. Does this sound remotely like
buying stocks that have no earnings? As with all bubbles, the breaking point
is hard to predict, but the danger signs are there. A factor that heightens
the danger is that many people have borrowed to close to the limit of their
equity. A modest pullback in housing prices would put these homeowners under
water, unable to sell the home for as much as is owed on the mortgage.
High Debt: Another fundamental element with disastrous implications is
the potential unwinding (collapse) of high levels of corporate and consumer
debt. Debt expands in a bull market, and bear markets punish those who
borrowed stupidly. Bankruptcies do not occur in a vacuum, they seriously
affect creditors and ultimately cause more bankruptcies. As companies fail or
cut back, the job market suffers, which in turn puts pressure on consumers,
who are not be able to service their debt. As personal bankruptcies increase,
mortgage defaults create an oversupply in housing and force prices down to
the point that mortgages exceed the value of the homes that secure them,
which sets the scene for more personal bankruptcies. Once the process gets
started, it can send the economy into a death spiral.
Higher Taxes: All levels of government are experiencing enormous tax
revenue shortfalls, and politicians and bureaucrats always respond by raising
taxes. Taxes kill economic growth.
Terrorism: If terrorists are able to acquire weapons of mass
destruction, they will use them. If they are successful just once, 9/11 will
pale in comparison. The war on terrorism, assuming we are going to pursue
actions such as the invasion of Iraq, will be expensive and protracted. The
whole process will be a continuous psychological and monetary drain.
Downside Targets: My current downside projection is for 350 on the
S&P 500 (plus or minus about 100 points) with the final low arriving around
December 2003 (plus or minus a couple of months). I expect comparable
declines for the Dow (3700) and Nasdaq (500). These projections are supported
by very simple, basic technical projections (trend lines and cycles) and
fundamental valuation measures. For now I am using as a model the type of
decline experienced during the 1929-1932 Bear Market. This is a treacherous
environment, suitable only for trading.
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