20-30% decline in market possible:
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Special MarketCentral Report For April 7, 1998
The stock market has rocketed past our predicted target area of 9000 on the Dow
Jones Industrial average (see our March 3rd and January 14th reports) and is now
poised for an intermediate term decline. The big question is when does this decline
begin and how deep a decline will we get. Considering all the media hype surrounding
Dow 9000, the continuing money flows into mutual funds and the stable interest rate
and inflation backdrop, we would expect a few more weeks of continued market
strength before a meaningful decline begins. However, we would not rule out a
short-term pullback from the current overextended levels.
The current rally unfolded as expected and recent excessive speculation and euphoria
have surrounded such issues as America Online, Lucent Technologies, Amazon,
Yahoo, etc. Each market top exhibits it's own unique characteristics as tops in the
past have shown excess speculation in the chip makers, airlines, computers, casinos
and other industry groups. We can't rule out one last euphoric blast, but it is late in
the day for the current advance that started in October at 7000 on the Dow and we
believe the next major market event will be an intermediate term correction. At this
point it is difficult to predict the severity of any decline as we would have to see
rising interest rates, a weakening earnings backdrop, rising inflation and/or other
negative economic events to predict more than a normal 10% or so correction.
The current rally has led to an overextended market with the price earnings ratio on
the Dow at a record 26.7 and rising. Our momentum indicators (see chart) are
exhibiting warning signs that indicate a significant decline to begin within the next
several weeks. Technically speaking, New Highs vs. New Lows and Net Advances
vs. Declines are still positive but we are beginning to see some deterioration in those
numbers. The last two days has seen the Nasdaq, Transportation Average and
Utilities diverge negatively vs. the Dow so market internals have weakened during the
final phase of the current rally.
We are also concerned that interest rates may begin to rise and inflationary
expectations are increasing. Recent strength in gold and silver, a possible bottom in
oil prices and continuing wage price pressures in addition to bullish chart patterns on
interest rates lead us to believe that higher interest rates are directly ahead. Adding to
the negatives is the slower earnings growth rates that are already occuring and is
likely to continue into the second half of 1998. With a record Price Earnings ratio now
present, any disappointments or negative economic news will likely cause lower stock
prices to bring this ratio to a more reasonable level. In fact, we wouldn't be surprised
by a 20-30% drop off the highs of this rally before the market stabilizes.
Another warning sign is the mega deal between Citicorp and Travelers. The biggest
deals tend to occur at or near market tops so it is not surprising that this deal was
announced on the very day the Dow closed for the first time above 9000. We believe
this is a warning sign of euphoria and exuberance as value goes out the window and
optimism reigns. A more sober atmosphere will return after the next market decline.
We are pleased with the action in the metals area, especially the gold and silver
stocks. We have been recommending a steady accumulation of the gold and silver
stocks and we stated that the stocks were trading at historic lows as measured by the
Philadelphia Gold and Silver Stock Index (XAU). So far the index has rallied nearly
50% off the lows (see chart) and additional gains seem likely. What is important to
note is rallies in the precious metals area tend to precede intermediate to longer term
market declines and lead moves to higher interest rates. So, this early warning sign is
already in gear and further reinforces our market outlook.
Should market conditions change we will inform our subscribers of any changes in
our outlook with a Special MarketCentral Report.
Roy Spectorman
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