Ned Davis on this bear market:
August 19th, 2002
Taking the Measure Of a Bear
We're in a secular downturn, says a legendary analyst, but the
market will rally now and then
An Interview With Ned Davis -- Long relied on as a fount of market statistics
and historical data, Davis is mostly known for his ability to sort through it all and
find measurable signs pointing to what the future holds. His indicators picked up
on the bear market's beginnings in 1998, yet also suggested trends were such that
it would be too early to pull out of the market, which didn't meet its comeuppance
until March 2000.
Davis might rightly be considered a quant's quant.
His Venice, Fla.-based Ned Davis Research -- a
technical-analysis outfit he started in 1980 on leaving
Nashville brokerage firm J.C. Bradford, where he
was chief investment strategist -- now counts 720
firms and 3,900 portfolio managers and securities
analysts as clients. Moreover, the firm manages
$125 million as a subadviser on an asset-allocation
mutual fund offered by Aon Corp. and an additional
$30 million for another Fortune 500 company's
pension plan. About four years ago, Davis started an
in-house hedge fund that is up a cumulative 33%
since inception and is in positive territory this year.
Davis updated his classic 1991 tome, "Being Right
or Making Money," to address what he calls "The
Bubble of 2000," and now he's out with another
update comparing the bubble market's peak to the
here and now. To learn what's in store, please read
on.
--Sandra Ward
Barron's: You turned very cautious in the late 'Nineties, but your trend indicators
kept you in the market as the "Bubble of 2000" was built.
Davis: It was a tough situation. The trend indicators were positive but not very.
The advance-decline line and the Value Line Geometric Index topped out in April
of 1998, and yet the S&P 500 and the popular averages kept making new highs. It
was not a broad rally, and that was one of the things that kept us cautious, but the
action of the averages kept us mildly bullish. It is common for breadth in
unweighted averages to top out before the market does, but the two years of bad
breadth we experienced in the late 'Nineties was an unusually long period.
Q: Was there ever a similarly extended period?
A: The late 'Twenties. The data is a little suspect, but at the time breadth topped
out for about a year before the market peaked in 1929.
Q: You've just come out with an update on the bubble market. What do your
indicators point to now?
A: A decent bottom was made last September and we turned bullish for a cyclical
swing in the beginning of October, but we have said all along we are in a secular
bear market. April of 1998 was the beginning of a secular bear market. September
was a good bottom for an intermediate cyclical swing, but it didn't represent a
long-term bull market because the market had a valuation ceiling. The market
began to deteriorate again and all the tape indicators turned negative, and the
market hit a new low in late July. Lately we've had some signs we're starting
another cyclical upswing. The rallies we've had suggest a base is being formed
and we expect the market to rally for most of the rest of the year. September, on
a seasonal basis, is historically the worst time of the year in the market, but overall
it will be a pretty good rest of the year. But I don't think this cyclical rally is going
to be a whole lot different than the one that began last September because of
secular pressures.
Q: So it lasts for a matter of months before losing steam?
A: Yes. We've had record oversold ratings. If you look at the up and down
volume and what percentage of it is in advancing stocks and declining stocks,
you'll find what we call a waterfall decline: two days or more in which 90% of
volume is on the down side and two on the up side. The New York Stock
Exchange data didn't show it, but our own database of the 1,500 largest
companies showed we had two 9-to-1 down days and then two 9-to-1 up days.
That is our definition of a selling climax. We've had record volumes and the
market made new lows before turning up. Normally, you would get a new cyclical
bull market out of that. This time, we'll see something more like last September,
but it will not be a sustained rally.
Q: Why won't this time proceed as normal?
A: There were a number of bubbles at the top, as there normally are, but the
biggest one was a valuation bubble in the stock market, and that bubble is
reverting to the mean. When something reverts to the mean, it usually more than
reverts and results in an oversold condition. So that bubble is only partly
corrected. The other big bubble is the explosion in debt. When the debt was issued
there was collateral to back it up, so it didn't look all that dangerous at the top.
What always happens, though, is that the assets disappear and the liabilities don't.
While 257 public companies with $258 billion worth of assets defaulted last year
and went bankrupt, the debt actually has continued to grow right through the bear
market.
Q: Are you worried only about corporate debt?
A: No. It's pretty much across the board. The only area of debt that has shown
any great improvement is margin debt, and it is still way above the 15-year mean
average. While margin debt has almost been cut in half, it's not fully corrected.
The rest of the debt -- household debt and corporate debt and overall
credit-market debt -- is now $29.9 trillion dollars, or 2.9 times GDP. And there is
less collateral for the debt, and that makes it a more serious situation. The debt
bubble is our biggest concern.
Q: Any other concerns?
A: The trade deficit was another bubble created by too much spending and not
enough savings, and so far the trade deficit is still at record levels. There were a
few minor inflationary problems, but those have been taken care of. Now we are
close enough to deflation to be worried about that. Lower inflation is nearly
always bullish unless it turns into deflation. The Fed was tightening at the top, of
course, and the 6% discount rate is nearly always a trigger for bursting bubbles. I
don't know why it's a magic number, but it ended the bubble in Japan and it ended
the bubble here in 1929 and it ended the bubble this cycle. The discount rate is
way down, the Fed's friendly, you've got a severe oversold condition, you've got
no inflation, you've got an economy turning around and you can make a pretty
bullish cyclical case. But we have this lingering hangover from the bubble, and we
don't feel it's been fully corrected. In 1962 and 1987, the sharp selloffs that we
experienced were disconnected from a generally rising economy, too. Yet in those
periods we were in secular bull markets. Now we are not.
Q: What's your overall sentiment? Are you more bearish or bullish?
A: On a trading basis, we are mildly bullish. We're making the case we are in a
cyclical upswing at this point. There's a four-year cycle in the market. It may be
tied to presidential elections or not. People try all kinds of ways to rationalize it.
Anyway, there's typically a bottom made either in the summer or the fall of the
second year of a presidential term. The pre-election year is usually the best year
for the market. I can't say we're out of the woods here. Most selling climaxes in
the waterfall pattern have a test and there may be a test in the fall, but after that
the odds are pretty good we'll have a rally much like we had last September and
then probably run into trouble again next year. Japan had a really bad two-year
bear market and they're right where they were 10 years ago. These secular bear
markets take all different forms. The last one in the U.S. lasted from 1966 until
1982. It went on for 16 years, and yet there were a lot of cyclical bull rallies in
between. So if you've got the patience to wait 16 years, you can say you're not
going to buy until stocks get cheap enough. For those of us in the business who
have some trading flexibility, we try to call cyclical swings.
Q: There's been
a big debate
raging about
whether you buy
or hold or trade
this market.
A: From 1966
to 1982, the
only way you
could have
made any
money was to
trade, so it's
hard to say buy
and hold is right
for everybody
all the time or
that trading is
right for
everybody. You
have to adjust to
the market
situation.
Q: Are you
concerned we
will slip into a
depression?
A: The key to a
depression is
deflation. The
psychology that
sets in becomes
one of putting
off spending
because prices
are only going
lower and
paying back debt becomes extremely painful. Real interest rates soar even though
they are low on a nominal basis. Deflationary accidents are associated with every
depression. Japan has had lower prices for about 33 months in a row. I wouldn't
say they're in a depression, but they have fought it tooth and nail. They brought
interest rates to near zero. While there are some things about the Japanese system
I don't like, the lack of openness and competitiveness for instance, there is one
thing in their favor: the Japanese have always been huge savers. We're big
spenders. Our low savings puts us at risk for a deflationary accident. The
producer-price index is already down a little over 1% from a year ago. If you start
seeing the consumer-price index go down and stay down, the risk of deflation will
rise dramatically.
Q: So far the consumer has held up. Will that continue?
A: On the consumer side, mortgage rates have gone down dramatically, and that's
allowed people to refinance and stay liquid. We've had huge tax cuts. We've had
much lower interest rates from the Fed. On top of that, the automobile companies
came in and offered zero-percent loans. So the ability to service the debt looks
pretty good now. But this cycle took the savings rate down to something we've
never seen. Household debt as a percentage of GDP is way up. At the top of the
bubble, household debt to GDP was about 72%; now it's 79%. Debt has
continued to skyrocket during this bear market. Consider how many times the Fed
has cut rates and the stock market hasn't responded. And how we've had a good
cyclical low like September 2001 followed within months by the start of an
economic expansion, and yet stocks still go down and make new lows. That has
never happened except in Japan after 1989 and in the U.S. after the 1929 bubble.
This is not a good sign. There's a bigger problem here than just a bear market or a
couple of corporate bad apples. The debt is still here but the collateral's gone. We
had a Goldilocks economy in the 'Nineties, and the question becomes, Is this a
Humpty-Dumpty economy?
Q: What about the real-estate market? Is there a
bubble forming there?
A: I suspect in the high-end markets and resort
markets there is some sort of bubble. We don't feel
comfortable talking about a housing bubble, though,
because housing stocks themselves are one of the
lower P/E groups in the market and I wouldn't
equate them to anything we saw in Japan. If there is
a housing bubble, it is relatively minor. But the fact
is, people have taken so much money out of their
houses with home equity loans that they're sitting
there with very little equity. It's not a great situation.
Debt is just a four-letter word to me. I am sure there
are times when everybody has to go into debt for
this thing or that, but we really make a lifestyle of it
in this country and it's dangerous.
Q: If we are going to have cyclical bull markets
within a secular bear market, are there ways to take
advantage of those rallies?
A: Right now we're at a point where we are stymied because the market started
down in April of 1998 led by Old Economy stocks while the New Economy
stocks continued to soar into March 2000. When the market started breaking and
the bear market got started, there was a whole area of stocks that represented
huge relative, and even decent absolute, valuation. We had about a year and a half
bull-market rally in value and small-cap-value stocks while growth got
slaughtered. There is usually about a 50% higher premium on growth stock
multiples than value, and now the premium is around 35%, suggesting growth is a
better relative value. We've also done studies on what happens when the dollar
declines and found that the benefits accrue to large-cap stocks rather than small
caps. We were in small-cap value and we've been taking our bets off the table
because we don't see a great style play here. If anything, large-cap growth would
be the favorite style play here, but only by a small margin. It's not really a great
bet. An interesting thing about this bear market and one of the reasons people have
stayed pretty complacent during it is because there were areas to hide in. That
was true up until the past month, when pretty much everything got taken apart.
Q: So where do you hide?
A: Bonds would be one place to look. Since 1998, stocks and bonds have traded
in opposite directions. The inflation picture still looks very good. And bond yields
are high enough relative to inflation to look like pretty good values if the stock
market gets a bit of a rally here and bonds sell off. Utility stocks are usually a
beacon in the storm of a bear market, but because of the collapse of the telecom
and gas-utility sectors, the whole utility area has been beaten up. Those stocks
look pretty reasonable and they might hold up in a selloff. But if you want to be in
the market, you're going to have to be willing to buy the oversold stocks and be
willing to get out when they rally.
Q: What are your favorite or most reliable indicators?
A: Our emphasis is on supply and demand indicators. We are real interested in
liquidity and debt in the overall economy and in the stock market.
Q: So you put a lot of weight on mutual-fund flows?
A: Mutual-fund flows are interesting. An indicator tracking mutual-fund cash has
really worked well for a very long period of time. In the mid-to-late 'Nineties, cash
in mutual funds got really, really low and it stayed low and the explanation was
because index funds weren't supposed to hold any cash. But if you take the index
funds out of the picture, cash is still low. Maybe the indicator is not the same as it
once was, but on the other hand, there is evidence that mutual funds just don't
have any money to buy stocks. In 1990, mutual funds had 12% or more of their
portfolios in cash. Now they have 4.4% in cash. That's a concern, and something
that could undermine a sustained rally. We also look at institutional holdings
besides mutual funds, and we look at household holdings of stocks. As a
percentage of financial assets, household stockholdings hit 46% in March 2000,
the highest it has ever been. It has dropped to 35%, but it is still way above the
50-year norm of 24%. And institutions still hold more than their long-term
average, so I think institutions across the board are fairly fully invested.
Q: You've refrained from assigning blame for all this. Are you critical at all of
Fed Chairman Greenspan?
A: I criticize him on two factors, and the second one is more a personal thing.
The main fault I have with him is the discussion about a bubble in September of
1996 at the Fed when Larry Lindsey recognized there was a bubble and advised
the best time to stop it was before the froth got really big. Greenspan essentially
said if there were a bubble, it could be stopped by raising margin requirements.
Yet he never raised margin requirements. He responded in December of that year
by talking about "irrational exuberance." He needed to raise margin requirements.
I'm absolutely convinced the bubble is a lot bigger than it might have been had
they raised margin requirements. My other criticism is how he cut interest rates in
surprise moves. It is one thing if you have an intra-monthly meeting and you
decide to do something and you think the time is right. But three times he cut
interest rates with about an hour left in the market. Twice he did it in an
option-expiration week, near the end of the week, when all the traders are short a
bunch of puts and calls. It looked like a move of genius in that it sparked huge
rallies and restored confidence. But to me, it looked like manipulation of the stock
market, and it backfired because it scared the heck out of the bond market. The
bond market reacted as if the Fed was trying to put this bubble back together
again. Since then, every time the market gets going and begins to act well, the
bond market goes down. The link was broken when bond market participants felt
as if the authorities would do anything to stimulate the market. To get a long-term
bull market, we need a healthy bond market and we need bonds to behave, and
that means yields have to keep coming down. We need to get long-term rates
down. Otherwise, Greenspan has done a very good job.
Q: What would be the importance of bringing long rates down?
A: During the great bull markets of the 'Forties and the 'Fifties, and even the
'Sixties and early 'Seventies, long-term interest rates stayed on average about 3%
below nominal GDP growth rates. In other words, if you borrowed money at,
say, 6% but your sales rose 9%, it was pretty easy to service the debt.
That relationship continued up until 1980. Then the situation totally reversed.
Long-term interest rates have averaged 2%-3% higher than nominal GDP growth,
and that has made it more painful to service debt. That's what broke the secular
inflation that we had in the 'Seventies and into early 1980, and that's what's been
keeping the pressure on the downside. I'm watching that relationship, and so far
there is no change. Nominal growth has been very low over the last year and
remains relatively low.
People point out that long rates are way down, yet relative to nominal GDP
growth they are still at pretty painful levels. My guess is when the debt market is
better deflated or savings have been rebuilt and the system is healthier, long rates
will come down, and that will be another sign that this unpleasant era is over. |
