BARRON'S: Taking The Measure Of A Bear: We're In A Secular Downturn, Says A
Legendary Analyst, But The Market Will Rally Now And Then
16 Aug 23:15
By Sandra Ward
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.
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 havebeen 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 hadhuge 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 seculays to take advantage of those rallies?
A: Right now we're at apoint 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.
Q: Thanks, Ned. |
