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U.S. Stock Market Outlook –2005: Storm Clouds on the Horizon?

by Mark Reiner, The Doctor's Investment Fund, LLC

NEW YORK -- Volatility is likely to increase in the equities market in 2005 from the historically low levels witnessed last year. This confluence of events will likely add to uncertainty, making it a bear market year.

Equity investors are currently complacent. Their optimism is reflected in record high investment advisor bullishness, low levels of equity derivatives volatility and a surge of insider sales. Late last year, insiders were selling approximately $60 in stock for every dollar purchased. This is troubling, as corporate management is generally more astute about their respective businesses, than perpetually optimistic Wall Street analysts.

While equity markets had been contained in a very narrow trading band for much of last year, the reelection of President Bush proved to be the catalyst for a relief rally, which measured approximately 5% on a monthly closing basis. Post election rallies are common in bear markets. During the last secular bear market of the 1970-80s, we experienced four post-election rallies. Each peaked during the following January, followed by harsh declines that did not bottom until the following year. The average move of these four rallies was 5.92% with subsequent declines measuring approximately 34%. These rallies occurred during periods of rising short-term rates and an expanding economy -- conditions similar to the current environment.

Bear markets have spectacular rallies, designed to suck investors in, whereas bull markets have violent corrections to shake out as many shareholders as possible before resuming their steady climb. The market has recently been contained to a narrow trading range, marking approximately a 50% retracement of its previous drop. Historical patterns from previous bear markets suggest the market may stall at this juncture, before resuming the next leg down of the bear market.

Subsequent to the president’s reelection, the US Dollar weakened markedly, while US equities continued to rise. This dollar weakness can be attributed to the twin deficits and record low consumer solvency. There is also concern amongst foreigners, that the U.S. will not be able to finance its current account deficit as foreign inflows lag the liabilities generated.

The dollar fell approximately 30% during Bush’s first term. The trajectory of this move is more than the “adjustment”, called for by many politicians and journalists. If this trend continues, a number of U.S. trading partners could be thrown into recession. In a worst-case scenario, the dollar could lose its status as the world’s reserve currency, with ominous implications. That is not a far-fetched thesis, as the English pound had been the world’s reserve currency earlier this century. The pound lost its prized status, as England became the world’s largest debtor. During the last year, a number of OPEC members proposed that oil should be priced in Euros and as world economic power and concentration moves to the Asian block, there remains the possibility of a drastic change in world currency supremacy.

A major propellant extending this rally has been the president’s plan to privatize Social Security. This proposal has created more greed in the market, as Wall Street strategists extrapolate an insatiable demand for equities. If this measure passes, there will be a supply of securities to meet the investment dollars, as Wall Street has traditionally been more than willing to issue new issues for public consumption.

However, most individuals are not capable of prudently managing their portfolios and this initiative may lead to financial hardship for many intended participants. We have recently witnessed a return of the public investor to the equities market. This group had been sitting on the sidelines, after being devastated by the puncturing of the NASDAQ bubble. Today, however, many have been actively purchasing many new “dream tickets”, such as satellite radio stocks, new internet concepts and stun-gun plays. This type of activity is not the foundation of a sustained market advance. It is usually witnessed as the market enters its last leg, prior to rolling over.

Even more worrisome is the additional debt burden this proposal would put on the system. Adding retirement accounts in place of Social Security could cost the government close to $2 trillion over the next decade, since these accounts would not go towards paying current retirees. To fund this expenditure, the government would have to borrow additional funds. As the president promised he would not increase taxes, passage of this proposal would be an additional fiscal burden.

To date, foreigners have been the largest purchaser of U.S. debt. This has helped to stabilize interest rates. As the dollar continues to decline, their purchasing habits may change, and they will look to be compensated for additional currency risk and the potential for principle erosion. Any sudden or significant change is likely to have a negative impact. It would be wise to remember upward movement in interest rates and a precipitous dollar decline were the primary causes of the 1987 correction.

Short-term rates have backed up at an unprecedented rate since the summer. While base rates were at a 46-year low when this move started -- the speed of the increase and rate of change is alarming. Changes in monetary policy take approximately six to nine months to impact the economy. Having assumed record levels of adjustable debt, U.S. consumers may be forced to drastically change their spending habits. This would have a dramatic impact -- as consumer spending has been responsible for 70% of GDP growth.

A forecasted slow down of the economy is also reflected in a narrowing yield-curve since the Federal Reserve Board embarked on a policy change. On June 30th, the overnight cost of capital was 1% and the 10-year Treasury note was yielding 4.60%. Last month -- with 2.25% overnight rates, the 10-year note yielded 4.15%. The 30-year US Treasury bond also had a commensurate drop in yield. If the economy was truly expanding, intermediate and longer term rates would have had commensurate increases. One might imagine, however, the change in relative rates is expressing the reality of the economy as opposed to the hope currently reflected in stock prices.

Other factors the market will have to wrestle with during the new-year include Alan Greenspan’s retirement, a possible economic slowdown in China, a permanently higher floor for the price in energy, inflationary pressures and the end of the re-finance boom. In addition, FASB 123, takes affect on 06/15/04. This regulation requires public companies to expense stock options in their current financial statements. It is projected that this expense will impact S and P 500 earnings by 3-5 percent. At a minimum this means these are additional elements of risk that will enter the equation.

While the current direction remains to be seen, investors would be well advised to consider that the bear market we entered in 2000 may again resume over the coming year. As the honeymoon period for the re-election continues to fade, and investors start to focus on trouble within the U.S. economy, it is unclear whether it will be possible to sustain the optimism now prevalent within the investment community
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Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Associate Editor: Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Russell L. Smith, Caroline G. Cooper, Mark Reiner, Jean-Marc F. Blanchard and Kumar Amitav Chaliha



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