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.
![[ Clients ]](../../../clients/aha.gif){kind=link}