Chapter 18: "Bull" Market?

It was on a weekend during the winter of 2004 and I was getting suspicions of the coming of another Fed-induced bubble like the one of the late 1990s. Social psychology seemed to be becoming more optimistic. However, it was not perfectly clear if it was just a general boom throughout the economy, or a bubble in a particular sector. I decided to take a look for myself.

It would be hard to deny that the American stock exchanges are experiencing bull markets. Last year (2003) the NASDAQ was up over 50 percent while the Dow 30 and S&P 500 had gains of 25 percent, and it seems that everyone is bullish this year. The Dow Theory (which is not much of a theory) tells us that we are in a bull market. If you are a follower of the “January effect,” where the month of January somehow determines the fate of the market for the year, you should also have a bullish outlook because all the stock market indexes ended the month in positive territory.

Only the New England Patriots’ victory would seem to have spoiled the party. The Super Bowl indicator predicts a good year for the stock market if a team from the old NFC wins and a bad year when a team from the AFC wins. Then again the Super Bowl indicator has lost some of its magic in recent years. Maybe we should switch to political indicators, which would suggest big gains in stocks during an election year.

But is the stock market truly showing signs of prosperity, or is it just BS?

I would like to suggest the latter and that it might not be a good time for you to obtain a home-equity loan to invest in hot tech stocks. We are going through a housing bubble, and stock valuations as measured by stock price-to-earnings ratios are at bubble levels. The buy low, sell high philosophy would lead you to sell stocks now, not buy them.

I’m not suggesting that you sell your house or cash in your retirement funds, only that you don’t throw caution to the wind and abandon traditional guidelines. Over 90 percent of stocks are now trading above their two-hundred-day moving average. I usually think of selling stocks, or at least stop buying them, when this indicator approaches 80 percent and then throw the cash back into the market when it gets down to the 20–30 percent level. At a minimum, investors should take the time to evaluate their assets and portfolio allocations between stocks, bonds, cash, and gold — between speculation and safety.

What is the case for a BS stock market based on?

First, the Federal Reserve has pushed short-term interest rates down to historically low levels. This has certainly buoyed stock prices, but it also has stymied savings and encouraged increases in consumption and debt. Americans have low levels of savings and high levels of debt, and this is simply not good for the health of the economy. In fact, statistics indicate that Americans have been taking money out of saving accounts and putting it into the stock market, but are not increasing their overall savings.

Second, the federal government has increased spending and debt at a rapid rate. Both are bad for the health of the economy, but do serve to keep up the appearance of prosperity in economic statistics such as GDP and the unemployment rate. When economic recovery is fueled by government spending, combined with stimulated consumption spending and housing construction, how real can the prosperity be?

Looking backward, we should also remember the decrease in the value of the dollar. Thanks to the Federal Reserve, the US dollar index lost approximately 15 percent of its value in 2003. If you had parked your money in a foreign bank or foreign bonds you could have avoided the loss plus earned interest, making the 25 percent gains on US stocks hardly spectacular in comparison.

Looking forward, we should note that the percentage of investment advisors who are bullish on the market is near the highest level experienced over the last four years. The percentage of investment advisors who are bearish is near the lowest level over the same time period. This psychological indicator is a contrarian indicator in that the larger the number of bulls and the smaller the number of bears, the more likely is a “correction” in the stock market. It is not a perfect indicator — nothing is — but it does line up with economic analysis in finding some trouble ahead in the US stock market.

This takes me to my disclaimer. If investment advisors as a group tend to be wrong about the future of the stock market, then how good can my advice and analysis be? The answer is caveat emptor, and that’s no BS.