Posted on 01/18/2006 7:52:44 AM PST by misterrob
Part I of this series reviewed our stimulus driven, real estate-reliant, post-bubble economy. Part II looked at the cycles of bull and bear markets, and how history suggests trouble ahead for U.S. stocks -- despite the strong start to 2006.
Today we focus on how it could all come together or, as the case may be, come apart. I'll detail how to get to my 2006 target of Dow 6800 -- the lowest (by far) in the Business Week survey -- and lay out a scenario for how the S&P 500 could take a 30% haircut this year. Before the Fall
With everyone so focused on the bearish year-end forecast, many have overlooked my expectations for early 2006. As the Business Week survey shows, my first half Nasdaq prediction of 2620 was the single most bullish in the group, while my mid-year S&P call of 1350 was in the top 10 of nearly 80 forecasters. I also forecast Dow 11,800 by mid-year. (For the record, the survey was conducted in early December.)
Why the bull call before the fall? Because that's how market tops get made: In the 12 months leading up to the October 1987 highs, the Dow ran from 1800 to 2700 (a 50% gain), while the S&P 500 sprinted from under 240 to about 340 (about 42%). From October 1999 to March 2000, the Nasdaq nearly doubled. Although I don't expect anywhere near those gains in the first half of 2006, the pattern could be quite similar: A leap to new highs on some widely held assumption, which subsequently turns out to be false.
In the present case, several suppositions potentially fit the bill: The widespread expectations that the Federal Reserve will halt tightening sooner rather than later and that the U.S. consumer will keep spending. And do you know anyone who doesn't believe earnings will remain robust? The Case of the Overdue Correction
One oddity of the move off of the prewar lows in 2003 is that the S&P 500 has yet to have a 10% correction. During the bull market period from 1996-2000, there were six corrections of 10% or more. Since the bottom on March 5, 2003, the S&P has sustained only three corrections of more than 6% and none greater than 9%.
Regular corrections serve a purpose for healthy markets: They cleanse the excesses that tend to develop, allowing further gains to proceed.
The lack of a 10% correction reveals high levels of complacency -- something the CBOE Market Volatility Index (VIX) has been implying for quite some time. This creates "air pockets" -- soft spots in the base of support that can potentially become more vulnerable to selling in the event of a test. As the 1966-1982 chart shows, broad trading ranges typically experience much greater than 10% corrections. Considering how regularly markets pull back and test support, the longer we go without that 10% correction, the greater the possibility of a steeper and deeper downturn.
The suggestion of a 30% fall in the S&P 500 has engendered widespread disbelief; investors broadly discount the mere possibility of such a correction. But as the nearby chart shows, there were five corrections that ranged in strength from 25% to 45% from 1966 to 1982. That averages out to one major correction every 38 months or so.
The S&P's last major correction was a 33% drop from March to July 2002. That was 42 months ago -- implying we are overdue for another steep decline. Structural Imbalances Create Vulnerability
Past crises such as the Asian currency crisis and the Long-Term Capital Management meltdown were able to be managed because of economic strength. When they occurred, markets were in the midst of a bull run and the economy was growing organically. The Fed had lots of room to add liquidity. The economy shuddered a bit, but handled these shocks well.
Ups and Downs The 1966-82 experience says we may be in for violent moves down and rapid blastoffs
Source: Rydex Funds
Today, the economy has far greater structural imbalances. As the markets get further extended, they become increasingly less able to absorb what has become euphemistically described as "an externality." As the current account deficit rises and the U.S. fiscal deficit worsens, so too does our ability to shake off an economic disturbance. Nouriel Roubini, professor of economics at New York University's Stern School of Business, calls this an "increased probability of a systemic risk episode." Getting to 6800
What would have to occur for 2006 to be the strong year for the Dow many are expecting? Forget Goldilocks, we would need a Cinderella scenario, where nothing goes wrong, and many things go precisely right: Earnings must stay robust, while energy prices and inflation moderate. The consumer would have to keep spending, despite signs of tiring. Businesses would need to build on third-quarter capex spending, and begin to hire in earnest. All of the vulnerable Dow stocks would have to avoid their major issues, or even a minor hiccup.
None of the negative "externalities" currently contemplated -- from a major bird flu outbreak to protectionist legislation or other policy mistake to an energy shock to a dollar crash to a geopolitical crisis over Iran's nuclear ambitions -- can come to pass, much less something currently not on the radar. Finally, equities would somehow manage to avoid the regular corrections so common in secular bear markets.
If Cinderella fails to show, how might the Dow work its way down toward 6800?
The momentum from the beginning of the year should carry stocks higher into February. But a series of earnings disappointments and a few negative surprises from select names -- think DuPont (DD:NYSE) and Alcoa (AA:NYSE) -- creates a wobbly market. Disappointments after the close Tuesday from IBM (IBM:NYSE) , Intel (INTC:Nasdaq) and Yahoo! (YHOO:Nasdaq) won't help matters and may prevent the early 2006 momentum from carrying as far as I originally thought.
Investors start to gradually recognize that all is not well in the economy. The P/E multiple compression discussed in part II only adds pressure to stock prices, as does options-expensing. Companies on calendar years are required to expense options, starting this quarter. The effects of expensing options will be seen in first-quarter and full-year guidance.
Vulnerable Giants
This scenario won't collapse the market, but makes it vulnerable.
Perhaps the first-quarter rally has trouble gaining traction in the second. A modest downslide starts, as first-quarter earnings are reported. The bulls declare it a mere retracement and buying opportunity. But it turns out not to be; by the second quarter, the cyclical high for 2006 already has been put in.
How does this possibly get us to 6800? The Dow is calculated via a divisor, currently 0.12493117.
A point of each Dow stock's movement is equal to a little over 8 points on the index. It's not too hard to imagine that as earnings slow, stocks begin to soften. A loss of 5 points on each component adds up to a Dow drop of 1,200 points (40 points times 30 stocks = 1200) -- that brings us to Dow 9800. And that's only 5 points; a 10-point-per-Dow-stock drop would drive the average to 8600.
All it will take will be a modest earnings slowdown, and the Dow slips below 10,000. That happens, and apprehension levels rise in earnest. Dip-buyers who bought stocks 1,000 points higher are upside-down.
Now imagine what happens if any of the highfliers -- say Google (GOOG:Nasdaq) or Apple (AAPL:Nasdaq) has a miss, or simply lowers guidance to reflect the slowing consumer. Or perhaps Home Depot (HD:NYSE) and Lowe's (LOW:NYSE) feel the pinch of slowing housing and refinancing activity.
Given the heavily promotional holiday-price cuts, I expect that many retailers -- Wal-Mart (WMT:NYSE) , Target (TGT:NYSE) on the low end, Tiffany (TIF:NYSE) and Nordstrom (JWN:NYSE) on the high end -- will see the margin pressure impact earnings.
The spillover effect will be substantial. And if the same happens in any one of the pricier Dow components -- Boeing (BA:NYSE) , United Technologies (UTX:NYSE) and 3M (MMM:NYSE) are all vulnerable -- we can easily see a day when the Dow is down 300 points.
In Japan, an investigation into Livedoor -- hardly a premier Internet company -- was a convenient excuse to whack the Nikkei 225 stock index down 462.08.
If breaking 10,000 will make traders nervous, below 9000 the fear levels will be palpable. At that point, any one of our laundry list of negative catalysts might come into play. In my war-gamed scenarios, the dollar doesn't have to go into crisis, and the avian pandemic need not kill millions; instead, the investing public need only become alarmed that something nasty might occur to take fear levels up toward panic.
The move from Dow 8800 to 6800 won't be a rational, calmly contemplated affair. No one will be quietly wondering about option-expensing or multiple compression. Instead, it will be a severe overreaction to some external event.
If and when that happens, it likely will be the best buying opportunity in the markets since the October 2002 cyclical lows.
DOW had been essentially flat for 6 yrs now with unprecedented liquidity courtesy of Greenspan. Next move probably will be down.
Goldbug Alert!
Never mind that technical stuff. The most certain indicator of a correction is that my wife just started buying stocks again.
Every time she gets the notion, something bad happens.
Me thinks this guy is an idiot -- not because a 30% decline can't happen, because clearly it has and will happen again -- but because he fails to recognize that we are currently in a long term bear market that happens to be going through a cylical bull market. As a result his historical comparisons are meaningless. I've said it before and I will say it again, that the market is going to to do whatever it wants to do whenever it decides to do it, and our job as investors is not to try to predict, but rather, to react without overreacting.
Are you a goldbug or just referring to the fact that gold has more than doubled over the same time period?
If no action is taken, when Iran gets nukes it will then block the Straits and the world economy will crash.
I would expect the straits to be blocked for a maximum of 24 hours.
Actually, if we have a shooting war with Iran the Dow could drop to around the 7,500 range reached as an aftereffect of the 9/11 attacks. I'd start investing in oil, gold, diamond and platinum stocks because you know those will hit the roof in value as investors reach for the safety of these commodities.
The vertical run up looks more like 1929 than 1965, but who knows what tomorrow will bring.
One thing for sure, PMs look way better than equities....unless you're talking energy, commodities, mining etc.
... or the flight time of a sub-launched Tomahawk to target, whichever comes first.
Only ONE way the Dow will decline 30+% in 2006. An Oil crisis.
Question: how many mobile Silkworm anti-ship cruise missiles does Iran have?
Question: how many days did it take to knock out all of Saddam's mobile SCUDs during Desert Storm?
(We never did.)
Well Said.
A monumental terrorist act would do the trick as well.
Naw... the only reason the Dow will decline is more sellers than buyers :-)
those russian silkworm missiles are going to really help the iranians when we fire salvo's of anti-ship harpoon missiles from submarines and F-15's at whatever Hitler Jr tries to block the strait with.
http://www.fas.org/man/dod-101/sys/smart/agm-84.htm
How does a Tomahawk open up the Straits of Hormuz, if the Iranians have 100s of hidden mobile Silkworm anti-ship cruise missiles, and they pop a couple off a day, (the way Saddam did with his SCUDs during every day of the Desert Storm air war?)
Not so. The number of sellers and buyers are always the same, no matter what the market it doing.
What does that have to do with ANYTHING if the Iranians have 100s of MOBILE, HIDDEN Silkworm anti-ship cruise missiles? Do you assume we know where every single Iranian Silkworm is hidden?
Are you aware of how many much larger mobile SCUDs we successfully destroyed before launching during the Desert Storm air war? Depending on who you read, from a handful to zero. Saddam's mobile SCUDs were launched on every day of that monthlong air war.
Sure, the SCUDs ended up not stopping us, but the equation is very different when you are taling about sea-skimming silkworms targeting fat slow oil tankers.
Once the tankers are burning, the insurance companies will declare that a state of war exists in the region, and they will cancel their policies.
This is one of the many ways that Iran can bottle up the Persian Gulf oil flow.
If the Iranians used their military to attempt such a thing from the land, it would cause fits for us and we would have to go into a fairly large war footing to put a stop to it. At that point it would be an issue of how much the Iranians were willing to lose to maintain such a condition...and how long we would be willing to attack them (and not just the launchers, but their C&C, infrastructure and other military units (anti-air, radar, etc.)). Given the economic considerations, we would go to whatever lengths necessary...but it would hurt economically, pehaps greatly, before we could put a complete stop to it.
If it were just their small Navy trying to launch them, that would be one thing...but if they are launching them from land launchers, particularly mobile ones, or from aircraft...then it gets much more dicey and involved as you correctly point out.
I keep reading rosy-scenarios like "In 12 hours we would crush them in an airwar" and I have serious doubts.
As I recall, we never had any success finding and destroying Iraqi mobile SCUDs during Desert Storm, and I wonder if Iran would be able to just pop off a couple of Silkworms a day to keep the oil flow stopped.
Look at this list of Iranian missile imports!
http://www.nti.org/e_research/profiles/Iran/Missile/2420.html
It's really just a function of how you look at it. Since it's low point in late 2002, the market is up about 50%. NASDAQ, on the other hand, remains about 60% below it's 2000 peak.
The Greenspan comment I don't totally agree with. He choked off the economy with a Fed rate of 6.5% in mid 2000.
You have FRemail
"Another problem with unbridled S-200 proliferation is the relative ease with which the interceptors can be converted into ballistic missiles. The S-200 is particularly suitable for conversion because it was originally designed to carry a large HE or nuclear warhead. In addition, the S-200 has a substantial range even in its unmodified state. With appropriate upgrades and modifications, rogue nations and terrorist-sponsoring states could significantly increase the range of the S-200, the end result being a highly capable offensive weapon
Not so right back at you: it's the number of shares wanted to buy and wanted for sale that ultimately will be equal as the market clears at the lower price. It's an old joke, anyway.
Good grief.
Not funny. She's already asking for more money to make up what she just lost.
Oh, damn. You were serious!
Not to mention mines
I would think that anyone that is not an idiot that knows that if they might face US they need to be able to operate without centralized command and control. That may be in our favor as tyrants can't really have their military operate with autonomy otherwise they will lose their grip on power. I have heard that a e-5 has more authority than a Capitan in most soviet/arab style military. And typically connections and ideology are the way to advance in rank in those type of millitaries so perhaps they have a bunch of inbred idiots in command
There are too many points on the globe where an oil crisis could happen. If it becomes necessary to put troops on any of these points it will already be too late.
"The Greenspan comment I don't totally agree with. He choked off the economy with a Fed rate of 6.5% in mid 2000."
Of course you don't agree. We talking about two different things. By liquidity I am referring to money supply. You obviously are talking about short term interest rates instead.
The way that the Fed loosens or tightens monetary supply is through interest rate hikes or reductions. What are you talking about?
Very hard to predict the effect of middle east strife on equities, except maybe for specific sectors directly affected.
Fact is, the market could plunge for cyclical reasons with no negative externalities at all.
"Question: how many mobile Silkworm anti-ship cruise missiles does Iran have?"
They have fewer mobile missile launchers than we have Trident warheads. :) Nuke 'em all, let Allah sort 'em out.
"Question: how many days did it take to knock out all of Saddam's mobile SCUDs during Desert Storm?
"(We never did.)"
Ah, but the SCUDs were fired at cities, which stay in one spot.
Ships, on the other hand, have this annoying habit of moving. (It's REALLY annoying for me, because I get motion sickness very easily.)
To find their targets, the Iranians will need to use radar and radio.
And it's a lot easier to kill radar sites and radio transmitters than Silkworm launchers.
Investor confidence is really the key here. Anything else is secondary.
FOMC Operations.
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