A Bull Until '99, Analyst Sees Recession by '01

There are a lot of tough jobs out there right now. Raising money for a dot-com, for instance, or running a gas station. But for sheer public humiliation potential, the award has to go to the market strategists who get paid to predict where stocks are headed. I don't follow many pundits, but it's hard to believe that more than a handful of them have made it through the past year's boom-bust-boom-bust without a nasty case of professional whiplash.

But one strategist who's looking pretty smart lately is Don Hays, formerly with regional broker Wheat First and now head of his own forecasting and money management firm. Through an accident of geography, I've been following his work for years, and know that after being bullish for most of the 1990s, he switched gears in 1999 (drawing a mention in my Aug. 27, 1999, column). This put him on the wrong side of the tech-stock boom of late 1999-early 2000. But the call was still arguably correct, since the number of stocks falling in the past year has exceeded the number going up. It's just that the winners have won so big that they've pulled the capitalization-weighted averages to new highs.

Since March, though, Hays has been unambiguously right. With the Nasdaq Composite Index at 4583 on March 29, he wrote to his clients that "the market is about to enter a correction." On May 24, after the Nasdaq had dropped to 3023, he wrote, "The first phase of the bear market is ending. Now it's time for an interlude rally."

On July 14, when the predicted rally had taken the Naz back above 4,000 -- and the world was bowing to Alan Greenspan's artistry and celebrating the soft landing -- Hays wrote, "Is this new short-term trend sustainable? I don't think so. ... The second phase of the bear market is close to starting." And you all know what happened last week.

But the real carnage, he says, is still to come, "especially for the highly overvalued Nasdaq indices." Last week was the beginning of the "concern" stage of the bear market, where it dawns on investors that economic growth (and thus corporate earnings and stock valuations) might not continue in an upward 45-degree arc, says Hays. Valuations that in good times seemed reasonable will suddenly look a tad aggressive, and the Naz will test its recent lows. Then, sometime in 2001 (after one or two more interim rallies), we'll enter the capitulation stage, where growth investors curl up into fetal positions and turn off their monitors, sending the big indices down to levels where their prices once again reflect underlying fundamentals.

He's basing this dark vision on four things:

The large-cap indices like the Nasdaq and the S&P 500 are wildly overvalued.

The smart money is bailing. Compare the emotion-driven action of the market's first hour to the more reflective action of its last hour, and you get something called the Smart Money index. When negative, it implies that the cooler, more analytical (i.e. smarter) investors are selling out to more excitable (dumber) players. It's been mostly negative since last November, and after stabilizing briefly in the July rally, has gone back into free fall.

The ratio of consumer-installment debt to disposable income is the highest it's been since just before the 1987 crash. So maxed-out consumers will control their plastic for a while, causing a slowdown in spending and "a major retraction in the economy."

Money-supply growth is slowing. This is what drives the whole show, says Hays. MZM, a money-supply measure said to be a favorite of Greenspan, has grown at double-digit rates for most of the past two years as the Fed countered a series of crises by flooding the system with liquidity. Whenever MZM expands at a greater than 10% annual rate, Hays writes, "a wildly enthusiastic rally occurs." Conversely, "Whenever growth in MZM drops under the 7.5% level, it starts to work against market optimism."

After peaking at 15% in early 1999, MZM growth is now running below 4%. So forget the soft landing. "I don't believe you can go from a wild, drunken orgy to a fresh-feeling head the next morning. ... Before this is over the year-over-year growth rate [of MZM] will drop to zero or lower. ... The U.S. will be suffering a recession by October of next year, and some of the world will be suffering a depression."

Especially vulnerable is Japan: "Their economy is running on a U.S. consumer 'breathing machine,' [and might] fall victim to the declining state of the U.S. economy." Now that Japan's Nikkei stock index has pierced the technically important 15,838 level, he adds, "I'm hearing rumors of big corporate bankruptcies."

Extreme stuff, this, but after last week it has an air of plausibility.

The good news is that the next bull market (scheduled for 2002) will be the best ever, says Hays. So keep that powder dry, and maybe we'll get the chance to see if the "buy low" side of the equation is as much fun as "sell high."