Why the Market Bears Are Roaring

Jon Markman

Editor's Note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on TheStreet.com.

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Every couple of months, the author of the SuperModels column answers readers who write in to ask questions with the cry, "Hey Modelman!"

Hey Modelman: What are you smoking? I am surprised you are telling people to expect new highs in the Dow Jones Industrials (in 19 Stocks for a Dow Peak). Isn't it more likely that the Dow will bump up against its old high and be repelled as it was throughout the 1970s? -- M.C.

Jon Markman: You may be right. That column was probably not my finest moment. It published on the exact day [May 10] the Dow began to tank. I think financial journalists in good standing are allowed a mulligan now and then, don't you?

To make up for it, I checked in with my favorite timers this week (before Wednesday's nasty selloff): Veteran tape reader Stan Weinstein of Global Trend Alert, Paul Desmond of Lowry's Reports, Bob Drach of Drach Market Report and Tom McClellan of McClellan Market Report.

Here's the two-minute version of their views:

• Weinstein expects a minor rebound from this week's lows, but says the highs of the cycle have been made and that a "baby bear market" is commencing. He thinks the Nasdaq may rise 50 to 100 points in the next week or two, but then sink as low as 1,900 to 2,000 by the fall. After that, he expects a solid rebound into 2007.
• Desmond has been saying for some time that the current bull market is very, very long in the tooth. He is looking for a recommencement of the "secular," or long-term, bear market that began in 2000 and was interrupted by a "cyclical," or intermediate-term, bull phase that started in 2002.
• Drach is heavily negative on the broad market and has been nearly all year. He sees a great disparity between high-quality and low-quality stocks and does not expect to give an all-clear signal for several weeks, if not months. Drach has an especially impressive record of calling bottoms, so when he gives the whistle, I will let you know.
• McClellan, who I think is the best intermediate-term stock-market timer going these days, is actually a lot less bearish than the rest. He called for the mid-May weakness a few weeks ago as the market was making highs, and now believes the selling will end some time next week. His cycle work suggests the market will then advance to new highs by the end of June, and then "chop sideways" through the summer into a soft spot, but not a crash, in the fall. His most interesting forecast is for crude oil and energy stocks to bottom in June and then advance through the end of the year, culminating in $100-a-barrel oil and $4-per-gallon gasoline.

I will keep track of all these forecasts over the next four months and report back if any of them change.

Hey Modelman: You haven't written about Mr. P in a long time. I would be very interested to hear his views on market direction if you get a chance to get hold of him. I always found your articles about his comments helpful.
-- D.E., Wisconsin.

Markman: The mysterious Mr. P -- an expert on market cycles -- was bullish for a year through the end of April, but he has since turned seriously bearish. For those of you just tuning in for the first time, he is the veteran research director of a major global macro hedge fund on the East Coast who shares his views with me from time to time.

Mr. P has seen and done everything in the markets, from risk-management to sales management, from bonds and equities to currencies and swaps, from New Jersey to Switzerland and Taiwan. On behalf of his partners, he rarely rests -- sleeping just a few hours a day in the early morning -- as he scans the horizon of time and geography for events in far-off places that might help or harm their positions.

In a normal 14-hour period, he will confer with his firm's and rivals' traders in Tokyo and London; read, analyze and distribute news headlines to peers; consult with professors, journalists, miners, mathematicians and farmers; and book travel to Iowa or Brazil, if necessary, to check on the soybean crop first-hand.

Mr. P, to whom I grant anonymity, is often very right -- and even when he's wrong, he can make you money. When first introduced in my column in early 2001, he called the Federal Reserve's hikes and bear-market action turn by turn. In the autumn of 2004, he called for a bear market and recession in 2005, which was wrong, but he advised buying metals and energy, which was right on: A set of 10 metal and chemical stocks he endorsed then is up 53% since vs. 9% for the market, led by a 190% advance in Commercial Metals(CMC Quote) and a 105% move in Phelps Dodge(PD Quote).

Why is he negative on the market now? A couple of things. An arch-conservative, Mr. P has become highly concerned about the loss of confidence in President Bush, both domestically and overseas. He faults Bush for not working hard enough at his job and hiring badly.

Because Mr. P deals with major European, Arab and Asian investors all the time, he understands how important foreigners are to our stock market. You see, most U.S. pension and mutual fund managers are already fully invested in our market. They steadily get more fund flows from U.S. workers' retirement plans every month, but that only really keeps the machine rolling at a steady pace. To get the market moving dramatically higher, Wall Street needs incremental new inflows from overseas pension-fund managers.

Political Worries

Foreign investors are very sophisticated about U.S. politics. Most have gone to the best schools in America, travel here frequently and pay a lot of money for top consultants. They are not naive. Foreign investors care a lot about leadership, Mr. P says. They don't really care if a Democrat or a Republican is in control of the White House. They just want someone firmly in charge so that they can have confidence that the money that they are entrusting here is safe.

When events transpire to make our government appear less secure, foreign investors get nervous. They don't necessarily withdraw funds. They just send less, which has the effect of making a rising market pause.

So what is the issue now? It's not just that the Bush administration is suffering from the weakest polling numbers in recent years. It is that foreign and other sophisticated investors smell the potential for major changes following the midterm elections, including the possibility of a Democrat takeover of Congress and the potential for tax-law changes and impeachment hearings.

Although a strong market always climbs a wall of worry, history has shown that investors do not like the impeachment process one bit. The dreadful bear-market years of 1973 to 1974 are the classic example. Yet you really only need to look back to 1998 and 1999 at the President Clinton impeachment process. The market ultimately rallied big in both of those years, but there were several death-defying 10% slides along the way.

There should be little doubt that if the Democrats' message finds a receptive ear among the public, Mr. P says, there will be investor-paralyzing hearings well into 2007. This is particularly true if, as rumored over the past week, key presidential aide Karl Rove is indicted for his role in the Valerie Plame affair. It's therefore a good time to get cautious on most industrials and consumer cyclicals. He sees the potential for a slide of as much as 20% over the next nine months.

Dangerous Time for Market

Of course, from a cyclical point of view, this makes sense. The midterm election year of a second-term president tends to be one of the most dangerous for the market. And this year, the ugliness may be amplified because of President Bush's low poll results. According to Ned Davis Research data, since 1950, the market has lost 3.5% during the period from April 30 to Sept. 30 during midterm election years vs. a gain of 0.9% in the period in all years and a gain of 5.6% in the other half of the year -- Sept. 30 to April 30. In other words, we are now entering what is historically just a bad, bad time for stocks.

So how do the poll numbers fit in? The Gallup Poll Presidential Approval Rating is now 34%. According to Ned Davis analysts, a low presidential approval rating can sometimes be a positive in a contrarian sort of way -- meaning that there is excessive pessimism afoot. Yet they hasten to add that when it is this low, "it's so bad that it's actually bad." During the rare period when the approval rating has been under 35%, the Dow Jones industrials have declined at a negative 6% annual rate.

Now, where it really gets ugly is when you notice that there is only one other precedent for the twin demons of low presidential approval and a midterm election year happening at the same time. That was in 1974, when the market would ultimately slide 45% to a 12-year low amid the Watergate scandal, impeachment hearings and the resignation of President Nixon, not to mention a gasoline-supply and price shock.

The Rise of Mercantilism

But that's not the only big problem that Mr. P sees. He also frets over what he refers to as "neo-mercantilism." Mercantilism, you may recall from economic textbooks, was the main paradigm that characterized world trade in the 16th and 17th centuries before capitalism shifted into high gear. It's a view that politicians, not business leaders, should guide international trade -- and that trade policy should serve strictly political ends.

Modern mercantilists include Vladimir Putin of Russia, Hugo Chavez of Venezuela, Evo Morales of Bolivia, and in some regards, the governments of Germany, China and Japan. Examples are Putin's withholding of natural gas from Europe; Chavez's takeover of foreign oil and gas interests; and Morales' nationalization of energy and mines.

Mercantilism is an unsettling type of economic warfare, says Mr. P -- an attempt to restore power to governments that was stripped from politicians by capitalism. You could almost call it the "weaponization of finance." If it swells, much of the market freedom that we know today will shrivel, he fears, as countries withdraw into their shells and restrict world trade.

On a more practical level, Mr. P says his models show that the industrial metals are four times more expensive than they have been historically, and consumer durables are twice as cheap as they normally are. He believes the gap will close, which means he thinks you should at least take advantage of the recent surge to sell your aluminum, zinc and nickel stocks.

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