Dow 1200? The View From the Bear's Den

During the first five months of this year, the major market indices fell sharply even as 60% of all stocks advanced. If you threw 10 darts at The Wall Street Journal's stock tables and created a portfolio divided equally into those randomly chosen names, you almost certainly would have posted a gain for 2002 through the end of May.

But since mid-May, the tide has turned dramatically for the worse. In the past month, nearly five stocks are down for each one that is up -- the worst ratio of infamy seen so far in the bear market that started in 2000. The rise in decliners, or decline in risers, depending on whether your glass of absinthe is half-full or half-empty, has been a direct result of investors' abrupt abandonment of the shares of small companies.

The swan dive of the small-caps can be seen in the performance of almost any measure you choose, broad or narrow: The S&P Smallcap 600 Index was down an extremely steep 8% from May 17 to June 17, but so was the Russell 2000. Even (WGROX Quote)Wasatch Core Growth Fund, which holds about 50 stocks and has soundly beaten its benchmarks and most competitors in the past 10-, five-, and one-year periods, was down 8% in the one-month span.

Monday's superball bounce notwithstanding, large companies' shares aren't exactly lighting the world on fire, either -- big-cap decliners have outpaced advancers by nearly a 10 to 1 margin in the past month. Among all stocks with prices of at least a buck, 3,940 were down from May 17 to June 17, while 900 were up. Among stocks with a market cap of at least $10 billion, only 32 made headway while 296 declined.

This degree of despondency among investors has perversely boosted the bullishness of a few formerly bearish market observers, who consider the recent smash-up a healthy sign of "capitulation." These reverso-world people think the abandonment of stocks large and small by investors large and small signals, in a contrarian sort of way, a time when markets can rise again. For proof of the correctness of their beliefs, they point out that the small- and mid-cap indexes bounced hard off their 200-day moving averages this week, an event that they say shows continued interest in these shares at lower prices.

Bears with truly apocalyptic stripes on their hide, however, see small-caps' collapse as just the end of the beginning of a market downturn, not the beginning of the end. They are rubbing their paws with morbid anticipation at the prospect of what they consider the precipitation of crash conditions, when fully 90% of all stocks go into free-fall and there are no sectors, market-capitalization strata or countries in which to hide. The belief on this side of the valley of death is that indices and stocks bounding off their 200-day support lines now will hit their heads on a down-sloping 50-day moving average line of resistance and get knocked out cold.

Den Leader Prechter

One of the more prominent denizens of this den of iniquity is Robert Prechter, publisher of the Elliott Wave Theorist newsletter and author of the new book Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression. Prechter gained fame in the 1980s for a long series of accurate bullish calls on market timing, but fell flat in the 1990s as he told readers to abandon stocks much too early.

His compelling research on the cyclical nature of stock and commodity price movements found more adherents again as the market fell apart at the start of this decade. And he gained prominence in recent months as he both accurately instructed readers to pile into stocks immediately after the terror attacks in September, and to sell again at the highs of March this year.

I'm not going to endorse or condemn his methods -- you can read his book or get his newsletter and decide for yourself. But his theories are at least imaginative and thought-provoking, and worth noting as counterbalance to the market cheerleading heard elsewhere.

In an interview last week, he declined to name exact targets for the Dow, S&P 500 and Nasdaq Composite, which are currently perched around 9600, 1030 and 1550, respectively. But he figures they will decline from their highs at a rate commensurate with each of the worst bear markets in history, including ones in mid-18th century England, the early 1930s in the U.S. and the 1990s in Japan, which bottomed at -60% to -90%. That would chop the Dow into a range of 1200 to 4800; the S&P to between 155 and 620; and the Nasdaq more toward 500 than 2000.

Prechter sees stock market averages as measures of social mood that can be used to forecast social change. During bull markets dating back to the dawn of the Industrial Revolution, prices on the London and New York stock exchanges have anticipated the big, positive world mood swings that have resulted in such euphoric events as nuclear test-ban treaties; trade harmony like GATT and NAFTA; the end of the Cold War, apartheid and PLO-Israel fighting; and the rise of the $3.50 cup of coffee. The most recent bull move, he says, began at the bear market low of 1974 and ended in the highs of early 2000.

Bear markets, in contrast, anticipate and augur cyclical changes in global mood to the downside, which result in wars, terrorism, recessions, government and corporate scandals, and general bad vibes. It was no coincidence, he says, that one of the defining moments of high tension in the middle of the last major bear market occurred in May 1970, when National Guardsmen fired on student protesters at Kent State University. The Dow hit a seven-year low in June.

And likewise, he would say that the September terrorist attacks and financial, religious and government scandals, as well as trade protectionism, are symptomatic of the latter early stages of a bear market. Go back a couple of hundred years, he says, and you will find that the Revolutionary War in the British colonies occurred amid a multidecade London Stock Exchange bear market that lasted from 1720 to 1784. Likewise, he would put the Civil War at the end of the 24-year bear market that lasted from 1835 to 1859, and World War II at the end of the 1929-1938 bear market and depression.

Opportunity of a Lifetime

For my money, all this and more sounds dangerously like data mining, in which a researcher makes historical information fit a theory rather than letting the data suggest a theory. But for now, let's let Prechter argue that bear markets tend to produce multiple recessions because as the mood of the investing class becomes more negative, business people become less willing to take risks. As a result, they invest less, businesses become less expansive and the economy sputters. Rinse and repeat.

Check out Prechter's newsletter and book for all the Elliott Wave jargon that explains and supports his point of view, but to cut to the chase, his advice to investors now is to get out of stocks now while they still have a pulse. He calls this moment the "opportunity of a lifetime" for making money on the short side of the market because declines at this stage of the economic and market cycle are "swift and steep." He points out that in bull markets, 60% of all stocks rise, but in bear markets 90% go down -- a scenario that oddly enough characterizes the current year's action.

For those who do not have the stomach or inclination to short stocks, he recommends moving all investable assets into high-grade U.S. Treasury bills, or money-market funds that invest solely in T-bills (no corporate commercial paper), and moving all cash into small- to midsized federally insured banks with the highest safety ratings.

Without intending to cast aspersions, it seems that these big-wave theories seem to appeal more to well-meaning eggheads than to demonstrably successful investors. World-altering economic and psychosocial patterns are easier to observe in retrospect than to forecast. The mathematical certainty that appears to attend cyclical waves in the past tend to dissolve into uncertain subjectivity in the present.

The present does seem unusually murky, however, as the market's two-year decline is regularly peppered with soured rallies. Perhaps these are the times foreseen by the great American philosopher Yogi Berra, who once said, "When you come to a fork in the road, take it."

To intersect equally with Prechter, Berra and your own natural optimism, consider hedging your long positions in stocks, indexes or funds with a handful of names to bet against just in case the waves of doom really are crashing on America's sunny shores. Here is a list of 10 stocks to consider selling short based strictly on their low rankings in our StockScouter rating system.

StockScouter Short Candidates*
Name	Scouter Rating	June 18, 2002 Close	Daily Volume
Viisage Technology (VISG:Nasdaq)	1	$5.06	75,000
Crown Cork & Seal (CCK:NYSE)	2	7.97	1,536,800
ImClone Systems (IMCL:Nasdaq)	2	10.97	6,174,100
Alpha Industries (AHAA:Nasdaq)	2	6.67	374,700
Computer Network Tech (CMNT:Nasdaq)	2	7.90	253,300
Extreme Networks (EXTR:Nasdaq)	2	10.08	2,495,100
Halliburton (HAL:NYSE)	2	16.95	2,699,600
Identix (IDNX:Nasdaq)	2	6.70	292,600
Infinium Software (INFM:Nasdaq)	2	6.10	111,100
Micromuse (MUSE:Nasdaq)	2	5.94	1,263,600
*Rated low as possible and member of out of favor market-capitalization, sector and investment-style groups. Minimum 50,000 shares traded daily and $5 price. List created strictly quantitatively; for illustration purposes only. Always do your own research before buying or shorting stocks.

Shorting is not for the faint of heart or inexperienced, as you can theoretically lose an infinite amount of money if a stock rises, while gains are capped at 99%. You can also only short in a margin account, as you are literally borrowing shares from your brokerage that you plan to sell back, or cover, later when prices are lower. You cannot short in a tax-free retirement account, as it is considered too risky.

If you want to short at a full-service brokerage, your broker will know what to do. To short online, read the site's "help" files carefully or speak to a customer service representative. Generally speaking, you will type in a quantity and symbol and click the "sell short" button -- it's just the opposite of buying. To capture your gains or limit losses, complete the trade by entering the symbol and quantity and clicking the "cover short" button.

I'll watch this 10-pack for the next six to 12 months and report back from time to time. Until then, if you follow Prechter, don't forget a can opener and corkscrew when you lock yourself into a bunker. And if you follow Berra, don't forget that you can observe a lot just by watching.