Time Is of the Essence

The time for prudence and defensiveness has come. Yes, it has happened a bit sooner than I expected, and we never came close to my target of 3450 on the Nasdaq Composite Index, but I don't dictate to the market. I can only try to listen to what it says, and I'll be the first to admit to having a tin ear on many occasions. Having been very bullish until we took out the 2550 level on the Nasdaq 100 March contract Friday morning, I thought I'd take a little time to explain the reason for my speedy reversal.

When the Comp hit the 2250 area, it was about as oversold as it's ever been, and other indicators also showed that the market was at a good bottom. Was it the bottom? It didn't seem likely, if for no other reason than investor sentiment never even turned as negative as one would expect to see amid a decent correction, never mind after the largest drop ever in a major market measure. It also appeared unlikely because I believed that analysts were still overly optimistic about earnings growth for the important tech and financial sectors this year -- and perhaps next year.

Following Conventional Wisdom

On the other hand, the Fed was chopping rates. Everybody knows that when Easy Al comes to the rescue, it's time to jump for joy and ride the wave. Why worry? Using no other plan than to follow this bit of conventional wisdom has proved to be very profitable in the past. Heck, the Comp posted a double-digit gain in January alone. Conventional wisdom also shows that as January goes, so goes the year. And all of the market gurus had their own data showing the massive gains generated when the Fed begins to ease. So easy, it's a wonder that anybody who has been in the market for the past 20 years hasn't already retired rich.

I had expected that a rush back into the market based upon conventional wisdom would lead to a surprisingly explosive move higher, irrespective of the near-term none-too-healthy prospects for economic and earnings growth. Investor sentiment indicated that greed was still dominant, and the majority of Wall Street strategists were a bit embarrassed but undaunted. "Another great buying opportunity," they shouted. Backed by strong technical indicators and very strong momentum measures, the short-term upside action could possibly have led to a buying panic. However, it would have to be done in very short order because I expected that the economic reality would lead to another break.

I anticipated that the top would most likely coincide in advance or amid the first-quarter earnings season. Not only was it likely that there would be an abundance of warnings across many sectors and further downward guidance, but many investors who lost money last year would still have significant capital gains to pay Uncle Sam on April 15. Unfortunately, the Naz stalled for two weeks and then plunged through support Friday, while investor sentiment had reached dangerously high levels. Time was of the essence in my forecast of Comp 3450, and we've run out of time already.

Consumer confidence has plunged, even before clear signs of economic weakness were evident apart from the manufacturing sector. As you already know, I became convinced in December that a near-term recession was unavoidable, with a good deal of the blame going to the media and exacerbated by then-President-elect Bush. Had consumers' balance sheets been healthy at the time, Mr. G's rate cuts might be counted on to stem the tide of eroding confidence. But they are not.

Indications of the Future

The market has proved over the years that man is hardly a perfect economic animal. However, when faced with huge debt built up after years of being told that the New Economy negated Old World realities, consumers will now face a far more uncertain future with much more restraint -- even if the Fed cuts rates another 75 basis points by March 20, as I expect it to do, and even if a significant income tax cut can get through Congress. Paying down debt will be priority No. 1 for many households, and saving for a rainy day will be the next priority for those who can. I wouldn't be surprised to see a positive personal savings rate in the not-too-distant future.

And then there's the matter of market inflows. After a record amount of mutual fund and foreign money flooding into the equity market, it's unrealistic to think those levels are sustainable. In addition, with margins shrinking from higher energy, labor and inventory overhang, not to mention higher borrowing costs for many companies, corporations will not likely be as aggressive in buying back or investing in other companies' stock. Should lower rates put further pressure on the dollar, a more sanguine outlook for Euroland would also stem the flood of money coming into the U.S. equity market.

As was the case in the final nine months of 2000, it seems that the Nasdaq will again suffer the greatest. First, technology inventories are perishable; second, multiples remain extremely high given the outlook for investment spending plans; and third, competition is fierce. A weaker dollar will help the export side of the ledger, providing a lift to overseas sales, but it probably won't be enough to offset slowing domestic demand.

In any event, my proprietary momentum indicators flashed a sell signal, and it's now time for prudence and defensiveness. Tech and financial stocks should be significantly underweighted, and portfolios should be very heavily skewed toward absolute value. Government and agency bonds should perform well, especially as short-term rates will depress money-market rates. I believe that value will continue to outperform growth for a very long time. Traders should look to short rallies but keep stops tight and be quick to take profits, as I expect a 25 basis-point rate cut before the next Federal Open Market Committee meeting. Time waits for no one, and time is of the essence. It's now far better to err on the safe side than to speculate that lower short-term rates will cure all ills.