Market Sage Issues Fearsome Forecast

Hedge fund insider Mr. P has made some good calls in recent years. He's very bearish now.
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Buckle your seatbelts, says Mr. P. It's going to be a bumpy ride.

It's been a long time since I checked in with Mr. P, research director of a major East Coast hedge fund who has supplied readers of this column with uncanny market-timing advice in the past four years. As you read on, you may wish I hadn't asked him what he thinks.

Back in our first encounter in January 2001, he climbed out on a limb to forecast a 3-percentage-point decline in the fed funds rate that year and equity distress. He went on to forecast an end to the bear market in October 2002, a huge war rally in March 2003 and a dull, trading-range market for 2004.

Now Mr. P's way-out-of-consensus belief is that the U.S. and global economies will slide into a pronounced recession in 2005 -- an event that will take stocks down 20% or more, boost bonds, spike the dollar and juice commodity prices. The plunge in stocks will end by the third quarter, he forecasts, followed by a rally that leaves prices modestly higher.

The Five Big Worries

Several theories underpin his forecast.

Operating leverage for companies is too high.

The operating leverage of major U.S. companies is two standard deviations higher than normal, a condition that has augured recession in the past. The simple definition of operating leverage is fixed costs divided by total (fixed plus variable) costs. When companies have high operating leverage, they rely heavily on fixed costs rather than variable ones. The greater the degree of operating leverage, the more earnings are at risk of small errors in forecasting sales -- as costs will stay high while revenue falls.

Companies have reached this point essentially by curtailing spending on variable costs as much as possible and stacking up cash. On one hand, they have low interest rates, low inflation, low offshore wages, low taxes and deferred taxes. They're paying down debt and aren't hiring.

On the other hand, they aren't buying a lot of new equipment. They aren't expanding domestic factories, either. Bulls suggest that companies' rising stockpiles of cash are evidence that capital spending is a tinderbox waiting to be lit, but Mr. P believes it indicates that companies fear the future. He says they're like squirrels, hoarding acorns for a long winter. Last year was the first in a long time in which more corporate debt was retired than issued.

Why would there be a decline in sales when so many pundits are forecasting a rosy future? Mr. P says it's simple: Higher short-term interest rates + higher oil + reduced fiscal spending + higher taxes + a big increase in dangerous, subprime real estate lending = a splat for consumer spending.

Nobody's talking about recession.

Mr. P is intrigued by how far off the radar screen the concept of a recession is now. Of all the questions posed to the presidential candidates at their first two debates, he noted, no one has asked what either would do in the event of a recession. All answers on both taxes and spending were predicated on the consensus belief that the economy is roaring and will continue to do so. "The fact that no one is even considering that this can happen will give us an order-of-magnitude change like you have never seen," he said.

Rising rates will draw cash from stocks.

If the

Federal Reserve

continues on its path to raising short-term interest rates to the level it considers equilibrium, or 3.5% to 4%, bank certificates of deposits -- which are largely invested by financial institutions in short-term debt -- will draw a lot of money away from stocks. A guaranteed 4%, Mr. P says, would look pretty great next to the lousy fixed-income returns of the past few years, not to mention next to stocks that have gone nowhere this year and might be declining next year.

Why would the Fed raise rates if the economy is stalling and stocks are declining? It may have to in order to encourage foreigners -- particularly China, Japan and the oil-producing states -- to keep financing the U.S. deficit and maintain price stability. If China follows through with its plan to switch its currency peg from the U.S. dollar to a basket of world currencies, it will have much less incentive to repatriate all the money it receives from its U.S. exports back to the U.S. in the form of bond purchases.

Mr. P believes the Treasury will have to pay higher rates to attract investment. Indeed, he thinks that oil-producing and Asian countries have been major buyers of U.S. dollars in recent months in an attempt to prop up President Bush's election chances. And they might shift their currency purchases to euros after November.

Crude oil supplies really are tight.

In the same vein, Mr. P foresees oil peaking around $60 in December and then tailing off for a while, dropping back as low as $45. He observes that oil is going through the process of price discovery. Because there is no transparency in oil reserves, especially in Saudi Arabia, speculators are jamming prices up to see the point at which more supply can come on the market.

If no additional supply comes on, they will attempt to prove through price that the Saudis have not been honest about their ability to provide the world with

spare capacity. "The market is saying, 'We don't believe you -- prove it,'" said Mr. P, noting that he thinks neither Saudi Arabia nor Russia have the reserves they have claimed.

High-priced homes with big, high-rate mortgages are vulnerable.

He fears that the rise in subprime real estate lending on high-priced homes in states like California will end very badly -- potentially with tens of thousands of defaults from people who obtained zero-down or interest-only mortgages. "The potential for a crash in the housing market is not anticipated," he said. "Thousands of people who are not creditworthy have been allowed to buy homes for almost nothing, and, if they are pressured by job losses or other effects of a recession, they will just walk away -- putting even more pressure on the banking system and homebuilding sector, not to mention the government, which could be called upon for a bail-out."

The Bleak Bottom Line

The bottom line: Mr. P believes that a confluence of higher interest rates and higher energy prices will depress consumer spending and corporate earnings. The financial markets will begin to sniff it out soon after the election, if not before.

He sees the broad indices trading down for the first seven months of 2005 as a compression in price-to-earnings ratios exacerbates a decline in profits. Bonds will be seen as a safe haven, as will more defensive stocks such as consumer staples companies like


(CL) - Get Report


Because some investors will wish to bet on something during the decline, Mr. P thinks commodity prices -- particularly industrial metals -- will continue to move up on a combination of expanding demand from China and raw speculation.

"We're bearish because we see a global slowdown and because we can see that both candidates are taking the economy for granted," he said. "If I'm right, you will soon have the most confused electorate in the world, as they come to realize that despite all of the words published during the race, none prepared them for the biggest challenge of the first year of the new presidency."

Mr. P's fund is currently short U.S. equity index futures, although that can change at any time. If his call turns out to be prescient, in a future column I will provide a list of stocks that may help you take advantage of his call.

Jon D. Markman is publisher of

StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. At the time of publication, he held no positions in the stocks mentioned in this column. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at; please write COMMENT in the subject line.