Six months ago, astride the great
rally of 2003, a handful of analysts expressed concern about the dangers of a market driven more by stimulative government tax and monetary policy than fundamental business conditions.
One was Michael Belkin, an elite independent researcher based in Bainbridge Island, Wash. In an interview published
here on Oct. 23, the former Salomon Brothers analyst argued that the 2003 advance would end in a fourth-quarter skid mark, as "bubble fuel" was drained from the system in an "involuntary deleveraging" process.
He predicted that its main victims would be technology and housing-complex stocks. Shares of chipmakers like
were to be hit especially hard. Beneficiaries, he said, would be large consumer products makers such as
and energy companies such as
For the next three months, Belkin was dead wrong. The market continued to shoot straight up, and readers emailed repeatedly to ask why he had been given any credibility.
Now, though, his views don't look so dumb after all. The Philadelphia Semiconductor Index, or SOX, is lower by 5%, though LSI Logic is down by 15%. And most of the large-cap tech and biotech stocks that make up the Nasdaq 100 (NDX) have gone nowhere, with
down by 18% and
down 6%. Meanwhile, ConAgra has jumped 23%, and Amerada shares are up 35%.
He says the recent setback is nothing, however, compared with what's coming. In an update interview this week, he said his research suggests that the market will revisit its October 2002 lows. He is sticking to his prediction of a "high-volatility dislocation" -- you might call it a crash -- en route.
He still singles out semiconductors as likely victims, but has now added emerging markets to a long list of investment areas he expects to get clobbered. Meanwhile, he still likes consumer products companies and energy as potential hedges, although he doubts they will provide positive absolute return.
The Dawn of the 'Real' Bear Market
His most interesting assertion is that March 2000 was not really the peak of the bull market that began in 1982. It was only the peak for the
Dow Jones Industrial Average
and Nasdaq. The agonizing bear phase that followed in those groups over the ensuing two-and-a-half years was counterbalanced by a steadfast rise in small-cap and mid-cap stocks, particularly ones categorized as value plays. In other words, agile money managers were able to sidestep the big-cap growth bear market by switching to, or hedging with, small-cap and mid-cap value plays.
When the S&P Smallcap 600 and S&P Midcap 400 indices reached historic highs in October last year and continued to make new highs through March of this year, bulls asserted that their success showed the bear market had ended and a new secular bull market had begun. But Belkin's view is that the real bear market is only now set to begin, with all market-capitalization, sector and style groups pushed to extreme valuations by an imprudent monetary policy that set interest rates far below the inflation rate.
By allowing the official overnight federal funds rate to lag well behind the inflation rate, he says, the
made the worst of all possible central bank mistakes. It encouraged as much unproductive speculation in the past year as it did in 1999, when it flooded the world with dollars in anticipation of trouble from the Y2K bug. For this handiwork, he labels the Fed board "worse than the board of Enron" for its obsequious obedience to Chairman Alan Greenspan.
"They're all total wimps; the board is all yes men -- academics who just rubber-stamp their boss. And they've now given us the biggest bubble in everything that I've ever seen," he said. "Through 2000, it was mostly the tech stocks but now it's everything."
Belkin fears that emerging markets have the furthest to fall because they have attracted the most excess capital in the past two years. "When capital is fearless, when investors feel bulletproof, they put money into the riskiest areas," he said. "That has pushed emerging markets into the worst extremes in my experience of about 20 years, including the periods preceding the big collapses in the 1990s of Russia, Latin America and Asia. The Fed has essentially bubble-ized the whole world."
He estimates that the Nasdaq, S&P 500 and German Xetra DAX have about 42%, 30% and 45%, respectively, to fall before they revisit their 2002 lows. He thinks the Brazilian market could fall as much as 58%.
A Rocky Road Ahead
Belkin depends on a model of the interconnected world market in equities, commodities and debt that he created at Salomon Brothers. He updates it every week with fresh data.
Many of his measurements are proprietary, but in the big picture, his model sees all markets as big expansion and regression machines, always moving to extremes in one direction and then contracting to a baseline and shifting to the opposite extreme. His data show that the appetite for U.S. equities "has been rotting from inside all year," despite tremendous inflows of cash into mutual funds from investors earlier in the year.
The peaks of inflow came in the first few weeks of the year, then tapered off. Then they hit a crescendo again in the first week of April, and have since tapered down back to lows. His view is that when the market can't make progress after that much fuel, investors inevitably get frustrated and slow or halt their contributions. And then the real trouble comes when fund outflows begin.
The analyst said he has been warning his clients, primarily large U.S. and European financial institutions, "not to get caught up in the Fed con game and positivity." He's also advising them to prepare for the possibility of a "high-volatility collapse" that will see a return to the treacherous, unstable days of 5% up-and-down days in the Nasdaq.
"The declines after bubbles are more violent and pronounced the more people are positioned wrongly, and I've never seen so many people on the wrong side of everything -- bonds, emerging markets, small-cap stocks and techs -- just as inflation and interest rates are getting ready to explode," he said. He thinks the Fed can hold back interest rates only for so long; then the market prevails. In the past seven weeks alone, the market has pushed two-year and five-year Treasury bill yields up 90 basis points, almost the equivalent of four Greenspan-style, "baby step," 25-point moves. In addition to tech stocks, he believes the financial services group, especially brokers, will be hit hard.
10 Large-Cap Leaders
Of course, not everyone is wrongly positioned. Even though the broad market is flat for the year, industry group rotation has gone exactly as forecast, with makers of personal products, food and consumer staples moving ahead as many major institutional funds have positioned themselves defensively this year.
Earlier in the year, the list of new highs on the
and Nasdaq had reached extreme historic highs, but they are now heading in the opposite direction. The McClellan Summation Index, which measures market breadth, started turning negative last week.
My own work, not his, suggests the large-cap stocks (in table at right) could outperform the pack going forward.
Many of Belkin's measurements only begin to matter when they matter, which is an existential way of saying that his work cannot be used to daytrade. He's paid to look far out into the horizon and help major portfolio managers turn their battleships slowly. The last time he appeared here, it took three months for his views to come into the mainstream.
With interest rates already rising, maybe their turning radius is now shorter.
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. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at
firstname.lastname@example.org. At the time of publication, Markman had a position in the following securities mentioned in this column: ConAgra.