Following the market's levitation since mid-March, the motto of many skeptics seems to be: "Disliked it at 7400, hate it at 8700." The bears have multiple reasons for their cautiousness, including valuations, the weakening dollar, punk economic activity, deflation, excessive optimism, rising speculation and a still unstable world, or some combination thereof. Optimists should take heed of these issues, although many will take heart in the skeptics' stubbornness. Indeed, those looking for the bears to capitulate are going to have to wait, which is a "good" thing for those thinking such towel-tossing will mark the rally's peak. Even prior to the market's setback on Thursday, scant few bears felt any siren call from the rally since the mid-March low. True, bearish sentiment in Chartcraft.com's Investors Intelligence survey has fallen to 22% this week from 35% in early April, but few of the skeptics in my universe have changed sides. In fact, many cite the falling bearishness in the II survey and other sentiment indicators to justify their own pessimism. "Yes the bears are being squeezed, and a bearish case is hard to stick with," said Phil Erlanger, editor of Erlanger's Squeeze Play. "But sentiment readings are reminiscent of major tops, not bottoms." Earlier this month , Erlanger said the postwar rally should be treated as a bear market interlude unless the S&P 500 eclipsed its August high of 965, preferably on expanding volume. He reiterated that view this week, even as the index moved within a few points of 965. Similarly, Steve Hochberg, chief market analyst at Elliott Wave International in Atlanta, discussed a "running triangle" here on May 2, suggesting that a bearish pattern would remain intact unless the S&P took out its Dec. 2 high of 954. The S&P exceeded that level -- intraday -- Wednesday and Thursday, but Hochberg wasn't coming down from the bearish ledge, even as he conceded the S&P's running triangle had been negated. "It's not a number, it's not prices rallying" that would change his viewpoint, Hochberg said.
"What would change me are indications the patterns are changing to clearly bullish. The last couple of weeks, indicators have gotten more bearish," most notably sentiment.
Additionally, the "top count" Elliott Wave pattern suggests a turn is imminent, he said Thursday afternoon. "This move is hours away from topping. We'll see a pretty hefty down move in the next few months and at a minimum we'll test the October lows." From Thursday's close to their respective October intraday lows would necessitate drops of 21% for the Dow Jones Industrial Average, 23.6% for the S&P and 42% for the Nasdaq Composite. Few market participants are currently contemplating the October lows -- and many believe they'll represent the lows of the postbubble decline -- but Hochberg's forecasts aren't the most draconian in the bear den.
Flagging Faith in the Fed
For some time now, Dave Hunter, chief market strategist at Kelley & Christensen, has forecast the Dow will hit 4000 later this year, as deflationary pressures overwhelm the debt-laden U.S. economy. "My convictions remain that we will see this target reached within 2003," Hunter declared via email this week. "While investors seem to be warming up to this market, I remain convinced that this is a high-risk rally that once it ends will go down as fast or faster than it went up." Hunter's chief concern is that while the Federal Reserve's aggressive monetary stance may be temporarily "alleviating stresses" -- and providing liquidity to aid financial markets -- the end result is a dangerous extension of the debt burdens of American households and businesses. "I think they are exacerbating the problems beyond the very near term," he said. "The further extension of debt and likely continued weakness in the dollar only increases the odds of a banking crisis at some point."
The dollar's recent slide is a key element to naysayers. As discussed previously, many bears foresee a doomsday cycle of dollar weakness prompting foreigners to repatriate assets, leading to more dollar weakness and more outflows by overseas investors. This cycle perpetuates itself until Americans' buying power and standard of living are eroded. Some have used the term "banana republic" to describe where the U.S. is headed given our rising current account deficit and falling currency. In addition to sentiment and the dollar's demise, valuation is the top obstacle preventing most bears from seeing the market through bull-colored spectacles. As of Thursday's close, the S&P 500 was trading at a price-to-earnings multiple of 19.8, based on actual 2002 results, and 18.3 based on Thomson First Call consensus earnings forecasts for 2003. Given the historic decline in Treasury yields, optimists say such P/Es are relatively moderate, further noting the S&P's earnings yield -- the inverse of P/E -- is above yields of long-dated Treasuries. But any self-respecting skeptic will quickly note that those earnings are on an operating basis, which excludes most restructuring charges and other "one-time" items. Using reported earnings, the S&P's P/E rises to 33.5 on a trailing basis and to 22.6 based on 2003 estimates, which, if recent history repeats itself, will prove overly optimistic. By S&P's so-called core earnings, which disallow most one-time items and include obligations such as pension funds, P/Es are even more egregious. Furthermore, the S&P's dividend yield of 1.7% is puny by historic standards, while other metrics such as price-to-book and price-to-sales are attractive only relative to the outrageously high levels reached in 2000, skeptics say. Generally, bears believe equity valuations got so stretched in the bubble era that it will take many years before fundamentals "catch up" to them, and justify optimism.
I was unable to reach Richard Bernstein, chief U.S. strategist at Merrill Lynch, who often cites valuation -- and the optimism of his peers -- as reasons for caution. As of Monday he maintained a recommended equity allocation of 45%, by far the lowest among so-called major strategists. Similarly, recent public comments by Doug Cliggott of Brummer & Partners suggest no abandonment of the skeptical view. One source who has done an about-face is Bert Dohmen, editor of Bert Dohmen's Wellington Letter and founder of Dohmen Capital Research in Los Angeles. On April 8, he wrote: "Any victory rally may be sharp, but short." This week, Dohmen expressed a far more optimistic view, citing recent passage of the $350 billion tax bill. "Without that tax relief it's just another bear market rally," he said Thursday afternoon. "I think this bill makes it a more durable event." Dohmen's view is that lower dividend and capital gains taxes will ensure success for the Fed's "reflation" efforts. "All this excess money is not going into economic activity, so it has to go into the market," he said, stressing stocks have become overextended near term and he'd wait for a pullback before making bets on the long side. In a nutshell, this gets to the heart of the debate: Bulls believe the combination of fiscal and monetary stimulus has turned the tide away from deflation and toward higher asset prices and better economic activity. Bears contend such efforts will only delay the inevitable and, quite possibly, make the ultimate comeuppance even more painful.