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Bernie Schaeffer: My 2003 Market Forecast
By Bernie Schaeffer
1/3/2003 9:30 AM ET



When I discuss the "fundamentals" with investors or the media, it is often with the caveat that "I'm not a fundamental analyst." My late and much-lamented dad, Jack Schaeffer, might respond, "Are you bragging or complaining?"

In fact, there is not much for fundamental analysts to brag about these days. During my appearance on the November 15, 2002 edition of Wall Street Week, I discussed (using WorldCom as my example) the fact that fundamental analysis provides no inherent exit strategy. It is thus fully exposed to the "death-spiral" process whereby, as a stock declines to lower and lower depths, it is deemed more and more of a "value" by the fundamental analyst. The terrible price action is almost always followed by a "deterioration in the fundamentals," at which point some (but not all) analysts will jump ship. But not before severe (and in many cases fatal) damage has been sustained to the portfolios of their followers.

Wall Street Week host Geoffrey Colvin responded that many would say this problem was due to "conflicted analysts," and unfortunately we then moved on to another topic. Here's my belated response to Geoffrey. This is not a "conflicted analyst problem." It is a "fundamental analysis problem." The tenets of fundamental analysis are inconsistent with the tenets of controlling losses, which guarantees that this approach (and the investors who follow it) will lose big money in a bear market.

But will fundamental analysis make big money in a bull market? Not necessarily, as often a fundamental analyst will jump off a rising stock because his or her price target has been achieved or the stock has become too "richly valued." In other words, the effect of fundamental analysis is often to cut profits short while at the same time allowing losses to become open-ended. Is this the exact opposite of the formula for success in investing? Yes.

So I may be bragging a bit when I disclaim being a fundamental analyst. But I also have a complaint – mostly with myself – when I make such a statement. Because in developing my market forecast for 2003, I realized that in many ways, the fundamentals are important to me, though not in the traditional sense.

I refer to my approach to investing as Expectational Analysis®. Much of this approach has to do with sentiment analysis, along the traditional lines of taking a contrarian approach when investors are excessively bullish or excessively bearish. I deem excessive bearish sentiment in the context of strong technical price action to be particularly compelling as a contrary indicator, and I found this to be the case throughout most of the bull market of the 1990s. Similarly, excessive bullish sentiment in the context of weak technical price action is also a compelling contrary indicator, and I've found this to be the case during the current bear market.

But while the process of superimposing an analysis of investor sentiment atop technical analysis can provide a very powerful timing tool, there is more involved in my Expectational Analysis® approach. And this "more" has to do with my approach to the fundamentals, which is a two-step process. First, I try to develop an objective view of the economy and corporate earnings in terms of where we are and the spectrum of future possibilities. Note that my goal is not to "forecast" economic growth or earnings growth, but to focus on a realistic assessment of the possibilities. Allow me to digress for a moment. Fundamental analysts love to smugly assert that it is impossible to forecast future price action from past price action. In other words, technical analysis is built on impossibility. I'll defer the defense of technical analysis for a future column. But here's part of my reply to those smug fundamental analysts. It is impossible to forecast the future direction of the economy and corporate profits. The best one can do is to develop a number of potential scenarios, assign some probabilities to them, and move on.

I chuckle when I hear an economist or analyst forecasting GDP growth down to the tenth of a percent level for four quarters out, and then disclaim that "if we go to war with Iraq or if there is a terrorist attack on American soil, all bets are off." Much obliged. And while we're at it, all bets would also be off if the dollar collapsed, if the real estate bubble popped, if the consumer retrenched and stopped spending, and if business investment was totally unresponsive to zero interest rates.

My purpose is primarily to illustrate the folly of "single point forecasts," but also to illustrate that such forecasts tend to be "best case." Why? First, because most "wild card" events that can seriously affect such forecasts tend to have a negative impact. And second, the vast majority of the forecasters are employed by firms whose interests would be best served by a strong or improving economy and a bull market. "Whose bread I eat, his song I sing."

So what's the next step in my Expectational Analysis® once I develop my "spectrum of future possibilities" for the economy and corporate earnings? I compare this spectrum to the prognostications of the community of economists and analysts who make the traditional single-point forecasts. If I find the aggregation of these single-point forecasts to be excessively optimistic, my conclusion will be that the market, whose current price reflects these forecasts, is vulnerable to disappointment. And if I find these forecasts to be excessively pessimistic (this does happen – but mostly during bull-market periods), my conclusion will be that the market could benefit from positive surprises.

Let's now move on to my outlook for 2003.


Fundamental backdrop

We all know the bullish case for the economy and the market in 2003. The economy is beginning to recover, the most recent Fed rate cut will help solidify this recovery, the Fed's "reflation" commitment will successfully head off potential deflation, price/earnings ratios (albeit based on tenuous 2003 earnings-growth estimates and the inflated "operating earnings" still accepted by Wall Street) are reasonable, and profit margins are improving. Productivity growth remains high. Dividend and other federal tax relief is on the way. Liquidity is impressive, what with all the money that has fled to bonds and to money market funds and with the Fed running the dollar printing press 24/7. The stock market is extremely unlikely to decline for four consecutive years, and the third year of a presidential term is always bullish for the market. The unspoken assumptions are that overseas wars will be brief and relatively painless and there will be no terrorist attacks of significance on American soil.

What are some of the flies in the above ointment? Per James Grant, the S&P P/E ratio thought to be "reasonable" is currently about 50 based on "core earnings" (defined by Standard & Poor's as excluding such goodies as gains on pensions and including options as an expense). As for other measures of market valuation, Bianco Research (by way of Grant's Interest Rate Observer) reports that the ratio of total market cap to GDP is currently just over 100 percent. While this is down from the all-time high of 183 percent at the 2000 market peak, it compares unfavorably to a figure of 81.4 percent on the eve of the 1929 market crash. GDP growth unquestionably decelerated in the fourth quarter of 2002, so there is little economic momentum as we move into the New Year.

Year-over-year corporate profit growth was a mere five percent in the third quarter but is expected to be +12 percent in the fourth quarter and to accelerate further in 2003 despite the recent deceleration in GDP. Sequential earnings barely budged from the second quarter to the third quarter. Earnings are being "grown" due to "cost cutting" – read "layoffs" – as opposed to top-line revenue growth. The Fed rate cuts have done little to stimulate the economy but have done much to put the consumer deeply in debt and stimulate a potential real estate bubble, both of which are serious threats to continued heavy consumer spending. Weak holiday season sales might be a first indication of a weakening consumer. "Reflation" could help touch off a major plunge in the dollar and a massive outflow of foreign money from U.S. financial assets. Dividend tax relief may get swept aside as the continuing tide of corporate layoffs fuels additional anger toward those who are "rich" and those who have jobs. And any stimulation from tax relief on the investment front may be more than offset by tax increases and spending cuts from cash-starved state governments. If the market can rally for five consecutive years (1995-1999), why is it so improbable that it decline for four? And war and terrorism can paralyze the economy if they escalate dramatically.

So there you have it. A potential economic recovery in 2003 on one hand and numerous risks to that recovery on the other hand. So how are the economists sifting through these various potential scenarios – this "spectrum of future possibilities" – in terms of their forecasts for 2003? The answer turns out to be quite simple. Of the 62 economists polled in the December 30, 2002 issue of BusinessWeek in their annual economic survey, exactly two are forecasting negative corporate earnings growth in 2003. In addition, each of these 62 economists was asked to forecast GDP growth for each quarter in 2003. Of these 248 quarterly GDP forecasts (62 times 4), exactly zero predicted negative economic growth. Let me rephrase this for additional emphasis. Not a single one of the 62 economists in the BusinessWeek economic survey for 2003 believes that the U.S. economy will experience a single down quarter. And finally, quarterly economic growth in 2003 is expected to proceed in a smooth upward progression, beginning with +2.7 percent for the first quarter (which is likely to be a good deal higher than that for fourth quarter 2002) and ending with +3.6 percent for the fourth quarter.

At this point, you don't need me to conclude for you that the economic forecast for 2003 underlying today's stock prices is biased in the extreme toward the best case. Nor do you need me to further conclude that under these circumstances, the market is vulnerable to being punished should this best-case scenario not materialize. What's more, the market is vulnerable to being mangled beyond recognition in the event of a worst-case scenario.

Does this mean that the best-case scenario (or a reasonable facsimile) cannot or will not develop? No. It simply means that the potential rewards in terms of stock price appreciation in 2003 under the positive economic scenarios are modest compared to the potential risks in terms of stock price depreciation under the negative economic scenarios. Despite this negatively skewed reward/risk ratio, Wall Street and the vast majority of the mutual fund management community are more than willing to make the bullish bet for 2003 with your money, just as they were in 2002, 2001, and 2000. Are you?


Technical backdrop


The importance of utilizing long-term charts and long-term moving averages for gaining the perspective needed for forecasting has never been greater, as the heightened market volatility in recent years has substantially increased the "noise" component for the shorter time frames. And speaking of noise and volatility, set forth below are the major rallies and declines in the Dow Jones Industrial Average (.INDU) for the period 2000 through 2002.






Does the above period strike you as a "devastating bear market," or just a "rollercoaster" characterized by "bookend" rallies and declines? Of course, the mathematics of cumulative gains and losses are such that gains and losses that are roughly equal over time will bottom line to a net loss. This effect plus the "unanswered" 7.8-percent decline at the end of the period were sufficient to produce a cumulative loss of nearly 30 percent.

Now check out the monthly chart below of the .INDU since 1995 with its 10-month and 80-month moving averages. Note that the 10-month moving average has been in a steadily declining mode since early 2001, and how the monthly .INDU closes have become more and more consistent below this trendline. Note also how the 80-month moving average is rising from below, and how the index's decline in September 2001 was contained on a closing basis at this longer-term trendline. But the 80-month was broken on a closing basis in July 2002, and since August 2002 it has not been penetrated to the upside even on an intra-month basis. Note also the "compression" of the declining 10-month and rising 80-month as the trendlines began converging until they ultimately crossed in December 2002. The .INDU rally in early December failed right at this critical juncture in the 9000 region.





My conclusions from this chart? We are mired in a very serious bear market, and despite all the volatile upside bounces, the bulls have not only failed to take control but are steadily losing ground in their battle with the bears. The failure by the .INDU last month at the convergence of the two long-term moving averages was extremely compelling technically, and it foretells yet another downside leg that is likely to take out the October 2002 lows.

Is this technical scenario set in stone? By no means. Technical analysis merely provides a road map of past price action that can be very helpful in forecasting future price action. So the best I can say is that the odds favor a continuation of the bear market. I can't quantify these odds, but I can quantify the point at which the technicals will improve significantly. Should the .INDU rally above 9000 and its 10-month and 80-month moving averages, and should the 10-month moving average begin to flatten and then turn to the upside, the .INDU would emerge from its bear market mode. But unless and until this occurs, the "trend that is your friend" – whether or not you want such a "friend" – is to the downside.

In addition to the road map provided by this chart, it is also extremely helpful in establishing a context for investor sentiment. When (as now) we are in a clear bear market, investor sentiment is expected to be bearish. To the extent that such sentiment can instead be interpreted as bullish or hopeful, the conclusion is that the bear market has not yet bottomed. More on this in my next section.

Why, you might ask, am I focusing here on the Dow Jones Industrial Average? For two reasons. First, it is the "headline index" that most investors use as a proxy for "the market." And second, the .INDU has outperformed other major indices in recent years to such an extent that it is not out of the question to refer to a .INDU relative-strength chart as a "bubble."

Below is a chart of the 14-year relative strength of the .INDU compared to the S&P 500 Index (SPX). For the past 20-plus years (including a period that predates this chart), the .INDU's relative-strength line has fluctuated above and below a mean relative strength value of 100. So at its current value of 125, the .INDU is 25 percent higher relative to the SPX than its "norm." Must the .INDU revert to its mean, and, even if it does, must this occur in 2003? No and no. But it is clear to me that the .INDU is the most vulnerable of all the major indices, and that it is likely to "lead" the next market leg down. And on this next leg down, it would not be unreasonable to expect the .INDU to give back half of its current excess relative to the SPX, which would amount to as much as 1,000 points of additional .INDU downside.






My final chart is that of the U.S. Dollar Index (DX/Y), monthly from 1988 to date with its 10-month and 80-month moving averages. After my discussion of the comparably situated .INDU chart above, it should come as no surprise to you that I see the technical picture for the dollar as both dire and dangerous. And there would be nothing nice in store for the U.S. financial markets following a sharp plunge in the dollar in 2003.








Sentiment backdrop


Bear markets persist when sentiment is hopeful and they end when all hope is gone.

I can think of no better illustration of this principle than the following quotations from The Plungers and the Peacocks by Dana L. Thomas, the best book ever written on the history of Wall Street.

"Many astute traders had accurately called the turn in 1929. During the summer (of 1929), the market looked extremely perilous to them and they withdrew, converting substantial paper profits into cash, taking shelter just in time from the hurricane. Then, still using their heads and following the time-tested maxims of classic trading strategy, they reentered after the (October 1929) crash, buying stocks at 'rock bottom' levels in anticipation of the expected rally … These were skilled professional traders, wise in their lore of the market, an astute minority that had accurately estimated the situation only a few months previously – and now (in late-1930) they too were being destroyed by a market that simply refused to act according to any historic pattern or rational line of behavior."

"Edwin Lefevre, a veteran financial writer who had been covering the Wall Street scene for thirty years and was personally acquainted with many of the top operators, conducted a survey in 1932 to find out just how the boys who had guessed right in 1929 were doing. Time after time he ran across men who had bought cheap stocks in 1930 and sold them at tremendous losses in 1931."

"In the summer of 1932, the stock market once again displayed its perverse penchant for doing the absolutely unexpected. Just as the majority of pundits failed to guess the top in 1929, so now they were unable to guess the bottom. Suddenly, without the slightest warning, when business was at its worst, when everybody was overwhelmingly bearish and there seemed to be no hope, the market started upward again. The low point of the decline was reached on July 8, 1932. The next day, stocks began to rally and within the next sixty days the averages shot up 90 percent in the quickest, sharpest, most precipitous climb in history."

So the majority of pundits failed to guess the top in 1929 and couldn't guess the subsequent bottom. Fast-forward to today. Clearly, the majority failed to guess the top in 2000. So is there any reason to think they'll be any more proficient in calling the ultimate bottom of this bear market? For further background, let's take a look in the table below at the results of The BusinessWeek Market Survey since 1995, when the venerable business magazine began polling upwards of 50 market strategists for their forecasts for the next year.






If you need convincing about the adages that "Bull Markets Climb a Wall of Worry" and "Bear Markets Decline on a Slope of Hope," just review the table above. The forecasts ahead of the four bull market years (1995-1999) were all well short of the actual result. Ignoring the transition year of 2000, the forecasts for the two bear market years (2001 and 2002) have been well in excess of the actual result. In fact, the more deeply we've moved into the bear market, the more aggressively bullish the forecasts have become.

Dissecting the data from the 2003 forecast a bit, we find that of the 65 prognosticators with Dow forecasts, 25 saw the Dow closing out 2003 above 10000 and just five saw the Dow below 9000. This is a remarkable statistic, given that the Dow was in the 8500 area when these forecasts were being developed. And how many of these 65 saw a declining Dow for 2003 – a close below 8500? Three.

The "Slope of Hope" (a term first coined by Bob Prechter) is not only alive, it is alive and kicking. Expectations for the market in 2003 are simply too aggressive, and they become even more out of line when considered in the context of the questionable fundamentals and the weak technicals.

Once again, this does not mean that the market cannot or will not be higher by yearend 2003, or that a monster rally will not occur this year. It simply means that the bull trade is still too crowded, which drastically lowers the odds that a final market bottom will be achieved in 2003. At what point will the odds be strongest for a bottom? To borrow from Dana Thomas, "When business is at its worst, when everybody is overwhelmingly bearish and there seems to be no hope."



Conclusion


I expect 2003 to be another bear market year.


I do not rule out an extension of the rally that began on the first trading day of the year through the end of January. If this rally occurs, it is likely to be a major fake-out that will result in an avalanche of money flowing into equities at just the wrong time.


I expect the bulk of the damage to have occurred by mid-year or shortly thereafter, with a potential Dow low in the 5800-6000 area.


I look for a rally beginning in the second half of the year that could take the Dow back above 8000, but only if the Dow first takes out the October 2002 lows and trades down to at least 6500.


I see Nasdaq and the techs as being the least vulnerable to a first-half slide and the Nasdaq potentially posting a gain of up to 50 percent for 2003. I am most bullish on the small- and mid-cap techs – the "single-digit midgets."


I see the biggest cap names in the Dow and the S&P as being most vulnerable to major declines. Many of these stocks have attracted "safe haven" money due to their large capitalizations and liquidity and the illusion of safety. But I see these names as being "first out" of institutional portfolios on the next market leg down. These include Pfizer (PFE), 3M (MMM), Procter & Gamble (PG), Citigroup (C) and General Electric (GE).


Overall, 2003 is likely to be a very tough year for heretofore "safe" or "quality" assets – mega-cap stocks, the dollar, and bonds. I suggest "thinking speculatively" – not with all your capital but with a portion of your funds – by investing in low-priced tech stocks and gold stocks (see below).


I continue to believe that all investors should have at least 10 percent of their portfolios in precious metals stocks. Gold has broken out to the upside technically and will be the beneficiary of the Fed's "reflation" push and potential dollar weakness. And investor enthusiasm on gold remains muted, with gold funds accounting for a smaller than average percentage of sector fund assets.





- Bernie Schaeffer