Q & A with Jim Stack

"Q & A" with Jim Stack, technical and monetary analyst, par excellence! posted 06/01/2000 James Stack is president of Stack Financial Management, and editor of the InvesTech Market Analyst and the InvesTech Mutual Fund Advisor. These publications began national circulation in 1982 and have earned widespread recognition for their time-proven risk allocation strategy, as well as their in-depth analysis of the Federal Reserve. In addition to addressing numerous investment seminars, Jim has been a guest on "Wall $treet Week with Louis Rukeyser," and is regularly invited to appear on the "Nightly Business Report" (on all PBS stations), CNN's "Business Day" and "Moneyline," and CNBC. For more information on InvesTech Research and Stack Financial Management, please visit www.investech.com.

Jim, thanks for spending some time with us. Let's get right to the question on everybody's mind: Is Wall Street officially in a bear market?
	The 'official' answer is still "no" - but only because the blue chip indexes have failed to drop 20%. That's the traditional threshold for labeling a bear market. But as we near the end of May, the majority of stocks are well over 20% off their highs. The DJIA and S&P 500 are down ~11%, the Russell 2000 index has lost -24.3% and the Nasdaq Index has tumbled -37%... its largest decline in 25 years. It's hard to say, after having lost over $2 trillion of value in two short months, that Wall Street is not in a bear market. When it comes to lofty expectations, valuations, technical divergences, and economic imbalances, we certainly have the prerequisites for a bear market. Our Gorilla Index, which is updated weekly on our website at www.investech.com, is right on the verge of confirming a probable bear market. The 17 stocks included in this graph are only 3% of the 500 stocks in the S&P 500 Index (25% by capitalization weight), yet they accounted for almost 60% of the S&P 500's rally from the October 1998 lows. They're the momentum leaders... and where they go, the broader market will invariably follow. Watch this graph for a break under recent lows.
What is the most compelling evidence of a bear market?
	In short - breadth, leadership and monetary policy. Bear markets have common characteristics. Among these are diverging breadth, poor leadership and an unfavorable monetary climate. One measure of the breadth or support behind market moves is the NYSE Advance-Decline Line. Even though the DJIA has rallied from its sub-10,000 lows in March, the A-D Line is still in a downward or bearish trend, having peaked over 2 years ago (in April 1998). This is the biggest divergence in history without seeing a bear market in blue chip indexes. The fact that this divergence is continuing only heightens the risk going forward. Among the technical models we follow in The InvesTech Market Analyst, our Negative Leadership Composite is the best tool for monitoring market leadership. This proprietary indicator is firmly in bear market territory. Even raw leadership data is compelling, as the majority of days continue to see more stocks hitting new 12-month lows than new highs on both the NYSE and the Nasdaq. In the monetary arena, every U.S. bear market of the past 40 years has unfolded while the Federal Reserve was tightening. In spite of the new economy arguments, "Don't fight the Fed" is as valid a doctrine today as it was in 1987, 1972, 1968, and every previous market peak.
How can a bear market occur with all the money flowing into mutual funds?
	This is a common, widespread question, and you're right, we should revisit this myth. A simple answer would be, "In the same way the bear has wiped out $2 trillion in wealth over the past 10 weeks in spite of net mutual fund inflows." Stocks don't rise on mutual fund inflows... they rise on soaring expectations. For every $1 that goes into a mutual fund and the fund invests in a stock, someone else must sell that $1 of stock. Money doesn't flow "into" or "out of" the market except in the case of new issues, secondary offerings, or cash takeovers. Money flows through the market - and it's rising or falling expectations that drive stock prices. Proof lies in historical fact. The chart below shows the cumulative inflows into equity mutual funds over this past bull market - a total of $1,287 billion. It also shows how much the market has increased in capitalization - $10,711 billion. It's a fallacy to think that $1,287 billion created the entire $10,711 billion increase in stock value. The majority of that increase came in rising valuations fueled by soaring expectations. Need more proof? Just step back to the 1969-70 bear market that ended the Go-Go Fund hey-days of the 1960's. Every step of that 18-month bear market saw net inflows "into" mutual funds... right up until the final month of the bottom. So, can a bear market unfold with all the money flowing into mutual funds today? Absolutely!
Why can't the Federal Reserve simply cut interest rates to save the stock market?
	For one reason, because Alan Greenspan is more worried about the economy than Wall Street. What has been construed as a pro-bull monetary policy has actually been only an anti-recession policy. The dilemma comes from the Fed being too willing to step in too soon at the first sign of trouble. To unwind that perception, we believe Greenspan will not ease until he sees the "whites-of-the-eyes" of a recession. Here's why... 1) Inflation expectations are rising. The Federal Reserve Bank of Philadelphia has raised its projected inflation rate for 2000 from 2.5% to 3.1%. The National Association for Business Economics has also raised its inflation forecast from 2.5% to 3.0%. A poll of members of the NABE revealed that 29% of the 109 firms had decided to raise prices - the largest share in five years. 2) The Federal Reserve is behind-the-curve in raising rates. At first, Wall Street celebrated the rate hikes - thinking each increase would turn out to be the last. More recently, analysts just scoff at the rate hikes and elaborate on how the "new economy" tech stocks are less sensitive to Fed policy. Both these views ignore the basic fact that the Fed is in trouble. It's a 10-year old recovery with significant imbalances that are getting bigger by the month. This graphic, supplied by our friends at ECRI (Economic Cycle Research Institute), shows their widely-followed Future Inflation Gauge (FIG) overlaid against the Federal Funds Rate. I'll point out two observations: First, notice how peaks (and bottoms) in the FIG usually lead the turning points in the Federal Funds Rate by 6-12 months. That's important in knowing when to expect this round of Federal Reserve tightening to end - the Fed pays close attention to this leading inflation model. The second observation is how wide the spread is between the current FIG reading and the Federal Funds Rate. The FIG is substantially higher than in 1994, but the Federal Funds Rate is just catching up to those '94 levels.
So, has the Fed's tightening been preemptive?
	Chances are, the answer is "no" and that there are more rate hikes to come. The FOMC made that explicitly clear in their May meeting. Not only did they raise rates by ½% pt (twice the level of the previous 5 rate hikes), but they also accompanied the action with strong rhetoric... "...the Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future." ... in effect, keeping a tightening bias and warning of another probable rate hike at their June 28th meeting. The stock market's reaction was decisively different this time around. At first, the Nasdaq tried rallying as it has in response to every FOMC meeting since last June. On the day preceding, as well as the day of, the FOMC rate hike on May 16th, the Nasdaq rallied 5.3%. In the 5 days following, the Nasdaq Index tumbled 14.8%.
Why would the market reaction be different this time?
	We believe one major answer lies in the vested interests. Until now, Wall Street firms, analysts, and media have been very successful in convincing the public to ignore rising interest rates. They, more than anyone else, don't want Wall Street's party to end. And if nothing more, they were quick to encourage a belief that the Fed would "save the market" if necessary to prevent a bear. But to tighten rates a full ½% pt... and accompany it with warnings of more rate hikes... and to do so after the Nasdaq had already lost 30%... planted an important seed-of-doubt in investor psychology. All of a sudden, the implied support (from the Fed) doesn't seem to exist.
Will tightening by the Federal Reserve lead to a "soft landing" this time around?
	It's possible, but improbable. Unlike 1994, where inflation pressure came almost entirely from higher commodity prices, today's imbalance comes from the tightest labor market in thirty years. Rising commodity prices are always easier to reverse than rising wages. The Employment Cost Index, which measures wage pressures, has hit the highest level since the 1990 recession, and anecdotal stories of wage pressures and unfilled job openings are far more rampant.
So why can't the Fed tighten just enough to raise unemployment 1% or so, without triggering a recession?
	Simply because it's never been done before. We've overlaid more than 50 years of Unemployment data with recessions (this graph is the featured chart-of-the week on bearmarketcentral.com as well as InvesTech's website from May 29th - June 4th). There is not one instance where the Unemployment Rate rose by 1% pt, or even ½% pt, without ending in recession within 12 months. What are today's odds? Not good!
If a bear market has begun, why not follow a buy-and-hold strategy?
	Wall Street insiders and mutual funds would have you believe that if you stick with the big-name or high-growth stocks and follow a buy-and-hold strategy, you can't go wrong. Historically, that's just not true. Here's another way to look at it... When you buy a new car, do you insist on an air bag because you plan to get in a wreck and use it? No, it's insurance against that unforeseen catastrophe. And while that serious accident is a low probability, the longer you drive, the higher that probability becomes. In a sense, the same is true with investing. Nobel Prize-winning economist Paul Samuelson theorized, during the big bear markets of the late 60s and early 70s, that the longer you invest, the greater the odds you will run into one of those catastrophic bear markets like 1973-74, 1929, or 1989 Japan. They're the kind of bear market you don't quickly recover from - either financially or emotionally. If you try to ride through one with a large, established portfolio, then it can change your whole life. Some will argue that those killer bear markets are "accidents" and cannot be predicted. True. But just as the worst traffic accidents usually come at the highest rates of speed, those killer bear markets invariably start from the highest level of overvaluation. And having an "air bag" means adopting a safety-first investment strategy like that used in our money management branch at Stack Financial Management.
This is a presidential election year, which is normally very stable for stock prices. Does this take some of the risk out of the market?
	You're right about election years. In fact, since 1956, not one Presidential Election year has seen the S&P 500 lose over the last 3,4,5,6,7 or even 8 months of the year. With that said, we should point out that the gains are typically meager - with 7 of the 10 election years showing less than 7% rise between May 1st and December 31st. Even so, this is not the time to underestimate the downside risk. We believe the election will have some influence, perhaps stretching out the bear longer than anyone on Wall Street would like - including us.
If this is the beginning of a bear market, when do you think we'll see the bottom?
	In duration, if we've seen the market highs, then we probably shouldn't expect to see the bottom until sometime next year. This Chart below shows all 19 official (-20%) bear markets in the DJIA for the past century. Investors have a misconception that bear markets are 3-month wonders - to ride through and get back to making money. Yet historically, the average bear market length -from top to bottom- is 1.54 years or over 18 months:
What kind of losses are we talking about?
	Any view on downside risk should look first at valuation. The biggest bear markets come from the highest levels of overvaluation... not the biggest runup in interest rates or the highest inflation, as many might think. We've updated the following "Bear Market Risk" graph to reflect potential losses from today's levels. This reflects how far the S&P 500 Index could fall if the Price-to-Dividend, Price-to-Book Value, or Price-to-Earnings ratios were to return to their respective 70-year norms in a bear market. We've also shown the downside risk to past bear market lows (in valuation). In simple terms, it means the downside risk is a LOT greater than investors are being told.
In light of this bearish evidence, what's your current advice?
	Add up the potential risk with the evidence we've discussed and you'll understand our "air bag" strategy... Keep any stock and mutual fund allocations small. We are still holding small allocations in Japan, gold and bear market funds, but the bulk (79%) of our portfolio is in the safety of cash or T-bills. In a year when most investors are under water and watching their high techs crash, our defensive portfolio is ultra-low risk and has remained surprisingly stable. More importantly, it allows us to sleep soundly at night. Remember, a bear market in stocks is a bull market in cash, and our high cash allocation guarantees that we will be able to take advantage of the great buying opportunities that lie ahead as this bear market runs its course.
Thanks Jim, it's been a pleasure and thanks for sending us your Chart of the Week each week. Our readers really look forward to it!
	Thank you!
	For more information on InvesTech Research and Stack Financial Management, please visit http://www.investech.com