The sky is falling - read all about it

The stock market is dispassionate. It is the ultimate arbiter. It invariably gives the investor what he deserves and seldom what he wants.
We are at the beginning of a multi-year market decline, a "bear market." There are three stages to a bear market.
In stage 1 the "smart money" leaves. It departs quietly and unobtrusively leaving behind a hope that this is merely a "standard" correction and that the market will soon resume its upward advance.
By stage 2 the "smart money" is shorting, gaining positive returns on each decline and selling off "long" positions into the rallies. Recovery is still the hope, though now the time scale has been delayed. Now it is not merely a "correction" but a "destocking of inventories." Better times are ahead, but not this year, possibly next, probably the year after, definitely the year after that.

As each stage passes, the I.Q. of the money left in the market and hoping for a restitution of their losses gets lower and lower until the very dumb money is left. And then the dumb money panics. This is stage 3 and a bottom is finally formed.
We are in the early part of stage 2 as the chorus of "experts" still cannot see anything amiss. Most still believe that the U.S. consumer will keep on spending instead of saving. They still see the possibility of the corporate sector increasing their capital spending and thus reviving the economy that powers the world.
There is another point of view, quietly voiced but gaining adherents by the day.
This perspective states that what we have experienced over the past 200 years was a secular bull market whose upward progress was interrupted by cyclical bear markets. However, two years ago there was a change in trend. What we are experiencing now and should experience in the future is a secular bear market whose continued slide will be temporarily halted by cyclical bull markets. In other words, for the next 18 years or longer, the trend is down and depression is on its way.
This is not a "doomsday" scenario, neither is it set in stone. It is a prediction based upon the laws of Elliott Wave theory, supported by the mathematics of nature and grounded upon more than 60 years of empirical research and practical application. It predicts "turning points" in social mood whose influence is mapped by the most accurate, the most detailed and the most dispassionate measure of human emotions - the stock market.
What we have experienced from the 1980s until 2000 was a mass mania of optimism of historically high proportions that propelled the stock markets of the world to extremes. However, as all manias of the past this mania will end at a point that is lower than the point at which it started.

So where does the bottom lie?
Does it lie at the time when U.S. Federal Reserve Chairman Alan Greenspan made his "irrational exuberance" speech on Dec. 5, 1996? Then, the Dow Jones Industrial Average stood at 6,437; the Nasdaq Composite Index at 1,300.12 and the S&P500 at 744. Should this be the case then the Nasdaq should be bouncing back soon as it is some 150 points lower at a six-year low.
Interest rates are at 40-year lows in the United States and the U.K. U.S. treasury yields on both five and 10-year notes have been driven to 44-year lows. Therefore it would seem probable that the markets will eventually bottom at similar 40-year lows.
This does pose a problem for the Nasdaq as it arrived on the scene on Feb. 8, 1971, some 10 years too early. In 1962 the highs that year were 71.13 in the S&P500 and 726 in the Dow Jones.
This won't happen overnight. Look at the Japanese experience. From 38,957 on Dec. 29, 1989 to a low of 8,969.26 so far this year with more than seven "bull markets" in between. And it will go lower. Much lower. Our predicted bottom is around 6,000, some 33% lower than the recent low.

The short-term crystal ball
Of immediate concern are the next few weeks. Historically the last two weeks of September and the first two weeks in October are the worst in the stock market calendar. Mutual fund managers restructure their portfolios ahead of their fiscal year end in October. Disposals are the first to be made and with the disaster of the preannouncement season this year the disposals are accelerating.
Secondly, at least 29 million investors in investment-based pension plans (401k) will receive statements of their accounts in the first two weeks of October. Recent research by the Vanguard Group, the second largest U.S. mutual fund manager, states that up until July 2002 90% of investors did not make any changes to their investments and that over 70% have been investing into equities.
During the record July decline $53 billion was withdrawn from mutual funds and many investors were on the verge of throwing in the towel.
In August only $5.8 billion was withdrawn. However this was the first month in over 14 years that stock funds faced redemptions despite a positive performance in the S&P500, which rose 0.65% over the month.
This month so far the Dow Jones is down over 5% in line with the fall in the S&P500. The Nasdaq is showing a loss of 6%. But these losses are insignificant when compared to the U.K., which is down 15.3%, France, down 21% and Germany 24%. So much for Europe driving the world economy.
The 401k investor will not withdraw. But he may switch out of equities into cash or bonds. So the next few weeks will be very interesting.
If you are not "short," if you cannot benefit from the declining markets, as we are, then you should be in cash. If you are still hoping for a change in trend and are determined to hold "for the long term" then may we make a suggestion?
Why don't you gift your portfolio over to your grandchildren, or better still, your great grandchildren. We have assumed that you can actually read and write.

Zbigniew Piekarski is a portfolio manager based in Warsaw. He can be e-mailed at zbigp@bipnet.pl