Archived Message from Ed - December, 2002

Happy New Year! Well, we survived 2002. The markets seem to have bottomed on October 9 and ended the year up 13% from then. What should we expect for 2003? There are several compelling reasons why we believe 2003 should be a good year.

In short, it looks almost definite that we have seen the market bottom and that the sun, moon and stars are aligning to make 2003 a good year. Here is why we believe this...

1. Presidential (4-year) cycle - There is an astoundingly consistent history of good years in the 3rd year of the U.S. presidential term. In fact, in the last 15 terms, the average return in the 3rd year has been 23.2% - nearly twice the return of any other year. Also, of the 15 years where the markets declined, 8 happened in the 1st year of a term, 6 in the second year, 1 in the 4th year - none in the 3rd year.
2. Decennial (10-year) cycle - The last 100 years, most major bear markets have been in years ending in 0-2: 1920-21, 1930-32, 1940-42, 1960-62, 1980-82 and 2000-2002. So far, they have always been followed by a strong year ending in 3.
3. 1973-74 Comparison - A graph of 2000-2002 is eerily similar to 1973-74 - the last large bear market. Both periods showed a decline between 49-50% from top to bottom, and had a big sell-off just before a double bottom. In 2002, the markets hit a bottom on July 24 and October 9, while in 1974, the bottoms were October 4 and December 9. This was followed by the markets jumping nearly 50% in the next 6 months.
4. Forbes forecast - Steve Forbes, an influential business writer, the owner of Forbes magazine and America's most accurate forecaster, is the only forecaster to win the prestigious "Crystal Owl Award" 4 times. This award goes to the writer that most accurately predicted the markets for the next year. Steve Forbes prediction for 2003 - S&P500 up 30%-50%.
5. Historical bear markets - Even though the Dow Jones has risen in 77% of months, in the last 50 years there have been 10 declines of more than 15%, with March, 2000-September, 2002 being the longest at 30 months. From the bottom, the average market rise lasted 46 months during which the market rose 109%.
6. Historical "secular" bear markets - While the last 3 years seem shocking to us, in actual fact the markets have had 7 declines of more than 40% in the last 100 years. Only 2 of these have been within the last 50 years. Excluding the 1929-32 bear (when government policies exaggerated the problems), the other 6 have been amazingly similar in size - all 6 have seen the S&P500 drop between 44%-51% from top to bottom. This would tend to suggest that the 50% decline we have seen from March 10, 2000 to October 9, 2002 is typical of secular bear markets and has fully run its course.
7. "Big picture" 10-year trend - To make any reasonable forecasts, we must understand what has happened. Why did we have this large bear market? During past "secular" bear markets, there were major problems in the economy and political events far more severe than anything from the last few years. With 20/20 hindsight, we can see that the main reason is the unwinding of the tech bubble. The NASDAQ index, which contains mostly technology companies, had been rising steadily through the 1990's, but then more than tripled from 1997 to early 2000. Since then, it has fallen back to 1997 levels. In short, technology had become overvalued, but the excess is now completely removed. This should mean that we can now expect to continue the longer up trend from the early 1990's.
8. 20-year trend channel - All the major stock markets have been steadily rising since 1980 within a "channel" - 3 parallel lines, with 1 through the market lows, one through the market highs, and one half way between. This channel has been rising at about 13.5% for the major markets. All the major markets are now right around the low channel line and they have turned upward whenever they neared this trend line within the last 20 years.
9. 50-year demographic trend - While the markets are often irrational short term, the long term trends are determined by the rising profits of companies and by demographics (the study of numbers of people in each age group). Demographics tell us that 1990-2010 should be the 2 best decades for the markets in our lifetime. This happened in the 1990's, but, of course, this decade has started out completely differently. There is no reason, however, to assume that we will not eventually return to the long-term trends, which would mean that the remainder of this decade should be exceptionally strong. For example, economists have recently been surprised almost every month by consumers (baby boomers) that drive 70% of our economy and have continued to spend and essentially prevented a recession during the last 3 years. Demographers, however, predicted this would happen 20 years ago! The leading demographer, Harry Dent, is now forecasting reasonably positive returns for 2003-4, with very strong bull markets from 2005-8.
10. War uncertainty - For more than a year, the markets have had to deal with war uncertainty, but that uncertainty is likely to go away in the next few months. Historically, markets drop when it becomes clear that a war is about to begin, but then rise sharply when it starts to look like the war is coming to an end. The markets always anticipate what will happen and are now already assuming that a war is inevitable (likely in February). Whether there is a short war or a war is averted, both scenarios are positive for the markets - and one or the other is almost sure to happen.
11. Market is cheap. - Based on the most widely accepted valuation method for stock markets, the Fed Model, stocks were 40% undervalued in early October and are still 30% undervalued. The Fed Model is based on earnings per share divided by the price per share of the companies in the index, adjusted for the level of current interest rates.