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A Positive Case for the Stock Market?

Below is an extract from a commentary posted at www.speculative-investor.com on28th November 2004.

In an interesting article at http://www.safehaven.com/showarticle.cfm?id=2187 Ron Griess attempts to present a bullish outlook for the stock market in 2005. Since this article is at odds with what we think will happen we thought we'd tackle, in today's commentary, the two main points raised by Mr Griess in support of the bullish case, and then take a look at what would need to happen in order for 2005 to be a good year for the US stock market.

One of the two main points in the above-mentioned article is that the "decennial cycle" points towards the stock market doing very well during 2005. To be specific, one aspect of this cycle is that years ending in '5' demonstrate by far the best average performance. For example, over the past 11 decades years ending in '5' have yielded an average gain in the Dow Industrials Index of 31.6%, which is way above the long-term average.

The way-above-average returns achieved during years ending in '5' might appear to be statistically significant at first glance because the probability is low that the '5' years could have generated such performance purely by chance. However, given the relatively small sample size (11) there would always have been a good chance that one year would yield returns that were well in excess of the long-term average; it probably just happened to be the number '5' year. In other words, unless someone can explain to us WHY the years ending in '5' should provide vastly superior performance we think we can put this oddity down to randomness, the upshot of which is that there is no reason to expect next year to be a good year for stocks simply because it ends in '5'.

The other main point contained in the above-mentioned article in support of a bullish outlook for stocks in 2005 is the performance, over the past few years, of both the Unweighted S&P500 Large-Cap Index and the S&P400 Mid-Cap Index, the point being that while some of the 'generals' (the stocks that dominate the S&P500 Index) have fallen on hard times the 'privates' have been doing extremely well. For example, the below chart shows that while the S&P500 Index remains well below its March-2000 all-time high the Unweighted S&P500 moved into record-high territory during the final quarter of last year and continues to trend upward. A chart of the S&P400 Mid Cap Index, by the way, looks quite similar to the Unweighted S&P500 chart.

Clearly, the broad market has done much better over the past few years than the market-cap-weighted S&P500 Index would suggest, but is this a reason to be bullish as far as NEXT year is concerned? In other words, just because a market has done extremely well in the past should we necessarily expect it to do well in the future?

In our opinion, no. For one thing, if the Unweighted S&P500 rises to around 2200 early next year then it will have doubled within the space of 27 months and will be ripe for a substantial correction. And even a normal correction within an on-going bull market would likely result in a retracing of around half the gains achieved since the October-2002 bottom, or a drop of around 25%. For another thing, the impression we get when looking at the chart is that the Unweighted S&P500 is well into the final upward leg of the rally that began in October-2002. In other words, we see nothing in the above chart to contradict our view that a major top will be put in place during the first quarter of next year and that 2005 will turn out to be a poor year for the US stock market.

On a side note, if you want to view the REAL performance of a market then you need to look at the market in terms of gold rather than nominal dollars. The reason is that inflation can, and often does, boost market prices, but when a market's long-term trend is higher relative to gold we can be confident that the gains are not purely the result of inflation. Taking a look at the S&P400 Mid Cap Index in terms of gold (refer to the chart below) we see that a large decline between the first quarter of 2001 and the first quarter of 2003 was followed by a rebound that probably peaked during the first quarter of this year, having retraced about 50% of the preceding decline. This chart has BEARISH implications as far as the coming year is concerned.

There are two main things that will have to happen to make 2005 into an up-year for the S&P500 Index and neither of these appears to be a likely prospect. One is that the T-Bond price will have to remain above the lows established during the third quarter of last year and the second quarter of this year because the bullish case for the stock market revolves around long-term interest rates remaining near current low levels. The other is that 'investors' must continue to become less risk averse (an over-valued market can continue to move higher as long as market participants are becoming more willing to take on risk).

In our opinion, though, the next big move in the bond market will be to the downside and such a move is likely to get underway during 2005. Also, we assess that sentiment is as bullish now as it was when caution was being 'thrown to the wind' during the heady days of 1999; so the probability that the general level of risk aversion will continue to slide for another 6-12 months appears to be low, to say the least.

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