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2004 Forecast

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Back to the Lows?


Long term trend analysis suggests that the equity market advance since October 2002 has been a bear market rally. Long term bull markets tend to stay above a rising 200 week average (ex: DJIA 1922-1930, Nikkei 1965-1990, S&P500 1976-2001). When a long term bull market is over, the index

declines significantly below its 200 week average, which begins to decline. Long term bear markets tend to stay below a declining 200 week average (ex: Nikkei 1990-present). Applying that analysis to the Nasdaq and S&P500 shows both indexes have rallied back to their declining 200 week averages (see next chart page). This is the zone where the advance should end and a new decline should commence.

The question is: How far could stock indexes fall in the next decline? In a long-term bear market the answer is simple -- back to the lows (at least). Of course, long term bear markets eventually produce lower lows, but from here (the declining 200 week average) -- the logical target is the previous lows. That is down 45% for the Nasdaq, 32% for the S&P500 and 46% for the Dax.

The next question is: When? We do not have a precise answer. But our hypothesis is that the Nasdaq high was one month ago (January 26th).

2009 a look back to the

2004 Forecast

26 June 2004

The Naz is down 7% from there and is sporting a typical 1929- style chart top pattern. Our model forecast points strongly down for most global stock indexes intermediate term (3 month view). The long term upward model forecast (which made us so bullish 15 months ago) is over (12 month view). Short-term the Nasdaq could be vulnerable (see comments below on 50 day average).

The October 2002-January 2004 rally lured consensus sentiment into utter complacency concerning downside risk. Back to the lows downside risk is not on many radar screens at the moment. Many market participants are long stocks based on momentum and trend following systems. Another 5% decline in the Nasdaq could unleash a torrent of stop-loss selling. There is the potential for a discontinuous event -- a downward price gap in which trade execution is impossible. Portfolio insurance is not a big product anymore (as it was in 1987) -- but delta hedging by brokers is basically the same thing. It amplifies declines. The market goes down, delta hedgers sell more without regard for price sensitivity. In that environment, daily percentage swings can get crazy. It is better to be prepared than to get caught napping.

Sector rotation forecasts support the downside market risk hypothesis. Low beta (fall less than the market) sectors look best in relative terms (consumer staples, energy, health care). Higher beta sectors have a negative relative and absolute model forecast (mainly tech and cyclicals). The S&P500 tech sector just declined below its 200 day average (relative to the index -- tech/S&P500). This advanced

state of tech deterioration is happening right before everyone’s eyes -- seemingly without recognition.

Equity mutual fund inflows have been strong this year, but have tapered off recently (from about $6 billion to $3 billion/week -- AMG data). Inflows have provided portfolio managers with ammunition to buy the dips. That has kept equity prices aloft -- but is probably just burning up capital. The Nasdaq has just fallen below its 50 day average. That is significant, simply because many market participants look at that level and it has kept them long the market since last March (11 months). Any further Nasdaq decline from here could unleash stop-loss selling.

That is our expectation. If a decline does arrive, the first logical target is the 200 day average -- down 8% for the Nasdaq. But the tech/S&P500 ratio has already broken that 200 day average level, so it may not provide much support. After the 200 day average, the next major target is the previous lows. The bottom line is -- there is a lot of downside risk out there and portfolio managers should do whatever their mandate allows to avoid it.

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