The bear's back in charge

published 31 October 2005

This is "no way to celebrate" a double anniversary, says Alan Abelson in Barron's. Instead of marking the fourth year since the great bull market's high in 2000 and the first birthday of a "spirited upswing" with a "real bash", investors "bolted for the door" last week. All three major US indices saw this year's gains wiped out, with the Dow Jones posting its biggest four-day drop in 15 months before a rebound on Friday left it 3.4% down on the week. UK and European markets, which "dance to the tune of Wall Street", also tumbled: the FTSE suffered a 2.2% fall on Thursday, its largest one-day fall since May, and Germany's Dax lost 5% as concern over the strength of the US economy was compounded by the terrorist attack on Madrid (see page 27). A correction was overdue, says E S Browning in The Wall Street Journal; the Dow Jones had gone nearly a year without a 5% pullback from a high. But most strategists insist that this should prove "a bump in the road", with strengthening earnings underpinning further gains.

Don't count on it, says www.Dailyreckoning.com. According to Richard Russell, who since 1957 "has called more important tops and bottomsthan anyone we can recall", Dow Theory (see right) dictates that the rally is over. "The die is cast", says Russell on www.Dowtheoryletters.com. The market "should now enter a broad decline" as the bear market, which was interrupted by the rally from October 2002, takes over again. It's not just Dow Theory that suggests stocks are in "sorry technical shape", says Mark Rostenko in The Sovereign Strategist. The Nasdaq is "way under" its 50-day moving average, while the S&P has "decisively penetrated" this support level. It is also weakening after retracing 50% of its original slide - often the trigger for the resumption of the long-term trend. This seems to be more than "a run of the mill correction". Nor are the economic fundamentals auspicious: the failure of the economy to produce significant job growth bodes ill for consumer spending and corporate earnings, which have hitherto been bolstered primarily by unsustainable cost-cutting. Indeed, the consumption outlook is already clouded by the fact that the average consumer's debt last year rose by 10% as income grew by 1%.

Another ominous sign is that while retail investors have poured billions into equities, corporate insiders have been "selling their own stocks like there's no tomorrow", says Abelson. Moreover, the S&P is still at 23 times earnings, and history shows that p/es always eventually decline to single digits as extreme bullishness is eclipsed by extreme bearishness, says Russell. The S&P could lose 66% of its value in the next few years. Investors would be well-advised to "sit with cash and gold until this bear market ends".