A Special Newsletter April 2003

Latest Major Signal in Model: 10/25/99 SELL, S&P; 1294

Junk Bonds! The next investor quagmire?  

For the sake of my sanity, I have almost had to totally stop listening to the spin doctors on the various financial programs. The hype and emotionalism has become so extreme that no one could really hope to get unbiased information from these programs anymore. Furthermore, many of the people making the strongest claims are not even investment professionals. Much of the faulty advice is actually coming from the hosts and anchors themselves. They are supposed to be reporters, interviewing experts and dispensing information that investors can use. Instead, I have noticed that either by inference or direct commentary, many of these characters are urging investors to jump back into the stock market. I have even seen some of them analyzing chart patterns, although I know that a short while ago they didn’t know the difference between a stock and a bond.

Don’t compare Dessert Storm to the present when it comes to investing.

Now, after more than three years of bad advice, the vast majority of these people are telling us again that we must immediately get back into stocks. Of course, their argument lately revolves around the fact that since the market rallied after the war in Iraq in 1991 began, the same thing should happen now that war in Iraq is underway again. I have already talked about many of the differences between the two eras, but this is such an important issue, I feel I must cover it more fully. As I have told you, although there are some similarities between 1991 and now, there are many differences, and to automatically assume that things will work out precisely the same way as last time is very naïve.

For example, during 1991, as you can see in the chart below, we had a very powerful, model-generated buy signal in place. Now, we are still under the influence of a sell signal. Then, interest rates had room to move much lower to stimulate the economy---now, we have had 12 consecutive interest rate reductions without effect. Then, the stock market was building a base for subsequent advances---now it is still in an obvious downtrend as the effects of the bursting bubble are still unfolding.



Are stocks now cheap?

But the most apparent difference, and one that flies in the face of most current commentary, is the matter of valuation. Pundits are continually proclaiming that stocks are now ‘cheap’ and have fallen so much that they are a bargain. So, just as in 1991, cheap stocks now will lead to big gains. However, the second chart casts doubt on that notion. As is obvious, valuations now are not cheap compared to the 1990-1991 period. At that time, P/E ratios were in the low twenty dollar area. Now, as you can see, P/E levels are hovering around the $30 level, historically very high. Now, I am well aware that earnings can be so low during weak economic periods that P/E ratios are skewed to the high side. But the economy was weak in 1991 as well and yet ratios consistently declined, reaching their lowest levels around mid-1994.

Data Source: Standard & Poors

Look again at the chart covering the 1990-1991 period. Now, compare the activity to what has happened in our current environment over a similar timeframe as depicted in the chart below. Does anything look that similar? Can you see that not only do the underlying economic conditions not match up in the two eras, the chart patterns do not look anything alike either.

In 1990, after Iraq invaded Kuwait, the DJIA fell some 20% from its high of 3000 in July 1990 to its low of around 2365 in October 1990. Then it basically chopped around until just before the war broke out in 1991. At that time, the model issued a powerful buy signal, which became very profitable for us. The fact is, though, the DJIA merely moved back up to the level it was at before the invasion of Kuwait, and then basically stayed at that level for the entire next year.

So the decline was sparked specifically by a particular event but that catalyst was not the real cause of the decline. The model had identified the changes that had taken place in the investment environment that indicated a decline was imminent, thus the sell signal of August 1990. The intensity of the decline, exacerbated by the fear of war and rising oil prices etc., allowed the fairly moderate bearish conditions to be worked out rather quickly and so we received a buy signal only 5 ½ months later.

Conversely in today’s situation, the market has been on a long-term decline, and the rally we saw as the war began is little more than a blip on the screen. Yes, as I always remind you, at some point we will get a new buy signal in stocks. We may even get some short-term technical breakout if certain downtrend lines or resistance areas are breached. But to constantly jump the gun and proclaim a meaningful bottom has occurred every time the market rallies slightly is nonsense.

Additional Faulty Assumptions

Not only have investors been urged to return to the stock market in the current timeframe, many are being lured into potentially even more dangerous investments. Again, the premise is based on the perceived similarity between 1991 and now. This particular investment area is ‘high-yield corporate bonds’, a euphemism for ‘junk bonds.’ This approach could lead to much pain. Let me explain

In 1991, many investors purchased high-yield corporate bonds, which eventually did very well as the economy, recovered and companies honored their obligations. Therefore, with the high returns available now (based on the current yield of available junk bonds) it makes perfect sense to make the same kind of investments now, according to this faulty logic. Once the economy recovers, which obviously will be very soon, using this same faulty logic, (as soon as the uncertainty regarding Iraq is removed) company balance sheets will improve, bond ratings will go up, companies will diligently repay their obligations and everyone will be happy. But what happens if the economy continues to worsen and companies are unable to repay their bond obligations?

There are so many companies right now on the precipice of financial disaster. Many companies that were recently investment grade bond issuers are now in the junk category, investment-wise. The next step could very well be default and we have obviously seen this occur more and more recently as companies are struggling under massive debt, with no pricing power and declining sales. If you buy junk bonds and a company goes bankrupt, you will be very lucky to get anything back on your investment at all. Secured creditors will almost certainly scoop up all available assets. So to play this game now, with no real assurance that the economy is about to recover (as recent data continues to confirm) is essentially the same as gambling. The only difference is in this case someone gets a commission instead of vigorish. Either way, you will likely lose.

So, to sum up, be patient. We are still making good returns with our current positions and I believe the stock market will make a significant move soon. And now that the readings of the model have started to move once again, I believe that some of the largest gains we will experience in our lifetime lie ahead. Take care, Jim Shepherd

3 Month Introductory Trial Offer - Only $99

Now for only $99 you can experience the finest investment advice in the country, which is a fraction of the $20,000 institutions and high net-worth individuals pay for Jim's prescient advice.

- Click here for this Introductory Trial Offer -

* Money-back guarantee applies only to subscriptions of one year and more.