Special Investment Newsletter

December 5, 2002

The stock market and what it holds for the near term

My model continues to indicate this is still a very dangerous stock market that is proving to be very costly for both bulls and bears. This bear market has now undergone 12 bear market rallies, each of which has failed when investors met their targets for covering a small portion of their previous losses and started to sell again. As each rally failed, the bears moved in again, convinced that the market would suffer a calamitous sell-off that would enrich their positions. However bear markets are well known for their ability to deplete the core-capital of both the bulls and the bears, and this one has been no exception. Since my model warned us in October 1999 that the end of the Great Bull Market was approaching, investors have lost over $8 trillion in the stock market. This does not include the additional capital losses suffered by the bears as they moved prematurely into investments designed to profit from a collapsing market that hasnít completed its cycle ... Yet!


Graph of the failed Nasdaq rallies

 

The bond market and the future for interest rates

Not only have we had 12 failed stock rallies since this bear market began, we have also now had 12 official interest rate reductions by the Federal Reserve. Do you remember that when the Fed first began cutting rates, way back in January 2001, everyone was saying that the Bull market would soon return? When my model issued the sell signal in October 1999 it also indicated that long-term interest rates were too high. And for those of you who understand the relationship between interest rates and bonds, youíll understand why my investment recommendation at that time has been so profitable. Our subscribers who purchased government debt instruments have seen them safely increase in value by almost 53% during a time when many other investors have lost 50% or more of their core or retirement capital. In my opinion long-term rates must fall farther because the implied yield on these long-term debt instruments should be around 1 Ĺ to 2%. This would mean that our investments still have far more potential for gains in addition to those already realized.

Inflation and Deflation

Lately we have been hearing and reading in the financial media about the possibility of deflation. And recently the subject has caught the attention of the Federal Reserve. In recent testimony before the Joint Economic Committee of Congress, Federal Reserve Chairman Alan Greenspan said that while the economy is not yet "close to a deflationary cliff," he and his central bank colleagues are watching it closely and taking it very seriously. This deflation problem comes, as somewhat of a surprise to those who thought that inflation was the real problem. However, my subscribers have been kept informed about the progression into deflation for over a year. The financial media, most of whom donít really understand the relationship between inflation and deflation, were quick to point out that the recent Producer Price Index rose 1% in October and that deflation was no longer a threat. What these commentators didnít understand was that the increase was not caused by too many customers chasing too few goods or services but was really caused by three occurrences that are unlikely to take place again. Among those was the West Coast dock closure that created a situation where goods were withheld from the system, temporarily providing price pressure on the index. Deflation takes place when there are too few customers chasing too many goods and services, resulting in repeated rounds of price reductions that lead to layoffs, falling wages, and a decline in business investment and consumer spending. When deflation gets a foothold, consumers and businesses, knowing that prices are likely to be lower tomorrow than they are today, hoard cash and put off buying, making the situation worse and driving prices and wages down farther. Competition has been so fierce during the last 12 months that companies have been forced to cut prices in what has proven to be a futile effort to maintain sales. Auto manufacturers have been offering deep discounts in order to maintain sales, at the expense of profits, and we are now seeing retailers using those same strategies in order to salvage what will probably be a very poor holiday retailing season.

Record Debt and Bankruptcy problems

Although there is great hope by many that the economy will soon recover and stocks will start to rise again in the beginning of a new bull market, the odds are against both. Our economy is struggling to deal with the after-effects of the unwinding of the largest financial bubble in history. Compounding the problems is the fact that until recently Americans had a negative savings rate that has left many completely unprepared to deal with the loss of their jobs or to pay existing debts that are at record levels. Corporate debt is also at record levels and the inability of many publicly traded companies to service their debts on time has resulted in a record number of debt downgrades by reporting agencies Moodyís and Standard and Poorís. In addition the Federal budget surplus has quickly turned into a deficit because of falling tax revenues and rapidly increasing costs for the war on terrorism and increased security costs. A recent survey of state Governors reveals that most states are in the worst financial shape since World War II and nearly every state is in fiscal crisis. The statesí fiscal problems will force them to drastically increase taxes, decrease services and to continue laying-off employees.

Our current view

If you think about it, it is obvious that something must truly be different this time around. If we were in a Ďnormalí environment, such as the one that preceded the onslaught of this bear market, certainly the market would have recovered by now. Surely 12 interest rate reductions would have revived the economy and breathed life back into stocks. Yet this has not happened, as anyone who bought stocks over the period of Fed reductions knows. Furthermore, the latest rather dramatic 50 basis point reduction clearly implies that the Fed is very worried about the future of the economy. Yet, for some strange reason, even with the pain so many investors have experienced, they are still ready to jump at the first sign of life in the stock market. We know why the commentators and analysts have advocated this activity, of course--- that is their business to do so. But why have investors not thrown in the towel, which would be one indication of the beginning of a true end to the bear market? I guess it must have to do with our fascination with the media. These days, because it is the business of the market programs to promote stock investing, most everyone gets caught up in the hype. If they only took the time to look at the obvious evidence that argues against the theories they have been hearing, they would make much wiser decisions.

I think the odds are high that this stock market will continue much lower. At the same time we are getting very close to a deflationary signal. If that happens, as I have said before, we will be taking action. Take care.

Jim Shepherd

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