Though it isn’t the usual fare for my list, I thought I’d send along this
Barron’s interview with Ned Davis, a stock market researcher. I thought it
helpful in understanding the bigger economic picture, esp. as regards our
recent tax and interest rate cuts and other measures intended to devalue our
currency. Wall Street columnist Aaron Task of TheStreet.com alerted me to
this article, and commented that in general, we are involved in a global
competition right now to devalue our currency, as are most other major
economic powers. Japan’s interest rate is already 0, has been for a few
years now, and it doesn’t seem to be helping them.
Sobering thoughts about our administration’s fiscal policy. It all seems
designed to prop up a fundamental bear market with short term gains, just in
time for the election…and just before the wind gets knocked out of it
MONDAY, JUNE 16, 2003
The rally is just a phase of a long-term down
market, researcher says.
By SANDRA WARD
AN INTERVIEW WITH NED DAVIS — Armed with rich
databases of economic and market information,
along with any number of proprietary
indicators, Davis and his team at Ned Davis
Research in Venice, Fla., are able to pinpoint
trends and patterns that are scarily reliable
in assessing where the market is headed. The
penetrating analysis and prescient
prognostications are the reasons that Ned
Davis Research, founded in 1980, counts 851
paid-up subscribers in 32 countries and has
4,962 people on its mailing list. He
graciously took our call recently and offered
his thoughts on why this rally is for real,
and why the continuing bear market is also.
Barron’s: I hear you’ve become more positive
about the market.
Davis: Well, I feel much the way I did when we
had the interview last year. This is a
cyclical bull market within a secular bear
market. There have been some distinct
improvements since we last spoke, but
basically the message is the same.
Q: What’s improved?
A: Since October of last year, corporate bonds
have been up nearly every day. They’ve been
really strong, and that is an added stimulus
on top of what the Fed has been doing. The tax
cuts certainly have had more of an investment
tinge this time around. Not only did we get a
dividend cut and the capital-gains cut, but
people in the top bracket will see their rate
cut from 38.6% to 35%. That’s a tremendous
drop in taxes. So that’s a tax cut on top of a
tax cut that was already out there. The
dollar, which had been drifting down for
almost two years now, really started tumbling
earlier this year, and that’s another
stimulus. It is a risky stimulus, but another
one all the same. There have been so many
added kicks that the market took off after
(Embedded image moved to file: pic03902.jpg)
Ned Davis says "cyclical bulls" like the
current market can last for a year. He’s been
buying tech stocks.
Q: But how stimulative are these tax cuts?
Don’t they just benefit the rich?
A: There is some truth to that. But the rich
are the ones that own the stocks. So, it won’t
mean much for the whole economy or for the 1.8
million people who have lost jobs in the past
three years, but it is very bullish for the
stock market and stock investors.
Q: What’s been the impact of long rates coming
A: Long rates were providing huge competition
for stocks. Also, a lot of companies had
gotten themselves into very heavy debt and
were not able to tap the commercial-paper
markets and had to raise money in the
corporate bond markets at higher rates, which
was a drag on earnings. There were a lot of
bankruptcies and to help them service the
debt, long-term rates needed to come down. The
yield on Baa, the main corporate investment
grade, has dropped 21% in the past year.
That’s about as low as they’ve ever dropped.
This was a tremendous stimulus. We find a 1%
drop on a 12-month basis tends to be bullish
for the market.
Q: What else points to a cyclical bull?
A: We went back and classified the market as
secular periods of three to four cycles of 16
to 20 years and then broke those down into
secular bull periods and secular bear
periods.Very, very long supercycles. We
studied cyclical bulls within secular bear
markets and found that they didn’t last as
long as other cyclical bulls and they didn’t
go quite as high, but in the 17 we looked at,
the S&P 500 went up an average of 50.6% and
lasted 371 days on average.
Q: More than a year?
A: Some of these were in the 1966 and 1982
period when the market went up for two years,
but we are using averages here. Still, they
were quite substantial. Then, while there are
a lot of dissimilarities between Japan and the
U.S., I think there are a lot of similarities,
too. We looked at the secular bear that
started in 1989 in Japan and found four
rallies of 48%, 34%, 56%, 62% that also lasted
many, many months. That gives you an average
of 50%. And it confirmed what we found in
cyclical bulls during secular bears here. On
top of this cycle, the U.S. also has a
presidential-election cycle and from the
mid-term election year lows, which are usually
reached in the fall, to the high of the next
year, we’ve typically had rallies measuring
51.2% on average. Those are three different
measures that suggest we could have a pretty
substantial cyclical bull, even amid this
long-term bear market.
Q: How much of this have we already
experienced? The market is up quite a bit.
A: The S&P is up about 28% from the lows. The
NDX 100 [Nasdaq 100] is up 53% from its low
and has already gained as much as the S&P
usually does in a cyclical rally. But we
looked at all the rallies in this secular bear
since the 2000 high and we also looked at the
rallies in Japan, and we found, in almost
every case, speculative growth stocks tend to
lead these rallies. We saw this after the 9/11
lows. The S&P went up 21% and the NDX went up
53%. For whatever reason, whether it’s the
level of short interest or beta or the nature
of bear-market rallies, the leadership is very
speculative, so even if the S&P goes up by 50%
or so, the Nasdaq could double. Already,
biotechs and Internet stocks have doubled. If
the S&P goes up by another 100 points or
whatever, surely they would participate, but
maybe not to the extent that they have so far.
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Q: What’s your model asset allocation?
A: We are 65% stocks, which is 10% overweight
the benchmark, 30% bonds and 5% cash, both of
which are 5% underweight the benchmark. I
wouldn’t call that a negative position on
bonds, but clearly we are favoring stocks
Q: Where are you putting your money?
A: Last year, our work pointed us toward
large-cap growth stocks. In the past month or
two, we shifted to small-cap growth. We are
still very heavy in the financials. But they
are slowly coming off our list, and tech and
growth stocks are picking up. There is a
general feeling that the financials are
overdone, and overweighted in the S&P. I’m not
convinced yet. They still act pretty good. In
every cycle where there is excess, the banks
finance it, so they typically end up getting
in trouble. In this case, they all have been
financing mortgages and housing prices have
risen. Actually, the mortgage foreclosure rate
is at a record high, but it is still only
1.1%. That is not the kind of thing where you
really get into trouble. I thought the REITs
would be the first place we’d see problems,
with the downturn in commercial real estate
and the fact that their dividends weren’t
going to be favored in this tax law. They did
have a pretty big correction, but they are
back up at their highs right now. It seems as
if they should be getting hurt here.
Q: Any other areas that you’re positive on or
more concerned about?
A: All across the energy spectrum — in
particular natural gas — we are seeing demand
higher than we would have expected and supply
a lot weaker than we expected. We really see a
lot of problems in the supply-demand situation
for energy, and the selloff that occurred
after the war was a buying opportunity.
Q: What about the hiding places for the bear
market you liked last year?
A: I thought you could hide in bonds and
utility stocks. The utilities didn’t do too
well for a while, but they have certainly come
on like gangbusters lately and that could be
because of the dividend tax cut. I still like
that group. Bonds have done well, too. A lot
of people have been saying for a couple of
years now that bonds were overvalued. But only
since the end of May has our bond valuation
index shown them to be overvalued. Bonds –
corporate and government — are not a good
hiding place right now. My guess is they are
going to have a pretty big correction in the
third quarter, and that may end up being a
good time to buy them again.
Q: Why the correction?
A: They’ve had a tremendous run here. My
suspicion is that the economy is really going
to surprise people in the third quarter and if
that comes about, after people have grown
accustomed to sluggish and muddling growth, we
could see a very strong third quarter and, if
so, the bonds would sell off. The pickup in
the economy won’t be sustainable and therefore
bonds would be a good buy if they have a good
shakeout. But I wouldn’t own them now.
Q: Why won’t the pickup in the economy be
A: All the stimulus will make a difference.
But the first round of stimulus only lasted a
quarter, and I am worried that may happen
again. Unemployment is still a weak spot. If
we do get a booming quarter as I expect,
there’s the risk that rates might go up. Or
the dollar will continue to collapse. In
either case, the boom won’t last.
Q: And the boom is driven by consumers
continuing to spend?
A: They’ve been selectively doing that. Mostly
in autos and certainly in housing. Mortgage
refis and mortgage applications have been at
new all-time highs. That’s the Fed’s position,
really: make cash trash. People don’t know
what to do about it. A year or so ago, there
were some things to do because bond yields
were high and housing was booming. Now the
bond yields have gone away. Short-term rates
are certainly going to go away. They may cut
them another half-percentage point. After fees
and all, you are getting zero on money-market
funds. So where does that money go? Auto sales
really have stalled out, but the incentives
are dramatic. When people get the reduction in
their withholding and a check in the mail,
that may be just enough to kick auto sales up
again. Housing is still booming.
Q: What’s your take on the housing market?
A: There are pockets of bubble. But it’s not
like the stock-market bubble. It’s not even
close. If there’s another run here, and we put
another whole layer of housing boom on top of
the mountain we have, that might be very
risky. I do think there is a mortgage-debt
bubble now. People say it’s not a problem
because rates are low and housing prices are
going up. That is all true. But still the debt
has got to be paid. If housing stalls or
interest rates go up, the mortgage-debt bubble
becomes a really big problem.
That is the Catch-22 the economy is in. We’ve
got this $32 trillion debt bubble out there,
and it is as risky as can be. And, yet, rates
are plunging, so everything looks manageable.
It is true we’ve had 2.4 million bankruptcies
filed since the economy started up in the
fourth quarter of 2001. But, with rates down
at these levels, we are managing. If somehow
the Fed succeeds this time and things heat up
again, interest rates will start up. The debt
service will be enormous and that will put us
right back to where we are now. That is the
problem. If the Fed doesn’t pull this off, and
they don’t trash cash and they don’t force
people to go out and spend their last dollar,
or borrow their last dollar, then you are
looking at deflation. And that is terrible.
Q: Somehow then, they have to manage in this
little sweet spot for quite a while.
A: Right. If they heat things up, it is bad
and if they don’t heat things up, it is worse.
They have clearly chosen to try to heat things
up. You’ve got an election next year and they
have a good shot at it. My guess is we’ll have
a great quarter, maybe a little longer than a
quarter, then rates go up and it will end
almost immediately. There is not a lot of
pent-up demand. All the pent-up demand is
coming from driving rates lower and lower and
The other side of that, the other big secular
risk I see — and it all ties together — is
that our exports are exactly what they were
back in 1997. This either means our goods are
not competitive or the dollar is way
overvalued. It is probably a little bit of
both. We had a productivity jump, though I am
not convinced it is as good as the numbers
show. Given that productivity jump, our goods
should be competitive, and they are not. We
definitely needed to see the dollar come down,
but it needs to come down carefully and
slowly. If foreigners understood our policy is
what I think it is, that is, making cash
trash, why would they keep their $3 trillion
in this country? At the point they realize
this, this nice decline in the dollar all of a
sudden becomes tremendously bad.
Q: So how do you respond to a cyclical bull
market within a secular bear market? Are you
bearish or bullish?
A: As a trader, I’m long and I’m bullish. We
might get another 10%, maybe more. The
question becomes how do you know when the
falling dollar turns from a positive to a
negative? It becomes negative when it starts
impacting the bond market. Given the dollar
situation, given the $32 trillion in debt, I
don’t think the bond market needs to go up
anymore. But it needs to behave. It can’t
start tanking. What will end this rally is
either the tape deteriorating or the bond
market starting to really go down.
Q: And you’re trading in and out of small-cap
A: Yes, mostly tech and biotech stocks. Every
week since we became pro-Nasdaq we read –
often in Barron’s — that tech is back in a
bubble. It is unnerving, it seems like there
is a tech stock every day that has a problem,
including IBM recently. It is very hard to sit
here but that’s where the leadership is.
Q: But you still think this is a
A: It is not going to feel that way next
quarter. I will be very surprised if we don’t
have a big jump in activity. But when you have
this kind of debt — we’ve had two rounds of
tax cuts and 12 cuts in interest rates and
only one good quarter of economic activity –
that tells me there is a tremendous drag,
whatever they want to say about debt being
manageable and debt service being low. There
is another drag in that the stock market’s
valuation, if you look at actual earnings,
clearly is not cheap. You can get a cyclical
bull but you can’t push it too far because the
turnaround stocks are already overvalued. If
you go buy that we are in a secular bear, this
is not just a little animated correction.
When you look at past secular market bottoms,
the P/E on stocks was 10 and the dividend
yield was 5%. You can talk about stocks at 15
times earnings being good value, but if you go
back to 1942, 1949, 1974, 1980, 1982 and 10
P/Es and 5% dividend yields, we are not even
close to that. It becomes clear that with all
the talk about the debt bubble, it still isn’t
being discounted by the stock market.
Q: A lot of people don’t seem to think it’s a
A: The Fed is trying to keep the economy
afloat while we are working ourselves out of
debt. The problem with what they’ve done to
get the economy going is they’ve tried to cure
the problem of too much debt by adding more
debt. It all looks good as long as rates stay
down here. I think whatever the Fed is doing
is wrong, but I don’t really know what else
they can do. If our problem is we save too
little and borrow too much, what are we doing
now? We are making savings worth zero and we
are telling people to borrow. We are doing
just the opposite of what we need to do. The
reason they are doing it because they are
scared to death of deflation. They are scared
to death of a depression. So they are fighting
it tooth and nail, and I think short-term it
is going to look pretty good. But I am very
dubious about the long term.
Q: What are mutual-fund flows telling you?
A: It is minor really, but we’re seeing
inflows again to funds after months of
outflows. They are not big but they are
decent. It started in March and April. What
was interesting was that fund managers didn’t
spend the money or spent very little of it. It
showed a fair amount of pessimism. It is not
like they’ve got much cash to speak of. If you
want to make a bullish case based on fund
flows, you have to base it on the fact that
for the past three years, a lot of
institutions have been putting a whole lot
more money in bonds rather than stocks. So
portfolios may be out of line with too much
exposure to bonds. They don’t have a lot of
cash, so in order to rebalance and buy stocks,
they are going to have to sell bonds. The
question is: When they start to sell bonds,
will that send interest rates up or is the
inflation picture so positive that it won’t
Q: Thank you very much, Ned.