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2006: To Bull or not to Bull?

by M.A. Nystrom
December 23, 2005
Cambridge, MA

1. Happy Holidays

First off, Merry Christmas, Happy Chanukah, and Joyful Holidays to all of you. I would like to say thank you to all of you for all of the support that you’ve given me this year. Remember to give thanks for everything you have during this holiday season, and send up a prayer for those who are less fortunate. Because I am a trader, I tend to write about money, the markets and other such worldly things. But at the end of the day, I know that money is just an illusion – bits of paper that we play with and trade for, but that don’t make a lick of difference in the things that truly matter. As I always like to say, the best things in life are free, and there is no amount of money that can buy them.

2. 2006: To Bull or Not to Bull

If there is anything that I have learned in my years of watching the market, it is that anything can happen! So that we’re not taken by surprise, I’d like to take a look at two opposing viewpoints on the stock market and the economy in 2006 and beyond. The bullish viewpoint, held by Harry Dent (read his free forecast) among others, holds that we’re on the brink of a new bull market that could bring the Dow up to 40,000 (literally) in the next several years. The bearish viewpoint, most prominently held by Robert Prechter, holds the exact opposite: that we’re on the brink of a deflationary depression that will ultimate bring the Dow down to 400 or below! Literally.

Now, you may be a bull or a bear and have already made up your mind about where the stock market is going. But I urge you to keep an open mind and take a look at both arguments. My generally bearish outlook made me laugh at the idea of Dow 40,000 until I actually read the argument. Considering everything, including the fact that Helicopter Ben will be sitting in the Fed Chairman’s seat for the next several years, Dow 40,000 is not an impossibility. The case for deflationary depression is based on cycles and extremes of valuation. Today the market is so historically overvalued, and global financial imbalances (read: American debts and deficts) are so large that a correction is all but inevitable.

So without further ado, the arguments!

2.1 The Case for Deflationary Depression

Robert Prechter’s argument, based on the Elliott Wave Principle, is that we are on the brink of a major deflationary depression. That’s depression with a capital D. The public is so heavily leveraged while at the same time invested in the equity and housing markets, that any decline will have a devastating impact on wealth, further impacting the economy and leading to a downward spiral into depression.

It is not difficult to imagine a recession next year, for a number of reasons. High energy prices have been a drag on the economy, confidence is eroding, the stock market has been struggling to make a new high, and we have a flattening (if not already inverted) yield curve. People and businesses see these signs and they begin to cut back on spending, creating a self-fulfilling prophecy. And because all of the economy’s actors – consumers, businesses and the government as well – are so deep in debt, there is no margin for error. What starts out as a small recession could slip quickly into a major depression.

As the American economy has matured, it has transformed from a manufacturing base to a finance base. For example, companies that were once America’s great manufacturers – Ford and GM – are on the brink of bankruptcy. General Electric, another of America’s great corporations has managed to remain prosperous by transforming itself into a finance company whose main function is the manipulation of credit and derivatives. This has worked out well during the rising wave from 1982 until 2000, but when the financial tide shifts, GE will face the same difficulties as GM and Ford, if not worse.

Banks and financial companies remain the most profitable today, but think of where their money has come from: fees – mortgage fees, fees for refinancing homes, and penalty fees. In the case of banks, ATM fees are up to $2.50 per transaction now! On a $20 withdrawal, that is over 10% in fees. A bounced check costs $20, a late fee on a credit card is $35. These are highly profitable but they are also extremely parasitic on the ‘customers’ they are supposed to be serving. Eventually they will bleed their victims dry – many have already been forced into bankruptcy. As the number of victims increases, and debt – which is a counter party’s asset – is eliminated, it will contribute to deflation.

Deflation means a reduction in the money supply. Today, the money supply is based completely on debt. Most everyone has spent money they don’t have – this is why they have big credit card bills, automobile loans and big, unpaid mortgages. The result of all this debt is higher prices for everything. Prices are so high that it is difficult to afford anything without going into debt. More money chasing the same amount of goods leads to higher prices.

At the same time, some things have come down in price. For example, I saw a brand new DVD player on sale for $19.00 at the corner drugstore! This is unbelievably cheap. How can this be, if there is so much excess debt money floating around? The reason is that for certain things there is so much excess supply – a lot of borrowed money also went into building production capacity in China and elsewhere. This money needs to be paid back, which means there is a lot of price competition for manufactured goods, which drives prices down. This is also deflationary.

Depressions occur when the economy contracts severely, which happens when there is a sharp decline in the demand for goods and services. A recession next year could easily lead to such a depression as people cut back on excess spending to meet the payments that really matter: the mortgage. Many families require two income earners to meet all the monthly expenses. If one income is eliminated, that means a lot of discretionary spending will be cut. Ebay and Craigslist do a booming business as unnecessary goods go up for sale. Pretty soon, everything is up for sale, from the third car, to the second car, then to the vacation house, the stocks and bonds (that are already crashing) – all in an effort to salvage value.

A deflation such as this contracts the total supply of money and credit. When that happens, the nominal prices for virtually everything, from stocks to bonds to commodities, go down. Even consumer goods go down in price in a severe deflation. People assume the Fed can save the day by lowering interest rates, but just as you can lead a horse to water but cannot make him drink, you can offer a man a loan, but you cannot make him borrow and spend. In such a pessimistic environment as a depression, no one will want to come near a loan. They will only want to pay back what they already owe (and are woefully behind on). Prechter believes that we’re facing such a possibility today.


Charts produced with Track’N Trade Pro

The stock market peaked in 2000, bottomed two years later, has been rallying for three years. All of this could simply be viewed as a huge, slow motion dead cat bounce. That being the case, the next leg in the decline, the violent third wave in Elliott Wave terminology, could be on the way next year.

2.2 The Case for the Next Bubble Boom

In some respects, Harry Dent is just as pessimistic as Robert Prechter. It’s just that he doesn’t expect the next depression (yes, that is still depression with a D) to start until sometime after 2010. In the meantime, he believes we’re likely to see a powerful surge that takes the Dow up to 40,000 before then. Dent claims that we are in a continuing bubble boom that did not end with the 2000 – 2002 crash in stocks anymore than it did with the 1987 crash. Rather than being a huge dead cat bounce, the market has been forming a base for the last 16 months that will lead to the mother of all rallies.



Charts produced with Track’N Trade Pro

Baby boomers have always been the primary force driving market movements in the US economy, and there is still no end in sight to this pattern. One of their primary concerns is retirement, which is causing them to seek sources of growth for their investments. As a result, they drove the stock market to historic highs in 2000. When this boom ended, they shifted their investments to housing, driving this sector to historic highs as well. Now that this sector is topping, they are looking for the next hot sector in which to grow their money. This is another reason that we’ve seen mini bubbles in commodities such as oil and gold recently – it is this hot, baby-boom money looking for a return.

So, where is the next hot market? Dent predicts that the stock market will rise once again, and the long sideways correction we’ve seen from 2003 to present is similar to the basing pattern that preceded the huge stock market rallies from 1925 – 1929 as well as from 1995 – 2000. In spite of all the bad news to hit the economy – from 911, the Iraq War, the most corrupt and manipulative presidential administration since Nixon’s, the terrible hurricanes, and an oil shock – the market has held its own. This is a good sign for future gains.

Both previous rallies mentioned above, in the 1920’s and the 1990’s, were technology driven. There were brand new technologies that spurred innovation, drove good deflation, and produced must have items for consumers. Harry Dent further notes that the 1925 – 1929 boom came a decade after a big boom from 1915 – 1919 when automobiles were first popularized. 1925 – 1929 built upon and extended that earlier boom. By extension he suggests that although 1995-1999 looked like the mother of all booms, there is still a bigger one yet waiting in the wings (the mother of the mother of all booms). This one will build substantially upon the information and communications technologies (ICT) infrastructure -- computers, cell phones and the internet -- that has been put in place over the last decade.

3. Nystrom’s Two Cents

Imagining the Dow at 40,000 is almost as difficult as imagining it back at 400. Both worlds would be radically different from the world we live in today.

A Dow 400 world would be a deflationary world, where the cost of everyday goods would also have fallen dramatically. The value of a dollar would therefore be much greater than it is today. In such a world, 25 cents might get you a burger, shake and fries, and a movie to boot (as it once did), instead of the $25.00 it would cost you today. But few people would be able to afford it. It would be a world with mass unemployment, hunger and social strife. It is often forgotten that the very survival of the United States was put into question during the Great Depression of the 1930’s because of the social unrest.

On the other hand, a Dow 40,000 world would most likely be highly inflationary. Not only would the Dow be four times higher, but the price of bread, milk and eggs would likely be as well. As I mentioned, everyone expects Chairman Bernanke to have an inflationary impact on the economy, and this may be his legacy. However, Dow 40,000 would also not likely be possible without the economic fundamentals to support it. What kind of new technologies could possibly cause such a boom?

I remember when Netscape came public in August of 1995. I was a stockbroker, and nobody in our office knew exactly what Netscape was or what it did, but we could all tell by its opening price that it was something big! Initially priced at $28, it shot to a high of $75 on the same day of its IPO! It had the biggest opening-day jump in history, eclipsing the last record holder, Boston Chicken, by a huge margin. (There was something simple that everyone could understand: Chicken.) Netscape was something entirely new, and it was like seeing the first shooting star in a meteor shower. First there was one, then there were a few others that soon followed – Spyglass and Uunet come to mind - that were also working on internet infrastrucure. Then came a slew of shooting stars that tried to capitalize on that infrastructure. Some stuck around: Amazon, Yahoo, Ebay come to mind – others didn’t: Webvan, Pets.com, Kozmo.com (remember them?) and a slew of others. The question that remains: Is the technology meteor shower over? Is this all we get before the deflationary depression begins? Or was that just the first wave of some Amazing technologies that are still to come and propel the market higher? What is Google -- the last shooting star we’ll see, or the first of many more innovative companies to come?

I would love to hear what all of you think about this question. You can post your comments directly to my website here: 2006 and Beyond: Boom or Bust? Alternately, you can email me directly.

I have my own thoughts on the subject, but I will save them until next week for my 2006 year outlook. If you would like to be notified immediately when I publish them, please subscribe here. Until then, Happy Holidays to you all.

References:

Elliott Wave International
Harry Dent
Track’N Trade Pro Charting Software


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