Your Economy (No Politics)

[Bullwinkle]

Market in Late-Cycle Topping Process
Market Views of Comstock Partners, Inc.
Thursday, March 31, 2005


The continuing Fed tightening and mediocre market action adds to our conviction that the cyclical bull market is running out of steam, and that the secular bear market is about to resume. We disagree with those who say that interest rate levels are too low to be threatening, and that the Fed remains accommodative. A review of the data indicates that Fed tightening is a leading indicator of recessions and bear markets, and that this is the case at any level of rates.

The late Edson Gould formulated his “three steps and a stumble rule”, indicating that three successive steps by the Fed to tighten money resulted in a subsequent bear market. According to Gould the steps could take the form of a rise in the discount rate, the reserve requirement or margin requirements. Since Gould’s time the Fed’s actions have become focused mainly on the fed funds rate, although the theory remains the same.

A study of Gould’s rule by Ned Davis Research indicates that there were 15 prior sell signals going back to 1915, and that only two of them did not work. The DJIA declined a median of 17% from the date of the signal to the bear market bottom. The current sell signal became effective on the third of what are now seven successive rate hikes, the most recent occurring last week.

In addition, our own research shows that it is the direction of the rates that count rather than the level. For example, the recession and bear market beginning in 1937 was preceded by a rise in the 90-day T-bill rate from 0.11% to 0.55%. In the first four post-war recessions the start of the economic declines were preceded by rate rises as follows: from 0.92% to 1.19%; 1.74% to 2.20%; 2.60% to 3.35%; and 2.85% to 4.50%. After that rates went on to higher levels, but our point is clear. When it comes to interest rate moves, direction counts even at the low levels of today. Although a great number of economists and strategists are now saying that the Fed tightening won’t do any harm because rates are low, we just don’t see them backing this up with any hard evidence.

In our view the Fed tightening in combination with high energy prices is now adversely affecting the market, and this is only the beginning. The S&P 500 broke upward to new cyclical highs in early March, but quickly fell back into its four-month base. Today’s close of 1180 was reached as early as November 12, which was shortly after the U.S. presidential election. On Tuesday the index bounced off its January low of 1163 after falling about 5.5% in a few weeks. Although the market appears short-term oversold and could rally some more, the action is probably indicative of an overall topping process that should lead to far lower levels. We note that the current reading of 1180 was first reached in 1998, meaning that the market, despite all of its volatility, has essentially gone nowhere for seven years. That just doesn’t happen in secular bull markets.

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