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Ned Davis Say Market Terminal, Even Energy?
Cruelest Month? Chance of an April rally fades with the stock market's retreat, says analyst Ned Davis

By SANDRA WARD- BARRONS
http://online.barrons.com/article/
SB111360851591808543.html?mod=b_this_weeks_magazine_main
An Interview With Ned Davis -- Artful in his ability to assess trends in the financial markets, Davis also throws in some heavy-duty science to best determine the direction of money flows. It's been 25 years since he started the independent research firm NDR in Venice, Fla., and Davis counts as clients hundreds of major institutions, all interested in tapping into some of the most current commentary and comprehensive market research available. Gauging everything from stock valuations to investor sentiment to sector disparities, Davis and his team are able to make the most of asset allocation. A contrarian sensibility comes in handy, too, especially in the current difficult market.

Barron's: You say we are in the late innings of the cyclical bull market but yet you remained bullish?
Davis: January is usually a very good month and usually there are very big inflows. This January was very unusual. We had extremely low inflows into funds and the market was under attack. The so-called January barometer says as goes January, so goes the market. That is not a good sign for the whole year, even though it may turn out the January barometer isn't right. But, the uncertainty over the Fed's actions and [the Organization of Petroleum Exporting Countries] and the Iraq election in particular might have contributed to holding things back in January. While inflows were terrible in January, they were very good in February and the market did pretty well. I thought the January lows would hold. That's what I was looking at to tell me there was something wrong with the bullish case. I figured if the January lows were taken out, that would be a problem and I would probably change my outlook for the market to neutral.

Q: Since the January lows were broken Thursday, have you changed you view on the market to neutral?
A: Yes. The Nasdaq and the Dow Industrials and the Russell 2000 had already violated the lows and Thursday the S&P 500 and the Dow Transports confirmed. When the Dow Industrials and the Dow Transports break their lows, that's a sell signal according to Dow Theory.

Q: So your hope of an April rally has faded even though the market appears to be oversold?
A: The market does appear to be oversold but I don't like to fight the tape unless I have a tremendous amount of evidence.

Q: What's your asset allocation now?
A: We are slightly overweight the stock market and slightly underweight the bond market and slightly overweight cash. We are 60% stocks, 20% bonds and 20% cash.

Q: Is cash on the high side?
A: Our normal cash would be 10%.

Q: Why had you been holding out for an April rally?
A: I was bullish but I was giving myself a very short leash. In August of last year, I changed my status to what I called leaning bullish. I say leaning instead of outright bullish because the Federal Reserve was raising rates. Generally, a string of Fed tightenings is negative for the market, so I was giving some respect to their position. But they had been overly accommodative and they were just becoming less accommodative and so it wasn't a typical tightening cycle and I felt I could stay bullish in the face of that. The market has performed in line with the election-cycle script, says Ned Davis, with speculative growth stocks pacing the first phase. Now dividend-paying and defensive stocks should lead.

Q: Why did the leash get shorter?
A: The Fed has claimed for the last three years that inflation was well contained. In fact, in May 2003 they were actually worried about deflation. However, now, the average of the CPI [consumer price index] and the PPI [producer price index] puts the inflation rate at about 3.88% from a negative rate in May 2002. At the Fed's last meeting a month ago, they said they noticed inflation was picking up and there was an increase in pricing power. This suggested to me they were thinking about fighting inflation. That goes beyond their neutral stance. It was a subtle change, but I felt it was an important change. Also, there has been some deterioration in the tape. Taking the two together, I feel the risks are fairly high.

Q: Weren't you also of the mind that now that the Fed is recognizing inflation, maybe it's time to start thinking about deflationary pressures again.
A: Yes. I was making a contrary opinion case. A lot of times contrary opinion is early. The behavior of the CRB [Commodity Research Bureau] Index is suggesting it has made a top. The CRB recently went up 11 days in a row -- very unusual and probably driven by short-covering. It was up 20 out of 23 days, then subsequently dropped five days in a row before making a pitiful rally and then dropped 10 straight days. That looks like a top. The trick here is whether inflation has peaked or not and will the Fed be allowed to tighten further. What happened in 1994? We had a whole series of Fed tightenings and the bond market got very nervous, which forced the Fed to quit hiking interest rates. Then the market took off. That could happen again.

Q: Hence the would-be April rally?
A: Another reason to believe in an April rally is that the market has tracked the four-year presidential election cycle really well. Not only did the overall market track well, but individual groups did well, too. For example, usually the market bottoms in the summer or fall of the mid-term election year. In this cycle, the bottom occurred in October 2002. It fit perfectly. The next year is usually the strongest year of the four and, in fact, we had a very strong year led by speculative growth stocks. Last year was an election year in which the market tends to be neutral a good bit of the year and through the election but usually ends well. The market went up almost exactly what it goes up in a normal election year. There is usually a switch in the election year to value stocks, which certainly happened last year. Energy has historically been the best group in an election year and that was true again last year. The post-election year is historically the weakest of the four-year cycle, but still it tends to be up around 55% of the time. The average gain is 2.9%.

Q: What are the strongest groups in the post-election year?
A: Very defensive groups. We have done a study breaking bull markets down into thirds. In the first third, there is a lot of stimulus and stocks that don't pay dividends in the S&P 500 actually beat dividend-paying stocks in the first third of the bull market by about 6%, which is remarkable. That has happened in this cycle. In the third stage, it flips totally around and dividend-paying stocks outperform non-dividend paying stocks in the S&P by more than 6%. At the start of the bull market people go for riskier assets, then as we get closer to the end the bull market cycle, they go for defensive groups.

Q: Does that also result in a switch from small-caps to large-caps?
A: Somewhat. But going into the post-election year there is usually some indigestion in the first quarter following a big rally at the end of the election year. I was not particularly concerned about the weakness earlier this year because the second quarter of the post-election year is quite strong on average.

These are road maps that work until they don't work. But this post-election year has really followed the typical cycle very well and so I had forecast a good rally would start in April.

Q: Are you concerned about the strength in the economy?
A: Last year when we talked ("Contrarian Jitters," April 19, 2004), I mentioned the huge debt bubble. It is now $37 trillion. I thought that if 10-year T-notes got up to the 4¾%-5% range, the economy would definitely slow -- historically it's the move from the cyclical low in interest rates that has slowed the economy. In fact, rates on the 10-year note did go up to 4.89% in May or June of last year. And the economy hit a speed bump for about a month. I thought rates would have stayed up but they then plunged from 4.89% all the way to 3.99%. The Fed called that a conundrum. Bond yields are back up and I feel a key area for the economy is close to 5% on 10-year T-notes. At that point, the economy would slow again.

There are other differences from a year ago. There was a lot of stimulus a year ago. The money supply was growing very rapidly. The government was running huge and growing deficits and the dollar was weak. There is still some stimulus in the system but not nearly what it was a year ago and of course oil prices are up a lot further this year. So there are some hurdles here and bond yields will be the key. If bond yields don't rise a lot from around the 4½% level, then you can still put together a bullish case. Profits are slowing but the economy itself is stronger than I thought it would be.

Q: Some indicators have suggested the market has been oversold. Do yours?
A: My work indicated the market was oversold but not nearly as much as some suggested. Also, our short-term sentiment indicator dipped into the extreme pessimism zone. That was another reason we thought we were setting up for a pretty good rally. But the rally we had was not very impressive to say the least. I don't have enough tape confirmation to be comfortable assuming the cycle will play out normally. Yet earnings and dividends have gone up more than the market has. The yield on GAAP earnings on the companies in the S&P 500 was 4.55% a year ago and now it is 5.15%. Dividend yields, which were extremely low at 1.58% a year ago are still low, but at 1.72% they're better than they were. So you can make the case that valuations are better than they were.
When you look at relative valuations a year ago, T-bill yields were less than 1% and now they've nearly tripled. If you take an average of short rates and long rates, they've gone up 50% from a year ago. So while earnings and dividends are up, compared with T-notes or T-bills or an average of the two, stocks are not quite such good values. There have been some improvements in absolute valuations, but there seems to be some sort of valuation ceiling. I don't know exactly what it is. I would say 1300 on the S&P would be an upside ceiling at this point. In a normal bull market cycle, the Nasdaq goes up 100% and the S&P rises between 50% and 62% from the lows. In this cycle, the Nasdaq has gone up 96% from its lows and the S&P has gone up 58%. We've had a fairly normal cyclical bull and we are probably in the late innings.

Q: You've written you're struggling with your bubble aftermath theme. Explain.
A: Throughout history there have not been that many bubbles, but there have been enough of them that some similarity exists. Usually there is a major bear market where the market declines by at least 50% after a bubble. Then there's a bottom followed by a huge cyclical bull market, but the market doesn't go to new highs. After that there is a very long period where the market goes sideways before another cyclical bull market occurs. But after the bubble of 2000, the recession was very mild and the economy has really done pretty well thereafter and this bothers me a little bit. In the stock market, none of the retracements in the S&P or Nasdaq are out of line with cyclical bulls and cyclical bears but small- and mid-cap stocks have gone up and made new all-time highs, and that is a little bit unusual. In the 1966 to 1982 period, which I consider a secular bear market, there were several averages that made new highs but they were unconfirmed. This time around, according to the bears, the bubble was solved by creating another bubble in housing.

Q: How are you positioned?
A: I'm mildly long and mostly in defensive stocks. But some of the defensive stocks I'm in I'm not totally comfortable with.

Q: Such as?
A: We've been in energy very heavily. It is still our favorite sector. We are also very heavy in materials. We have been trying to get more into health care and moving toward dividend-paying stocks. The problem with the energy stocks is that the bull market in them has gone a long way. The Fidelity Select Funds have four energy-related funds out of a total of 41. Normally the energy funds -- and this goes back 15 years -- have about 6% of overall assets. Now they have nearly 18%.

Unfortunately, the numbers don't go back into the early 'Eighties, the last time we had an oil bubble. There is still a bull market in energy and natural resources and commodities and so forth but it is probably in the late phases. That run-up in commodity prices 11 days in a row I mentioned earlier followed by a string of net down days makes me uncomfortable. But when you have this kind of momentum, making a top can take forever. Even if energy is starting to top out, it will take a while.

Q: Are you backing off your energy holdings at all?
A: Not really. I mention them, and where they are in the bull market, because we are risk managers and it is important where we are in terms of a trend.

Q: Any sector or asset class that's a great opportunity that people are overlooking?
A: No. People probably should stay with most of the stocks that are acting well, but maybe start to scale into some put options on the S&P to hedge themselves. Our indicator has also flashed a signal favoring large-cap stocks. While there are still some reasons to favor small-caps, they are fairly valued relative to large-caps and we don't want to fight the tape and the broader evidence leads us to side with large-caps.

Q: What do you see as the main problem for the market at this point?
A: Again, 3½% on Fed funds and 5% on T-notes is really all the market can stand, therefore anything above that would be a real problem for the market. On the upside, as I suggested earlier, I think the key is to feel like the Fed is finished and right now they don't sound like they are finished. We need a break in inflationary pressures so the Fed can say that's as far we are going to go.

Table: What Goes Around…




Q: What about the dollar?
A: I agree with the bears that there is a structural problem there but as of December last year it seemed as if everybody was bearish on the dollar. It was probably about the most shorted trade we've seen. We did some sentiment work on the dollar and it showed extremely pessimism in late December and gave a buy signal. It is probably range bound, and the upside on the dollar index is resistance around 85-86 and more around 89. I would be surprised if it broke above those levels.
There is a fundamental valuation argument for the dollar as well. We found when U.S. short rates are below the average of foreign short rates, that tends to be negative for the dollar. This is common sense. Now, U.S. rates are actually three- quarters of a percent above average foreign rates. Not only that, because our economy is strong and the Fed is promising to raise rates again the difference between U.S. short rates and foreign rates is probably going to widen because Europe's rates are probably not going up.
Europe is not in a recession, but they are growing very, very slowly.
There is a contrarian bullish case here, which is wearing off now because the pessimism around the dollar is letting up a little bit, and there is also a fundamental bullish case. Short term, there's a seasonal case to be made because the dollar typically does well the first couple months of the year. I'm guessing the dollar this year is going to look a lot like the dollar last year.

Q: Does that bode well for foreign central banks sticking with the dollar?
A: Yes. The dollar has structural prob- lems in terms of the trade deficit, which is almost an unsolvable problem.
We are depending on the kindness of strangers, as it has been said, and there has been talk of foreign central banks diversifying out of the dollar. But we haven't seen any signs of that. There are also some other factors in the bond market that are bullish and if foreign central banks did unload dollars, the bond market can handle it. I'm not overly concerned about it.

Q: What's bullish about the bond market?
A: One of the things that feels decent about the bond market and why I would be a buyer again at the 4¾%-5% range, is that domestic bond funds have 9.4% in cash. That's the highest amount of cash in bond funds in 15 years.
You can see in the commitment of traders data that large speculators, hedge funds, are short the bond market and so are the dealers that trade the bonds. This should be the smart money, but it turns out their record is not very good and they are in the largest short position in years. If the Fed keeps pushing rates up here and inflation doesn't come down and bonds get back up to 4¾%-5% zone, I would be a buyer.

Q: That's not a widespread view.
A: So many people make the assumption that rising interest rates mean lower bond prices and that bonds have to go down as a result of Fed tightenings, and it is not necessarily so. Bonds actually went from a little over 3% to almost 5% before the Fed even started tightening, so the tightening was already discounted. Therefore, when the Fed started tightening and people felt like inflation was going to stay contained, they went back into the bond market. After [Fed Chairman Alan] Greenspan declared that a conundrum, people dumped their bonds and yields backed up just below 4.6%. If the Fed raises short rates above 3½% [from 2¾%], you wouldn't want to take a risk in a longer-term note at 4½%. It would be tremendous competition. But, at this point, my guess is the Fed will stop and with these technical factors being positive for bonds they are not going to go above 5%.

Q: How does oil figure into this?
A: At $60, it would definitely be a problem.

Q: If you don't see inflation getting out of hand, do you see deflationary pressures?
A: Well, when you have a $37 trillion debt bubble outstanding and rates rising, there's a chance debt service is going to be a problem. The key for the Fed is to not let housing get out of hand. They were not able to pull that off in the stock market in 2000 but they cleaned up the mess pretty quickly. It's a tricky job and they've done a good job of it. But government and mortgage debt have exploded and I'm not sure we are in any better shape.

Q: Thanks, Ned.