The New Math: Does Dow 10k/Y2K Equal Dow 5k?

I heard another analyst today interviewed by the financial media say when commenting on Dow 10,000, "that's all anyone talks about." Another analyst said he couldn't wait until the Dow reached that level "so we can all get on with our lives." Seemingly all of the media are prepared for special broadcasts if the Dow hits 10,000, and the fanfare over the Dow milestone is mounting with even greater force than when the benchmark average first hit 1,000 in the 1960s.

The vast majority of options traders apparently cannot wait for Dow 10,000, either. The Chicago Board Options Exchange (CBOE) has been reporting consistently low put/call ratios for the past several days, including Monday's very low 52%. That brings the 10-day average of the Put/Call ratio to 58%, the lowest since the January 8 record high in the market and similar to the situation in 1987 when Put/Call indicators reached extreme levels.

It is true that the vast majority of money is made by those who do not follow the trend--the contrarians. Yet, contrarian investing does not always mean doing the opposite of the majority. Instead, the contrarian only takes an opposing position when sentiment reaches an extreme. Between extremes, public sentiment toward the market is trending from pessimism to optimism, or vice versa. While it is trending, money flows are moving in the direction of the majority, and therefore to take an opposite position for the sake of being contrarian can mean stepping in front of a freight train.

Nonetheless, the investment markets frequently move into contrary opinion situations, then reverse trend on a major scale. Most recently, bond prices plunged from their October 1998 peak (low in yields) right when the Federal Reserve Board began to ease in response to deflationary pressures and their effects on liquidity. Just when deflation became accepted by the majority, interest rates began to move in the opposite direction.

Moreover, the very bull market in stocks that has attracted the attention of the average investor has its roots in a contrary situation, too. In 1991, in the midst of recession and the start of the biggest war in decades (the Persian Gulf War), the stock market exploded, launching today's bull market.

Other contrary opinion situations have existed throughout history. In the midst of the most severe inflation of the century, gold peaked in 1980 and then collapsed. Soybeans peaked right at the start of the drought of 1988, and so on.

Why does Contrary Opinion Theory work? For several reasons, not the least of which concern money flows. As investors move from a state of pessimism to optimism, money is flowing into the market, producing an imbalance of buyers versus sellers, and prices rise. As more investors catch on to the trend, and as disbelievers reverse strategy and become buyers, the market vaults higher, but eventually buying power is spent. Additionally, high prices attract more sellers, both in the form of profit-taking and in the form of speculative selling in anticipation of lower prices.

Contrary opinion, then, is just one more indicator measuring supply and demand: money flow, for it is money flow that pushes prices around, not just estimates of economic growth, inflation, or earnings (although these factors influence opinions which, in turn, influence money flows). The astute trader or investor seeks to measure extremes in sentiment, and to anticipate changes in money flow. One symptom of an imminent change is when there is a selling climax or a buying climax.

Presently, investor and media fixation on Dow 10,000--an arbitrary number that has no significance to chart points or to fundamentals and does not reflect the health of the underlying market--and low CBOE put/call ratios spell imminent danger for stock prices and an imminent buying climax. Major market peaks have occurred after sentiment reaches extreme levels such as that which we are seeing in the U.S. stock market now. Declining bond prices, which also occurred in 1987 before the market crash, also help contribute to a significant change in trend in the stock market. U.S. bond prices have been in a downtrend since October 1998.

So, what will be the catalyst for a market peak this year, we are frequently asked? Several known factors will contribute to the next market decline, as well as whatever as-yet unknown factors materialize in the coming months. For example, market peaks typically occur when buying power is spent relative to selling power, which, in turn, increases the higher prices go. A "normal" sell-off typically ensues at first, and that is followed by a rebound that does not set record highs. Then, a catalyst emerges--the bad news--that assists more sellers in their decision-making process, and further price declines occur. Buyers turn to sellers and the whole cycle reverses course.

If fundamentals are poor enough, prices can plunge or crash, especially if a speculative bubble drove prices too high to begin with. This year, for example, with the global economic crisis still in force (don't fear looking beyond mainstream media headlines--the global economy is in much worse shape than most realize), and with the potential for further economic or earnings-based shocks, the market may decline. As our March 11 issue of The Global Market Strategist analyzes in detail, the Y2K problem may not be much of a problem for the United States, but for some other troubled economies of the world, there will be enough enterprises that fail to become ready to cause a problem. If only 10% of the economies of the world are only 80% ready, for example, demand will drop enough to further effect already-falling earnings of U.S. and European corporations. Our March issue also presents a table showing which major companies are effected by slowing sales in Europe, including the entire S&P 500, in which 21% of sales are to Europe. Europe has recently slowed more than expected, in part due to the Asian crisis, and there are many companies in the S&P 500 Index that will soon see their earnings decline.

The bigger problem in March and April 1999, then, appears to be the Dow 10k problem, not Y2k. While Y2k will contribute to problems of some degree, the Dow at 10k is massively overvalued and has helped mask what is happening in the underlying market since April 1998: declining stock prices. A bear market has existed in the underlying stock market since April 1998.

Whether or not Y2K ultimately contributes to lower stock prices, one thing is becoming clear: American consumers, currently stockpiling everything from food to water to gold, may be setting themselves up for a bank run-type panic out of stocks later this year. In a "typical" bank run, problem banks see rapid withdrawals from panicky customers, who in turn seek to withdraw savings even from healthier banks, hurting the bottom line or solvency of healthy banks, too. If bank run-type mentality hits the stock market later this year because of Y2K, a self-fulfilling market collapse in the wake of a massively overvalued Dow 10,000 could occur.

Whether or not it does remains to be seen, but one thing is for sure: investing strategy should be based in proper risk/reward assessment of the investment market being considered, regardless of one's opinion on Y2k or on the degree to which traders are too bullish and are buying too many call options. Given that major bull markets if the past have frequently ended in crashes, collapses, or panics, one might seek to adjust current investment strategy by considering that, even if the Dow goes to 11,000, downside risk is, say, 4,000 to 5,000 points, with upside potential only 1,000 points, making the risk/reward ratio of staying invested in the U.S. stock market, or of committing new money, 1:4 or 1:5 in favor of the risk side of the equation.

There are plenty of investment markets "out there" with a much better risk/reward ratio. Y2k, and the challenges of 1999, may not bring on the end of the world, but they may, in fact, bring on the end of the present bull market in stocks.