Underestimating Market Vulnerability is Hazardous to Your Portfolio

When our November 1996 issue of our monthly market letter and our daily research first published our Dow projection of 9654 +/- 1 1/2%, the time frame that this level would be reached -- if it were even to be reached at all -- was perhaps more difficult to forecast than the price target level itself. After falling just shy of that level last July in the face of that year's global economic shock, the Dow reached it on the nose last Friday, January 8 in what is thus far a bulls-eye into a very important cluster of long-term resistance.

Why is this important? For several reasons, not the least of which is the fact that the market has so soon vaulted back to a state of overvaluation (the S&P 500 Index carried a P.E. Ratio of 30 at its record high last week) -- so soon, that is, after the stock market annihilation of 1998 when the average NYSE and NASDAQ stock fell a whopping 50% from its April high into its October low.

In fact, we have already written in our research the past few months that the October low, which occurred in part as a result of the very dominant 4-year cycle low, saw the S&P 500's Price to Earnings ratio bottom at the highest level for any 4-year cycle for which we have such data -- a ratio of 23 times trailing earnings. One can go back over a century (see our November 1998 issue of The Global Market Strategist for a table of all the P.E. ratios at 4-year cycle lows, and at market cyclic highs, of the past 67 years) and find that many bull markets don't even get as high as a 23 P.E. ratio, let alone reaching that level after a significant correction in which the average stock is pummeled for 50% of its value in just six months. It's never happened before, nor has the unprecedented near-vertical advance of the past three months so soon after an annihilation like we saw in 1998.

Other reasons resistance targets are important have to do with what nearly two decades of research, trading, brokering, publishing market research, and money management have taught me: that the best approach to investing and to trading is one that combines fundamentals, technicals, and market psychology, for no one component can be ignored and they are all important. No bull market begins or ends without all three components ripe for that bull market beginning or ending. In fact, we can take this concept one step further by submitting that, for all practical purposes, the fundamentals are, in fact, reflected in the charts, and the charts reflect fundamentals. This does not imply that fundamentals can be substituted for technicals or vice versa, nor does it imply an attitude that one is as good as the other, so why not just settle on either fundamentals or technicals?

The reality is that we as investors and traders in the various markets....well, what the heck -- we as humans who cannot see the future with certainty -- need all the information we can get to make up for that uncertainty the future brings with it. By researching as many aspects of the market as is viable, we can turn a random walk into the future into an educated and researched approach that manages risk as well as seeks proportionate reward, and we can prevent the kind of blindside that rips markets apart and separates us from our hard-earned profits.

Institutions watch both, too. In fact, most watch the state of market psychology -- the sentiment that investors have toward the market. Are investors too much in love with stocks? Or, after bear markets, do they hate stocks (or any particular market) too much? Symptoms of a mature bull market, as well as a mature bear market, show up in the form of investor attitudes (en mass) toward the market. The 1987 crash caught the general public by surprise and sent them scurrying away for the next five to six years because they were late selling -- at the low of that move instead of anticipating and strategizing ahead of time. They were, once again, caught up in the euphoria of a bull market and sent it into a "blow-off top" that year before the collapse.

Presently, all experience shows that investors are in the opposite frame of mind--too much in love with stocks right now, especially the Internet sector, rampant speculation in which has led us -- for the sake of prudence and risk management -- to turn the attention of our readers toward various panics, manias, and speculative bubbles of the past in our Tulipmania article. When you read that article, remember that our intent is not to try to rain on your party but to alert our clients and our readers of our research publications to a sector that is out of whack with regard to risk/reward management.

In fact, our Forecast '98 report a year ago observed that during 1998 investors will learn the gambling nature of the market, and gambling it has been for investors to trade internet stocks up 400% to 600% in a matter of weeks. Short selling them has been a gamble, too, and for reference, the other end of the spectrum is the gold stock sector, so out of favor that the marketplace values the entire capitalization of every gold mining company in the world to be no more than a blue chip stock like Pfizer (see our various articles on this subject in 1998). Two opposing extremes that we'll lay money that these extremes don't last much longer without great changes hitting the marketplace.

With the results of a Merrill Lynch poll of mutual fund portfolio managers, the results of which were just announced Tuesday January 12, showing that a full 61% of money mangers consider the stock market overvalued and more expensive than even future earnings merit (to Alan Greenspan followers, this will sound very familiar), and that the economy will slow in 1999, it is worth noting that they, too, watch chart points, and use these points to employ their strategies.

Chart support and resistance areas are not mere mathematical calculations, then. Rather, they are points of climax that mark turning points or climactic breakouts or breakdowns, and they form a marker in time and price, so to speak, marking the reality of the situation and of a market trend on that particular day that the market declared the chart point important. They mark history, and typically occur at areas known as Fibonacci resistance areas (for more on this, see our book and trader's manual, The Successful Trader's Companion) but they are obviously the most valuable when acted upon in real time, not when reviewing past history. So when the market crashed in 1987, it wasn't the end of the world, but the resistance level that I observed in real time in 1987 (Dow 2720) both on my television show at the time and in our telephone hotlines was every bit as important as the Dow 9654 level, which we also anticipate as a potential significant turning point in today's market. No end of the world occurred in 1987 at that chart point, but certainly the end of a trend did occur, and arguably the end of an era. To be sure, it does not also have to be the end of one's portfolio.

Presently the chart points we observe in this month's market letter, The Global Market Strategist, that are in the Dow 9576 to 9799 zone (with particular attention to that long-term resistance number of 9654 we detailed in our calculations in our November 1996 monthly market letter) are so important given the potential for this overvalued stock market that is likely soon to be buffeted once again by global political and economic shock in the coming weeks that we have issued special bulletins and strategy changes to our clients. Not just because they are resistance numbers, but because the potential for a market turn is great enough based on supporting technical, fundamental, and cyclic factors that suggest they are not to be ignored. They are, in fact, every bit as important -- only at the other end of the fear and greed spectrum -- as the bullish numbers we published in early February 1991 calling for the market to advance 75% in the face of recession and the Persian Gulf War to the Dow 4044 to 4403 resistance zone. Later when the market broke out we received projections from our work to Dow 6187, then 9654. Back then, the numbers were important support numbers as a result of bullish technical action in an undervalued market and they allowed us to recommend buying the market and to maintain an outlook for substantial economic expansion (see our Forecast '92, Forecast '93, and other reports of the time for reference). Today, the numbers are important resistance numbers with accompanying bearish fundamentals and technical action in an overvalued market.

Two extremes, but typical of the cyclic nature of the market, and of the business cycle itself. And to summarize those extremes, I excerpt a partial paragraph from our January issue just published this week:

How, then, does one handle this array of chart points [that were reached the first week of January 1999]? The answer is that they should be parsed...and prioritized.... Look for the Dow to peak its advance from the October 8, 1998 low [and, in turn, as this issue and our Forecast '99 report observes, the 1974-1999 secular bull market] in the 9433-9799 zone, and for the S&P 500 Index to peak in the 1297 area [all are +/- 11/2% margin for error].....And if these resistance levels are exceeded by the margin for error, then look for the next resistance level of Dow 10,188....{However], the most probable stopping point is the Dow 9654-9799 zone...

That zone was achieved last Friday, January 8, with the Dow printing an intraday high of 9648 and also registering the commonly followed theoretical intraday high above that level. The rest is up to history.

For the full analysis, strategy, and portfolio recommendations, see our January issue of The Global Market Strategist. Purchase of at least a 3-month trial at this time yields a special bonus offer: receive our Forecast '99: Investing During The Void report at no extra charge. Don't wait to be blindsided before you consider adding our input into your trading and investing equation. Read up ahead of time. It's worth it.

For information on Dan Ascani's mutual fund money management program for individual investors, see our page on The Bull And Bear Enhanced Index Portfolio.