How to Intelligently Predict
the Future Of The Stock Market!

by Bob Boshnack
Chairman, Vision LP

One way we can uncover what the future may have in store-in particular, for today's challenged investors-can be had by reading Michael Alexander's groundbreaking book, "Stock Cycles." Written during the first quarter of 2000, Alexander's propositions have accurately described the markets since then! You can order the book at Amazon.com.

The author demonstrates how the use of historic stock market cycles in predicting the performance of the stock market one year from now is pretty much open to random chance. Statistically, he concludes, from almost any starting point, and factoring in price movements alone, there is only an approximate 50/50 chance that the stock market will rise or fall. But Alexander deftly points out the existence of certain long-term cycles which are not random, and the probabilities of those repeating, he asserts, are very high. As one would expect, the patterns and techniques of successful investing change somewhat dramatically from one cycle to the next. The trick, of course, is in deciphering where we stand, vis-a-vis the stock market, in any given cycle.

The only statistically valid, non-random cycle Alexander could find is a 13-year cycle. Since 1800, he shows, there have been 15 alternating good and bad cycles of 13 years, from periods where stocks were undervalued to stretches where they were overvalued and back again. There was one period during which the pattern, instead of reversing itself, continued for an additional (and precise) 13 years. In his model, the year 2000 represented a 13-year peak. There is only a 3.9% probability that this pattern is random. In other words, Alexander concludes, there is a 96.1% chance that the market topped in 2000 and will underperform for an additional 10 years.

An examination of the data would suggest that index investors have little hope for capital gains over the 13 years following 2000. Buy and hold investors will probably be better off in money market funds, just as they were in 1966 and 1929. This is essentially the same conclusion we have expressed on too many occasions over the past three years in our Special Reports!

"Given today's low dividends and high valuations," Alexander writes in early 2000, prior to the onset of the latest bear market, "a money market fund is, on average, a better investment over the next 5-20 years than the S&P 500 Index.... In the case of overvalued markets [like today], holding for longer time periods, even up to 20 years, does not increase your odds of success."

Past performance is not necessarily indicative of future results. The risk of loss exists in futures trading.

In the book's third chapter, the author looks at the historical cycle of bull and bear markets. Stocks, he observes, have returned about 6.8% per year in real returns (adjusted for inflation) over the last 200 years, but about 4.6% or two-thirds have come from dividends. The remainder corresponds to the real annual growth in GDP over that time. The stock market, he asserts, does not grow faster than the economy. If it ascends too high or falls too far, it always comes back to trend.

But stock prices fluctuate dramatically. There have been seven secular bear and seven secular bull markets since 1802. These are periods of at least eight and up to 20 years in duration where stocks are either generally rising or falling over the entire period. There are, of course, bear market rallies and bull market corrections, but the long-term trend is still either up or down.

Investors in the stock market during the 95 years of the bear market cycles, achieved only a 0.3% annual average rate of return. If they picked the cumulative 105 years of bull market cycles, they earned a 13.2% rate of return. But actual returns for any one ten-year period would be totally dependent upon when investors made their initial investment. The cycle length from peak to peak is 28 years on average.

Consistent with our own market advice, Alexander believes that buy-and-hold index investing will not work in this next cycle. He concludes that simply picking any old mutual fund and expecting a rising tide to 'float an investor's boat' will only enjoy a random chance for success in the next economic cycle. In other words, investors must change their investment strategy if they want to succeed.

Peter Bernstein on the Buy and Hold Mentality

Peter Bernstein has his own thoughts about the buy-and-hold approach to investing. A financial historian and head of his own advisory firm, Peter Bernstein has been in the investment world since the 1950's. He helped launch, among other gems, the Journal of Portfolio Management and is the author of "Capital Ideas,, "Against the Gods" and co-author, with Wharton professor Jeremy Siegel, of "Stocks for the Long Run."

"We've reached a funny position where the long run doesn't work; where the long run evidence doesn't fit circumstances as they are today," observes Bernstein. "Forget investing for the long haul. The long run, right now, is irrelevant."

This is a remarkable and somewhat ironic comment. Why? Bernstein and co-author Siegel wrote the book that espoused the virtues of 'buy and hold'. Bernstein readily concedes Siegel's assertion that stocks-for-the-long-run have produced remarkably consistent real returns of 7% per year since 1880 -- at least when measured over 20-year time chunks. "But the average dividend yield during all those 20-year periods was over 4%," he points out, stressing that "Real price appreciation contributed only 2.1% to that long-run 7% annual return. All the rest was dividends, received and reinvested. By contrast, today's dividend yield is in the neighborhood of 2%. Which means that in order to add up to 7% real growth over the next 20 years, we'd need 5% real growth in earnings, in addition to those dividends--and that's not exactly a reasonable expectation over the long run. Impossible, in fact..."

Past performance is not necessarily indicative of future results. The risk of loss exists in futures trading.

That's why, we say, Siegel's analysis is as deceptive as it is factual. When calculating long-term investment returns, the starting price matters. Even the lowest common denominator of stock investor, or a Wharton professor for that matter, would understand that a stock market selling for a low multiple of earnings and paying a high dividend yield is much more likely to appreciate than a richly valued market paying negligible dividends.

"The historical average returns that so many rely on as guides to the future are misleading," says Bernstein. "The double-digit returns that stocks were able to generate over the last century were due to equities starting cheap and getting richer over time. The problem is the stocks that once were cheap are now expensive."

We compliment Peter Bernstein for his willingness to change his opinion based on objective analysis. We believe many investors can learn from Mr. Bernstein's adaptability!!

"Unreal Expectations"
Bernstein's points are also espoused in an April 21, 2003 Barron's article, entitled, "Unreal Expectations." The article highlights the fact that the historical 10% average rate of return of the S&P500 was primarily dependent on P/E ratios and dividends, which today are much different than in the past. The article states:

"Now consider the current stock market and notice how it lacks many advantages enjoyed by earlier ones. Today, the S&P 500's dividend yield is just below 2%, less than half its average for most of the 20th century. This puts investors at an immediate disadvantage?Perhaps the most dramatic hindrance to those betting on a recurrence of historical equity returns is stock's vastly elevated valuation. The multiple of previous year's earnings reflected in stock prices was 10.2 in 1926 and averaged 15 for the 75-year span. Today, the market sits at 31 times 2002 results."

Additional Points of Note
What investors must realize, (and what we, by the way, have been "preaching" for the past three years) is that in 2000 we ended one of the biggest, speculative bull markets in history, where stocks rose to absurdly high levels that were nowhere near justified by their earnings. And secular bear markets traditionally follow 'super-bull' markets. The key to understanding the stock market is to understand that the bigger the boom, the bigger the bust and the longer it takes for the market to recover. We've seen that in the "new era" bull markets that peaked in 1901, 1929 and 1966.With regard to each of these three super-bull markets, post-peak, returns averaged 1.9% to a negative 0.2% for a period of almost 20 years. In retrospect, when the bear market began for each of these secular markets, few investors realized or ever imagined a 20-year period of famine would ensue - one that would post average returns from a scant 1.9% to a negative 0.2%!

Why, we ask, should we assume the present recovery will be any shorter than it was for each of the three bear markets described, especially in light of the fact that the bull market leading to this bear market was even stronger, more excessive and financially more damaging than all of its predecessors? For investors' financial well being, we urge them not to delude themselves, or be swayed by self-serving "cheerleaders." The excessive overcapacity and debt caused by the biggest financial bubble in history will take many years to unwind, contributing to the stock market's underperformance for the foreseeable future!

Past performance is not necessarily indicative of future results. The risk of loss exists in futures trading.

According to John Mauldin, the well-respected editor of "John Mauldin E-Letter," the stock market's valuation is higher than the previous tops achieved during any previous bull market. According to Mauldin:

"There has never been a secular bear market cycle in history that has ended with P/E ratios at the level they are today. That is why I believe the market has a long way to go on the downside, and why this cycle will probably last for years."

One of today's most successful money managers, Warren Buffett, also believes the market is way overvalued. In his annual shareholder letter, on March 8, 2003, he states:

"Despite three years of falling prices, which has significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuation reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge."

The biggest money manager in the world, Bill Gross didn't sugar coat his stock market forecast when he wrote:

"My message is as follows: stocks stink and will continue to do so until they are priced appropriately, probably somewhere around Dow 5000, S&P 650, or Nasdaq God knows where."

A Closer Look at the Stock Market's Historical Performance
A closer look at the stock market's historical performance shows lengthy periods of stagnation and lackluster performance! From 1881 to 1921, a 40-year period, the market experienced little change. Once the market peaked in 1929, it wasn't until 1954, 25 years later, that the market recovered to its 1929 highs. And for 15 years, from 1965 to 1980, the market made little progress!

Investors with a long-term buy-and-hold mentality may find themselves extremely disappointed in the coming years! Market timing is one of the most critical components for a successful investor. There are clear market cycles and fighting the trend is a loser's game!

Past performance is not necessarily indicative of future results. The risk of loss exists in futures trading.

Secular Bear Market Rallies
The secular bear market cycle we are now in typically incorporates fierce market rallies which can exceed 25%. Japan had nine rallies greater than 25% since 1990, and three that were greater than 40%. Nevertheless, the almost 20-year long bear market in Japanese stocks is still in full force, with the Nikkei recently making new lows.

The U.S. stock market experienced 13 rallies in excess of 30% during its secular bear markets of 1902-21, 1929-49 and 1966-82. Correspondingly, since the market topped in 2000, we've had at least five strong rallies.

The rallies during the bear market phase of a 13-year cycle generally appear to look like the bottom and are heralded as such by stockbrokers. These rallies serve to convince many investors that a new bull market is on the way, eventually providing "fuel" for the next decline, as disillusioned bulls exit the market.

Don't Worry About Missing a Rally!
What good is it to buy shares of stock and, on paper, experience strong gains, only to see those gains turn into losses over time? That's exactly what has happened for three years now (and counting)! Remember, this is one atypical bear market. And, since we are still in its relatively early stages, one that many astute analysts believe will last at least ten years or more, any gains one may have realized through buying and holding stock will probably be lost at some point in time. Case in point: This is exactly what has happened over approximately a 10- to 20-year period in each of the past three secular bear markets. It is also exactly what has happened over the past three years, which we expect to continue for the next 10 years-stock buyers beware!

The ability to profit in the market by employing the buy-and-hold strategy is over and, we believe, won't come our way again for many years! If you don't embrace and adapt to this change, we believe you will suffer the financial consequences!

Change
We find ourselves in a state of change. For many, this can prove quite unsettling, to say the least. However, change can also bring comfort and optimism, depending upon how it is perceived and, more importantly, how one reacts to it!
On a more melodramatic note, the predicament in which we find ourselves can be compared to the ultimate fate of the French aristocracy during the French Revolution, who, when they failed to recognize the changes brewing in the political system, literally lost their heads as a consequence. Whether it's one's neck or one's investment portfolio, the facts tell us to pay attention or else!

Past performance is not necessarily indicative of future results. The risk of loss exists in futures trading.

Coming to Grips with Reality
We realize how difficult it is for many investors to come to terms with this scenario, considering the past 20 years has accounted for an astounding 80% of the market's growth. But we are in a different world now, one which the average investor doesn't understand or doesn't want to understand. We would love to have a more optimistic market outlook, as we had in 1999. But we will continue to tell it as we see it, good, bad or somewhere in between.

And while we expect there will be selective stocks that will hold their gains and offer attractive returns, we strongly believe these will be the exception and not the norm. Selecting them will be like finding the proverbial needle in the haystack, a difficult task and not worth the risk in our opinion!

Wishful thinking and emotions are poor substitutes for using logic and intelligence. Many investors have lost so much in the market, they erroneously believe the market owes them something. They believe if they hold on to their losing stocks the market will recover their losses. In 10 to 20 years, they may be right. That's how long it took many losing stocks to recover in previous secular bear markets. And those bear markets weren't as severe as the one we're in now!

Past performance is not necessarily indicative of future results. The risk of loss exists in futures trading.

Final Food for Thought
The biggest fund manager in the U.S., Bill Gross, and one of the best and most respected investors, Warren Buffett, both see stocks underperforming for years to come. We are in the early stages of a long-term secular bear market that very well may last at least 10 more years. What's more, we believe we are now in a period similar to that of the super bull markets, which peaked in 1901, 1929 and 1966, where 20-year returns following each peak averaged only 1.9% to a negative 0.2%. The market should move in a sideways pattern with a downward bias for many years to come!
There is simply too much risk and not enough return in the stock market today, and for the foreseeable future. Working off the excesses of the biggest speculative bubble in stock market history will be a long and arduous process. If one is to survive and prosper in the coming years, we strongly believe it is necessary to let facts and logic overcome one's emotions, realize we are in a long-term secular bear market, and invest accordingly! Invest with the trend and don't fight it!

Instead of risking double digit losses for single digit returns, we advise the following: The long-term historical average of the Dow Jones Industrial Average is only around 7%. Considering the uninspiring, long-term outlook for the market, we believe the very wisest thing an investor can do is to attempt to play it safe and place the majority of one's portfolio in historically safe, income producing investments that approximate the Dow's historical average. We would also recommend investors place a portion of their total allocation, based on their temperament and suitability, into more aggressive, non-stock-correlated investments.

This report is issued by Vision LP, a registered futures commission merchant, based upon reliable sources believed to be accurate. The views expressed herein may differ from those of Vision LP's brokerage or investment management affiliates, whose investment policies and outlook may not coincide with those of Vision LP or its officers and principals. The historical information referenced above is for illustrative purposes only and is not meant to forecast, imply or guarantee the future performance of the indices mentioned or any transaction. Futures traders should be aware that daily market volatility may cause loss despite prevailing trends in the stock market.

Past performance is not necessarily indicative of future results. The risk of loss exists in futures trading.