'Tis The Season, Part II
While laying the groundwork for detailing what I expect out of the stock market for the next year on Monday, I ran out of time and space before really getting to the meat of what I wanted to talk about. So I'm not going to waste any time rehashing that discussion and want to pick up right where we left off. If you missed Monday's article, here's the link so that you can catch up with the rest of us.
For ease of discussion though, I am going to replicate the charts of the SPX and COMPX here, so we have pictures to talk about during today's discussion.
S&P 500 (SPX) Weekly Chart
NASDAQ Composite (COMPX) Weekly Chart
As you can see from the weekly charts above, both indices are in protracted and well-developed downtrends and there are some distinct overhead resistance levels that must be overcome. With few signs of improved business demand throughout the economy, breaching these resistance levels is going to be a tough nut to crack unless companies provide more encouraging news in the way of increasing demand for their products and services, which will translate into improved earnings. In my opinion, just showing improvement relative to last quarter or last year, isn't necessarily going to get the job done. Those comparisons 'should' be easy to beat due to the dismal performance in 2002. But we're still left with the fact that valuations are extremely high compared to the norm near bear market bottoms. Translation: Not only has the fat lady not sung, she hasn't even arrived at her dressing room yet!
I feel that the rally of the past week has been due to expectations of wonderful things from the President's economic stimulus plan, and the weakness today was just a continuation of the 'Sell the News' reaction of yesterday afternoon. Don't get me wrong -- I really liked the President's proposals, and I think it will help to stimulate the economy. I just don't think it is enough to stimulate a business turnaround this year. Let's face it, most of the tax-related proposals (even if they do make it through Congress) won't really have any material affect until 2004, when the 2003 tax returns are filed.
The cornerstone of the stimulus package, at least for investors, is the elimination of the tax on dividends. As Larry Kudlow pointed out on CNBC yesterday, if passed, this tax cut should start to focus investors' attention on the dividend yield of a metric of corporate health, removing in large part the debate over pro-forma earnings. Dividends are real money being paid out. You can't pay a dividend out of EBITDA earnings -- you need real cashflow to do it. Here's where it gets interesting though. The aggregate dividend yield of the S&P 500 is currently about 1.75%, ridiculously low by historical standards. In the past, a dividend yield of roughly 3.5% has been typical of market tops. Just to get to that level, either dividends paid out would have to double or share prices would need to be cut in half. That would equate to the S&P 500 trading for about 450, level last visited in late 1994! Don't worry, I'm not going to predict a slide to anything approaching that level...at least not this year. No, I think we'll see gradual improvement in earnings and dividends paid out. But at the same time stock prices will continue to drop, helping to bring the actual dividend yield higher.
I don't hold any illusions about a sharp near-term increase in the dividend payout from the companies in the S&P 500. The primary reason why is that they just don't have the income stream to do it. Currently, approximately 45% of the earnings of these companies is paid out to shareholders. Just to get to that 'historically toppy' 3.5% yield, companies would need to pay out 90% of real earnings in the form of dividends. Think that's going to happen? Not on your life! That would leave virtually no working capital with which to go about growing the business, which is precisely what businesses will need to spend money on if we're going to return to a steadily growing economy. In the past, bear market bottoms are accompanied by dividend yields in the neighborhood of 6%, 4 times what they are right now.
With that perspective, I think you can see why I pay so much attention to the long-term charts that I inserted above. They tell me the dominant trend is still very much down, and that coupled with the fundamentals of the economy and the market tell me there isn't enough fuel to break out of those trends in any decisive manner.
I think there is a large contingent of investors (actually institutions) that have a vested interest in seeing a healthy market, at least for the first quarter of 2003. There's a historical pattern that says if the market falls below its December lows anytime in the first quarter, then it's a bad omen for the remainder of the year. With most of the strategists and economists (as well as the Wall Street firms) touting that we won't have a fourth down year in a row, I expect to see some significant effort expended to ensure that we don't violate those lows over the next 3 months. For the SPX the low to watch is 869.45, and for the COMPX it is 1327.19.
That gives us some solid numbers to watch over the next few months, now doesn't it? If those levels are violated, I would consider it a big warning sign that new lows lie in our future. However, just because those levels aren't violated in the first quarter, it certainly isn't a sign that the bulls are back in town. With virtually all of the 'experts' lined up saying that we won't have a fourth down year, you would think that it would be a no-brainer to expect the contrarian view to once again be correct. But believe it or not, I have to say that I don't expect 2003 to close in the red.
My expectation is that the recent rally up to the 930 level on the SPX isn't quite done yet. Oh sure, it looks like we've got some near-term weakness to deal with, and the arrival of earnings season next week isn't likely to help the bulls' case. But I expect another run during the first quarter to challenge the December highs and then quite possibly the descending trendline on the COMPX and the upper channel line on the SPX. To be sure, challenging those trendlines looks like a long-shot now, and if we accomplished it in the next couple weeks, we would have established the first higher high in a loooong time. But what happens if that rally to those resistance lines takes until mid-February or later? By then, the SPX upper channel line will be near 960 and the COMPX descending trendline would be right at 1600, which is heavy resistance. The COMPX would establish a higher high, but not the SPX. Embedded in that view is my belief that Technology will outperform to the upside this year, but more on that below.
I expect any rally up near those higher levels to be met with heavy selling pressure, getting the mid-year decline I expect off to a roaring start. All right here's my view in a nutshell: We could get a rally continuation over the next couple months or we could just muddle along sideways -- I think that first phase could go either way. But as we move beyond the April/May timeframe, I expect selling pressure to once again increase and I expect a major breakdown again to new lows. For the SPX, I'm thinking that the 700-750 level will define the floor, depending on timing. But watch the center-line of that descending channel, as my expectations are that it will act as support as the year rolls along. In contrast, I don't expect to see the COMPX violate its 2002 lows this year, primarily because so far in this bear market, Technology stocks have suffered much more damage than the rest of the stocks making up the broad market. As such, I look for Technology to outperform to the upside in 2003. That said, I fully expect to see the COMPX trade below 1200 again in 2003.
After that decline, which likely lasts through the summer and possibly into early fall, my views turn more optimistic. I actually expect by the 3rd quarter, we'll start to get some more positive comments out of Corporate America, and the end of 2003 should provide a strong rally. In fact, it should be strong enough to finally break the SPX out of its descending channel to the upside, since the top channel line by then will be in the vicinity of 800. Technology stocks should lead on that rally and the early signs of this occurring will be the COMPX breaking out decisively over its descending trendline, which by that time (early September) will be near 1400.
By the end of the year, I'm looking for the SPX to be trading north of 900 again and the COMPX to be above 1450. Those certainly aren't levels that will excite the bulls looking at current levels, but coming from the levels I expect to see mid-year, it will represent quite a year-end recovery. As they say, "it isn't the destination, it's the journey". As you can see, I'm looking for a mild year-over-year rise, but only after once again breaking the most recent lows. Buy and hold investors will once again get abused for listening to the rosy predictions of the Wall Street strategists, but those that listen to the language of the market and trade the major swings over the next year should do quite well.
There are lots of factors that I didn't get to today, like what's going to happen to the dollar, the price of gold, interest rates and then the whole inflation/deflation debate. So much to cover, so little time. Maybe I'll do another article, delving into those topics, or maybe I'll see if I can twist Buzz's arm and get him to chime in with his views. After all, diversity of views provides a better well-rounded view of the beast we call "The Market".
Of course, all of the foregoing is predicated on the assumption that I know what I'm talking about. They don't call the market "The Great Humiliator" for nothing, and this could be the year that I'm left wiping egg off my face. If so, I'll take the abuse in stride, knowing full well that it happened because I got too cocky for my own good. I'll revisit my musings throughout the year and we can look together to see if I'm even close to the mark. At year-end, I think it will be interesting to see how my crystal ball performs relative to some of the more well-known analysts.
Feel free to send along any comments or questions and may we all have a prosperous year in the markets!