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Bear market warnings: Investment legend among those believing stocks could tumble again

by Wayne Cheveldayoff, 2003-11-23

The consensus among market strategists is that U.S. stocks will continue to climb in 2004. The bulls are counting on continued growth in the economy to push profits and stock valuations higher.

But not everyone is bullish. Some very experienced market experts believe the recent upswing in stocks is a liquidity bubble that is about to burst.

They cite a long list of reasons why North American stock indices, which recorded gains in the range of 15 to 40 per cent so far this year, could start tumbling again.

The bear case was recently highlighted by investment titan Jeremy Grantham, a 35-year veteran whose top performance over the years has earned him legendary status up there with Warren Buffett and has attracted US$48 billion to his New York money management firm.

“This is not just a bear market rally but the greatest sucker rally in history,” he recently told Barron’s magazine.

Here is a summary of the reasons he and others give for why the bear market will return in the United States:

· Valuation: The stock market is overvalued. U.S. stock prices are on average 24 times earnings, which is quite high historically. A more reasonable level would be 16 times earnings. Thus, there is little room for multiple expansion to carry stocks higher. For the market to keep rising through 2004, profits would have to continue climbing rapidly as they have this year and that is unlikely. Another factor is that the stock market tends to anticipate economic developments by about six months. Future good news of a recovering economy and profits has already been priced into the market.
· Debt: Debt levels have climbed dramatically. Consumers are overextended with larger mortgages and credit card debt than ever before and have little spending power left. The tax-cut-induced spending spurt since July will peter out. U.S. government borrowing as a percentage of GDP is higher than the peaks reached in previous cycles. Just as the stimulus of a rising government deficit has been supportive of the economy and markets, the coming necessary adjustment to a lower deficit will be painful, and the stock market can be expected to start anticipating this result.
· Sentiment: “Extreme optimism” prevails, according to most investor sentiment indicators. Optimism relative to pessimism among stock investors has risen to levels not seen since early 2000 just before the 1990s bubble market peaked. With bulls already outnumbering the bears by at least five to one, compared with one to one at the beginning of 2003, there is not likely enough buying power left to support the market at current levels, let alone to carry it higher, especially with foreign investors being spooked by the prospect of further declines in the U.S. dollar.
· Liquidity: The 2003 stock market rally was fueled in large part by the deflation-fearing Fed’s pumping of liquidity into the financial system. But with money supply growth recently having stalled, inflation threatening to make a come-back, and interest rates set to rise in 2004, this liquidity bubble is about to burst, just as people are starting to think a liquidity bubble can go on indefinitely.
· Election cycles: Stocks have the best chance of performing well in the third year of a presidential election cycle when stimulus measures aimed at re-election have the most impact. The third year of the latest cycle is coming to a close and so is the high probability of a rising market. The historical record shows that stocks can go either way in the upcoming fourth year of the election cycle.

To support their views, some of the pessimists point to the ground-breaking research on stock market bubbles by University of California Geophysicist Didier Sornette, author of a book entitled “Why Stock Markets Crash.”

His extensive modeling of major historical bubbles, including the 1990s Japanese stock market collapse, points to another downward crash for U.S. stocks in late 2003 or early 2004, with the S&P 500 index possibly dropping 30 to 40 per cent to around 600, compared with its current level just above 1,000.

For the pessimists, this year’s U.S. stock market rally is reminiscent of a similar run-up in the Japanese Nikkei index to just over 20,000 in 1992 after a post-bubble dive from 30,000 in 1990. Just as the market sages turned bullish again, the Japanese market reversed course and languished for years, bottoming recently under 10,000.

For those willing to look at some scary graphs of possible “anti-bubble” outcomes for the U.S. market, Professor Sornette’s research is regularly updated at his website at

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at

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©2003 Wayne Cheveldayoff