Financial survival in 2002 (page 1 of 2)

First let us look at some broad trends. Since 1998 the US stock market has been tracing out a major top formation and a resumption of the bull trend is most unlikely. A large number of stocks - mostly old economy stocks - peaked out already in 1998, while the NASDAQ, which is heavily weighted by high tech stocks, made its final high in a speculative euphoric blow-off in March of 2000.

The reason that it will be difficult for stocks in the US, from here onwards, to make new highs is that interest rates will no longer decline, but rise if the economy and corporate profits improve, as most Wall Street strategists and economists presently expect. Conversely, if a bullish case for stocks were made based on a continuous decline in interest rates, one would have to assume that a further decline in interest rates could only occur in an environment of additional economic and corporate profit weakness.

Thus, the US stock market is caught between the prospect of rising interest rates amidst an economic recovery scenario and a further contraction in the economy in 2002 with no corporate profit recovery in sight - something I personally suspect will happen. This dilemma for the stock market would not be particularly dangerous if valuations were as low as at the bottom of previous bear markets.

Since the end of the Second World War, the S&P 500 sold at major market lows, on average, for just about 11 times earnings, had a dividend yield of more than 4% and an average price-to-book ratio of just 1.5 times. But, today, with the S&P 500 selling at more than 35 times trailing earnings, a dividend yield of just 1.3% and a price-to-book ratio of more than 6 times, I would, at very best expect the S&P 500 index to trade in a range of between 900 and 1250 for the foreseeable future.

Moreover, it would not surprise me in the least if we had not already seen the stock market's highs for the year 2002, in early January, when the S&P 500 reached the 1180 level and when stocks had become quite overbought among widespread optimism in the investment community about a V-shape type of recovery. So, while I can see a volatile trading range for the US stock market for the next 12 months or so, I still do expect the market to eventually sell-off badly, and the S&P 500 to decline to around 600 or lower.

However, we should not forget that the US government can by means of the Federal Reserve Board's monetary policies and the Treasury's ongoing market support measures and financial manipulations support the market for quite some time, as it already did in 2001. Still, based on my studies of financial history and my personal experience, I have never seen or read about any market support measures, which succeeded beyond the short term.

Eventually, market support and artificial stimulus measures create further imbalances and additional unintended consequences, and fail as badly as Japan's and Argentina's economic policies have done in the last few years! Therefore, the final bottom for the US stock market may only be reached in the 2003 to 2005 time frame, which would still be an improvement on Japan whose stock market is still hovering at an eleven-year low!

Regarding US bonds, I feel that the upside potential from here is also limited. Maybe, investors will not lose much money in bonds and even earn around 5% per annum, and so, at least, outperform US equities. But the huge gains, which were achieved since 1981, when interest rates reached an all time high and thereafter steadily declined, seem to be a thing of the past.