January 2004
January, 2004
harry s. dent, jr.
H.S.DentForecast The Economic Guide for Effective Financial Decision Making
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inside
Feature Articles
The Recovery Has Been Stronger than Most Have Expected, Now It’s Likely to Moderate...........1
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Review of the Recovery............. 2
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A Review of Recent Forecasts....3
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Looking Forward into the Next and Last Great Bull Market...........5
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Using Cycles to Approximate the Next Great Bubble Peak................7
Extras ▲
South Korea–Where Everything Happens at the Speed of Light.... .9
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Sector Updates and Allocations......................... ...........12
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Likely Mild Pullback Ahead After Achieving Our Initial Targets for the Stock Market Recovery of 10,000 – 10,400 In brief: The markets finally did break up above 10,000, and we warned in our 12/11 update that the Dow would probably keeping moving up towards a ceiling of about 10,400. The Dow hit just over 10,450 on 12/29. More revealing is the fact that the Nasdaq and many growth sectors topped out between early November and early December and have just barely made new highs after moving sideways while the Dow advanced more strongly. This “divergence” more into basic stocks (The Dow) suggests that this rally is nearing its end for now and that valuations, especially in the growth stocks are getting ahead of themselves. Hence, we think this rally is very near its end near-term and our best target for the Dow is around 10,490 – 10,500 in the first days of January. But it more and more looks like the 4th wave correction off of this strong 3rd wave rally since early March is about to begin. This would suggest a mild correction for the next few months, likely seasonally into February. The best downside buy targets would be 9,600 on the Dow – and the correction is not likely to break much below 9,000 at the worst. The Nasdaq would have its first and most likely support around 1880 to 1890 and worst case around 1780. So, we’re not expecting a big correction, just a healthy sideways movement for a while before advancing
towards 10,800 to 11,300 on the Dow into April or later this year. We do not consider this enough of a downside correction to be worth longer-term investors taking defensive measures. The market’s tendency in recent months is to keep going up a little higher than anyone thinks. But if we do see a mild correction, as seems likely soon, it will provide an opportunity to invest new monies or to get more aggressive.
The Recovery Has Been Stronger than Most Have Expected, Now It’s Likely to Moderate Economic growth surprised everyone (but us) in the third quarter coming in at a revised 8.2% rate. That was because business and capital spending finally kicked in on top of already strong consumer spending as we had been forecasting by fall. But we have been warning that home sales would finally start slowing just as the broader economic recovery got under way due to peaking demographics in mortgage interest and trade-up home buying. Since a strong August peak, home sales have been slowing. We expect this to be a longer-term trend with autos, furnishings and home improvement expenditures to help make up the difference over time. But looking at broader indicators and a slightly weaker than anticipated Christmas season, consumer spending does seem to be slowing a bit. And, there is no way that we would
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harry s. dent, jr. 2
line fashion on average. Straight-line progressions only 14 look straight-line 10 until you look at them more long 6December 19, 2003 term. Bubble-like 2progressions are only -2 obvious in extreme -6 short-term cycles like Dec-02 Mar-03 Jan-03 Sep-03 Dec-03 1995 – 1999, but this always happens, just Source: www.businesscycle.com Chart 1 to different degrees see a continuation of 8.2% growth in short-term and longer-term, and weaker and stronger cycles. rates in GDP.
Weekly Leading Index (growth rate)
Our Weekly Leading Index in Chart 1 has been moving sideways for a number of months after a strong advance. This would suggest as well that we will not see growth quite as strong in the coming quarter or so. We also have rising threats near-term from Al Qaeda and a pledge from Osama bin Laden for a major U.S. attack by February. These threats have enough credibility for the U.S. to have substantially increased security measures across the board. In summary, moderating growth (but still strong) plus rising terrorist threats would also be consistent with a short-term correction just ahead.
Review of the Recovery, Our Past Forecasts and Our Evolving Forecasting Methods We want to use this issue to review our forecasting methods, how they have evolved and why they are proving to be increasingly effective. Then we want to re-look at how this next and last great bull market will likely unfold. The truth about life and the markets is that things grow exponentially and then collapse, but we would all like to believe that life and the markets just grow more in a straight-
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Our longer-term demographic cycles are very fundamental and projectable, but the gyrations around them are exponential – up and down – due to human nature. We started out in the late 1980s using very long-term fundamental demographic projections and technology cycles to predict everything from the collapse of Japan, to the early 90’s slowdown in the U.S., to the strong recovery in the 90’s, to falling inflation trends, and a balanced federal budget by 1998 to 2000. (See: Great Boom Ahead: Ten Years Later) But over the years we have increasingly used cyclical indicators -- ranging from the 1-year to 4-year to Decennial cycles -- and technical indicators -- ranging from the Dow Channel on the broader horizon, to Elliott Wave Patterns, to short-term overbought/oversold indicators like volatility indicators including the VIX, and broader valuation measures like the Fed model (yields on 10-Year Treasuries vs. the S&P 500). These indicators help us to forecast the huge swings that occur more exponentially short-term and long-term. Since we started with the more powerful fundamental indicators, it has taken us some time to refine them
with these more cyclical indicators to greater advantage. We look at many such cyclical and technical indicators, but we work religiously to distill down to the few that actually seem to work over time, and that also correlate effectively with our broader fundamental indicators. After having much success with our broader fundamental indicators after we started this newsletter in 1989 we feel that this last year has proven this unique combination of fundamental, cyclical and technical approaches to forecasting. We still always remind our subscribers and followers that the more we move from long-term, deterministic fundamentals into more probabilistic cyclical and technical indicators that our chance of being wrong in the short-term grows. The best technical indicators are only right 60% – 70% of the time, and that has been our experience even with our best indicators. But this combined approach, starting with the fundamentals and then moving progressively to the cyclical and technical indicators does give us better forecasting abilities. Hence, when we say in this newsletter that the odds are that the markets will take a short-term correction – that is our best guess from near-term cyclical and technical indicators. It is not as likely to occur as our longstanding predictions that this boom will continue into the latter part of this decade based on demographic spending and inflation trends, and our SCurve and four-stage cycles in technology and new economy trends. These fundamental trends are more “cause and effect”, and hence, more predictable in reasonable long-term
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harry s. dent, jr. 3
time frames. But even in the strong long-term trends we have been the most successful at predicting, since the late 1980s, we have tended to under-forecast the targets due to the inevitable bubble nature of all trends, and especially strong trends. Despite major corrections in the stock market like 1987 and 2000 – 2002, the long-term fundamentals keep winning out and that is the most important insight for long-term investors. Holding even through these major corrections has and will very likely continue to be very rewarding. If you are jumping out of the markets all of the time, history has proven you will more likely lose than gain, as you will get out of a bull run too early or late, and then get back into the next bull market too early or late. But our research has added a unique longterm insight that holding equity investments through long-term demographic slowdowns in spending is very unrewarding, and even disastrous! Now we have clearer recurring cycles and technical indicators that allow you as an investor to better time such long-term changes in direction, as well as when to get more aggressive or more defensive in the short-term, especially as new monies become available to you or you are forced to make short-term withdrawals. Our investment philosophy has always been longer-term and based on fundamentals, but we don’t deny that cyclical and technical factors make a difference as they clearly do. It’s just that there are so many of them and they are often conflicting and changing.
short-term, and why we’ve learned to whittle technical indicators down to the most reliable ones. We aren’t stock pickers as that is a very different discipline and we don’t consider that to be very fruitful in an era where you can buy index or mutual funds with proven risk/return track records, and now ETFs. Why add the work of analyzing individual companies against the best analysts, and take the risk that despite your best research you end up with an Enron! So that is the focus of this newsletter: To identify the best sectors to invest in and how to re-allocate them over time, especially during major “season” changes in our economy – from long-term boom to bust – and from inflation to disinflation. The last year or two has given us greater confidence in our forecasting models now that we feel we are starting to develop the right balance between our fundamental, cyclical and technical indicators. So we wanted to start with a review of our forecasts and how they have worked out in the last year or so as our indicators have proven to be more accurate than ever.
A Review of Recent Forecasts Our Dow Channel and technical indicators first warned that a top was approaching in early 2000. At that time we did not expect the severity of the downturn that actually occurred, especially in the Nasdaq and tech sectors. But we did warn in our February issue of 2000 that the Internet bubble seemed to be peaking, and then in the April issue of 2000, that it was time to allocate more out of the greater performing sectors like technology and Asia exJapan and more into health care, financials and multinationals. After a sharp correction into mid-2000, the markets rallied steadily and then retested those lows again in late 2000. Up to that point this looked like a normal, healthy “A-B-C” correction pattern and we were hoping for a continuation of the rally. But in November of 2000 in Chart 2, we started warning that if the Nasdaq didn’t hold near its fair value point in the middle of its Channel, but instead began to break down that we would
Nasdaq Channel
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harry s. dent, jr. 4
Chart 3
Reverse Head and Shoulders Bottom Dow April 2002-April 2003 11,000
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be likely to test the bottom of the Channel near-term or as late as late 2002. The markets did deteriorate sharply into December of 2000. Then in January of 2001 we warned that from technical indicators that the Nasdaq looked like it would fall back to its bottom up-trend line from late 1990 around 2080, and if it broke that it would likely fall back to its late 1998 lows of 1350 – 1400. So we did start getting progressively more bearish in late 2000 and early 2001 due to technical indicators, and the market did break 2080 on the Nasdaq, and the Dow and Nasdaq proceeded to test their bottom channel lines and 1998 lows by late September of 2001 with the 9/11 crisis. And all along we were warning that even if things did get worse, we would still see a strong rebound by October of 2002 on the 4-Year cycle.
Deloitte Leading Index of Consumer Spending % Change
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We first gave buy signals in late 2001 just after 9/11 when the Dow tested the lower-end of its channel around 8,200 and the Nasdaq first tested 1350 – 1400. We gave buy signals again, a little lower on the Dow at the bottom of its Channel again, and the Nasdaq in July of 2002. Those signals were premature (and we did warn of further weakness many times throughout the first half of 2002), but still profitable given the strong rebound since late 2002. In late 2001 we also revealed unique research that explained why this “tech wreck” was occurring on the S-Curve cycle, and why it was almost identical to the tech wreck of the early 1920s that lead into the greatest “buy opportunity” and bull market in history from 1922 to 1929. We gave our strongest buy signal in the history of our newsletter in early October of 2002 as we got the strongest confluence of technical,
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cyclical and fundamental indicators ever – and the bottom did indeed occur there. We later gave another strong buy signal in March with the pullback in the Dow into the 7500 range on a “technical” reverse headand-shoulders pattern that proved very accurate and with Nasdaq targets of 1250 – 1280 much above its lows in October of 2002. Most forecasters back then were calling for new lows in the Dow and possibly new lows in the Nasdaq. In Chart 3 we show our forecast back in the February newsletter of 2003 with the head-and-shoulders projection for
a bottom around 7,500 – and then a projection for the first major rally off of that to go to 10,000 to 10,400 on the Dow. That rally has occurred right into our targets recently, but took longer than we first anticipated. But again, this shows how you can use technical forecasting methods to improve the accuracy and targets of stock market moves within larger fundamental and cyclical factors. The reasons we gave our strongest buy signal in our history in October of 2002 was that technical indicators (like the VIX and Fed Indicator) were screaming off the charts for an oversold panic by investors, and the
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harry s. dent, jr. 5
Chart 5
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80.5 Year Lag 12 10
before moving sideways again into much of 2004 before the next great bull run into 2005 and 2006 (similar to the rebound in the early 1990s in Chart 5). We also argued on the 4-Year Cycle that you typically see an approximate 50% rebound from the lows in the mid-term year into the highs of the next or third year in the Presidential Cycle. The Dow now approaching 10,400 is up 44% from its low in late 2002 and the Nasdaq is up 81% from the lows of early October 2002 when we gave our strongest buy signal ever. So, this cycle, like the Decennial Cycle has been very useful in anticipating shorter-term moves in the markets around our longer-term fundamental trends that point strongly up into the rest of this decade.
8
Looking Forward into the Next and Last Great Bull Market
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Decennial cycle had bottomed in June/July of 2002, followed by the 4Year cycle bottoming in October of 2002. All of our key fundamental, cyclical and technical indicators had lined up in October of 2002 unlike any time we had seen in decades! Then in the May issue of 2003 we presented the new Deloitte Leading Index of Consumer Spending (Chart 4) that suggested a stronger recovery into the fall of 2003. This represented another new indicator that we found made sense and was likely to be predictive in the short-term. In successive issues we argued strongly that this recovery would not be jobless
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(that jobs followed on a relatively predictable lag) and that this recovery was following a similar path to the early 1990s recovery and stock market boom in Chart 5 from the November 2003 issue. We also argued for many months that that capital and tech spending would lag, but turn up by the fall – and all of these factors have indeed coincided to produce the stronger economy and continued stock rally into December. But despite these positive factors, the stock market has largely already discounted these trends and is now likely to move sideways into February until it turns up again
We will now go back again 80 years or so to the scenario of the Roaring 20s with the tech-lead crash and the recovery out of the first tech bubble into the next greater one into 1929. In Chart 6 we look at how the Automotive Index peaked in late 1919 and then crashed into early 1922 – very similar to the recent tech crash that we described in depth in past issues of our newsletter. The Nasdaq is recovering pretty similarly to what happened back then. The correction went a little deeper and a little longer, and has been a little slower to recover. But the pattern is still very similar on an 80-year lag. This chart would also suggest that there is likely a bit more to come of the present recovery rally before we see a 4 to 6-month minor setback. But it suggests something more
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harry s. dent, jr. 6
Chart 7
Dow vs. Auto August 1921 – December 1930
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important: This whole cycle seems to be occurring on an 80.5 year lag, which means this rally could last a bit longer than the one that occurred from early 1922 into late 1928 in tech stocks. This means we could see a peak well into 2009 in tech stocks, and then a much later peak in the broader markets like the Dow as we will discuss ahead.You would normally expect, like in early 2000, that the Dow or broader markets would first peak and then that the tech markets would peak later as everyone rushed into them in the final stages of the bubble. But that did not occur in the late 1920s or second great bubble in the last technology revolution!
Chart 8
Small Cap Growth and Value vs. Dow 1926 - 1932
This shows a clear progression in the past that could and is likely to repeat in the future on an 80-year to 80.5year lag or close. Small cap growth stocks will surge again with the next S-Curve cycle that emerges in the 60% to 90% second growth surge. We will see arenas like broadband, digital cameras and appliances, Wi-Fi, and later stage-biotech innovations
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Small Cap Value 2.500
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emerge from 2005 – 2009 – among others. But the small cap growth stocks would naturally peak earlier as they have to sell or merge into larger companies that are winning the broader race for leadership in this new economy cycle as their S-Curves are coming later and moving faster. As this race for leadership intensifies even small cap value could start to fade – who wants failing or lagging companies at this late stage of the revolution even though they aren’t as overvalued? But here’s the key insight from the late 1920s bubble and how it played out. The investors who inevitably were sucked again into the next great
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Chart 7 shows how the Automotive Index greatly out-performed the Dow from 1922 to 1928, but then peaked in early 1929, about 8 months before the Dow peaked in September of 1929. This represents an important divergence that we could see in the next bubble that could help us gauge when to start getting out of tech stocks first, and then broader stocks later. We can also see in Chart 8 that the higher growth small cap stocks also peaked earlier than the Dow. We only have indexes on small cap stocks back to 1926. But they show clearly in Chart 8 that the small cap growth stocks peaked first around March of 1928. Then small cap value peaked in late 1928 just before the automotive index peaked around early 1929.
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bubble in tech and small cap stocks, started to remember the prior bubble and crash only a decade before (from late 1919 into early 1922). They can’t and won’t resist the unbelievable returns, like in 1995 to 1999. But they start thinking – the last time this happened, the tech and growth stocks got hit the hardest. So, they decide to stay in the markets, but switch more to broader-based stocks like the Dow. Hence, there was a reverse divergence between late 1928 and late 1929 as greedy, but bubble-wary investors switched first out of the highest growth small caps into small cap value and then tech stocks, and then finally into more
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The Decennial Cycle (averaged over the last century) has been strongly influenced by a few major crashes like late 1987, 1937 and 1907, that aren’t as typical in most decades. The 1995 – 1999 and 1925 – 1929 bull markets and bubbles didn’t see such dramatic setbacks in the 7th year of the
Ned Davis Composite Equal Weighting – October 2002-October 2012
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We have already noted that this cycle in tech stocks is tending to occur about 80 years and 6 to 9 months later than the last major new economy and technology cycle. The last technology cycle peaked in
Chart 9
Oct-05
It may sound like a simple thing to move systematically from growth and equity investments to high quality bonds and defensive investments around late 2009 or so to avoid the next “great winter”, but it’s not that easy in real life! The nature of bubbles is such that if you get out 6 months to a year or more early, you can miss 50% or more of your potential gains. But conversely, if you get out 6 months, or a year too late, you can lose 50% or more of your gains. The best strategy would therefore be to phase out systematically over a short period of time – but even that takes timing – and that is where technical and cyclical factors can again help.
Chart 9 shows a composite of our two key cycles -- the Decennial and 4-Year Presidential cycles – and how they are likely to play out over the rest of this decade. They again, have already been instrumental beyond technical indicators in calling the bottom of the last downturn between July and October of 2002. These two cycles would call for a short-term minor setback and then slightly higher stock prices into early to mid-2004 towards 11,000 in the Dow plus or minus. Then there would likely be a correction into the summer of 2004 (back to around 9600 or so) before we see the next major 3rd wave surge in this bull market from around late 2004 into early 2006. Then there would be a flattening or correction into late 2006, and then perhaps a sharper correction into late 2007 before we see the final bubble and peak into around late 2009.
We will also be looking to our Dow, Nasdaq and other channels to help gauge such a peak, as well as to shorter-term technical indicators that can only be evaluated at that time. But our cyclical indicators can also help us start to gauge in advance when this bull market is more likely to peak, as well as how this bull market is likely to emerge over the rest of this decade. And they would suggest a peak by late 2009.
Oct-04
Using Cycles to Approximate the Next Great Bubble Peak
Oct-03
When it comes to timing the rough peak in this last great bubble and bull market, we will be looking for such divergences. But we will also look to our technical and cyclical indicators that have been working so well for us in recent years. Every bull market and bubble peak works out a little differently and always has. Being closer to timing the top of this next, and perhaps, greatest bubble will be critical.
September of 1919, while this one peaked in March of 2000 – 80 years and 6 months later. The last tech crash bottomed in January of 1922, with this one in October of 2002 – 80 years and 9 months later. So, this approximate 80-year new economy cycle seems to be occurring 6- to 9months later on the time clock of this decade. Again, that alone would suggest that this boom could peak a little later than the one did in late 1928 for tech stocks and late 1929 for the broader markets back then. We could see a peak in tech stocks more like the spring to the fall of 2009, with a slightly earlier peak in small cap growth, and then a peak in the Dow and broader markets more like early to mid-2010.
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stable and broader Dow-like growth companies in the last year of the bubble in 1929. But that was the beginning of the end that lead into the greater crash and Great Depression of the 1930s and early 1940s.
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harry s. dent, jr. 8
decade. Hence, we think that the 4Year cycle down into late 2006 will be more dominant, but that there still could be short, but sharp setbacks into late 2007 and late 2008 on the way up to a volatile peak in late 2009 or early 2010. These cycles suggest a peak around late 2009. But remember before that the larger 80-Year cycle seems to be playing out 6 to 9 months later than the last one. A number of the Decennial cycles have turned down in the early part of the new decade rather than by the end of the decade. The 1960s boom only saw a recession and downturn in the stock markets in early 1970. The 1990s decade saw a recession and a downturn in the stock market that only began in July of 1990. So, it is clearly possible that this 80-Year cycle could peak a bit later into early to mid-2010. But considering all of our cycles, it could peak by late 2009. Our present best estimate of the peak of this next bull market and bubble is between August of 2009 and September of 2010 – about a 1-year time frame for phasing out. The peak would be more likely to
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occur in the Dow and broader markets between October of 2009 and April of 2010 – a six-month time frame. But the peak in the tech markets and Nasdaq could come earlier, say between March of 2009 and August of 2009 and that would represent an early warning signal and a reason to start shifting out of tech stocks earlier. Small cap growth stocks are likely to peak even earlier in the cycle as they did in the late spring of 1928. Our approach will be to continue to broaden our research and to monitor all of our fundamental, cyclical and technical indicators as we approach the end of this decade and the beginning of the next. We continue to think that this period will represent the most important transition in your financial and personal life. We hope you will stick with us through the great bubble and bust ahead and let us guide you with these fundamental, cyclical and technical indicators. We will obviously continue to refine all three as we move forward and get better information and tracking of their accuracy.
© Copyright 2004,H.S. Dent Publishing
rodney johnson President of H.S. Dent Investment Management 9
from the January 2004 issue of the
H.S. Dent Forecast monthly newsletter
South Korea–Where Everything Happens at the Speed of Light History has not been kind to South Korea. The country has been ravaged by war, occupied by foreign forces, and for the past fifty years has been continuously threatened by its neighbor, North Korea. So how did this pint-sized, war-torn country with an oversized population and few natural resources become an economic force in less than half a decade? By leveraging its assets – people and foreign aid. From there the country remade itself several times and is currently on the verge of another revolution – responsible corporate governance and democracy. These changes, along with the extremely favorable demographic composition of its population, will continue to aid South Korea’s move into the top echelon of economic powers in the world – and will continue to present favorable investment opportunities even as other economies begin to stumble later this decade and into the next.
Recent History In 1953 South Korea hit bottom. The cease-fire agreement with North Korea had been signed, but the country had endured three years of devastation and heavy casualties in the preceding war, which had come on the heels of a 35-year occupation by Japan from 1910 through 1945. In 1953 the average annual income in South Korea was a mere $87. The country had scant natural resources, a large population to feed, a standing army to maintain, and almost no
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industrial infrastructure. At that time, 70% of the population was involved in agriculture. South Korea was a nation of farmers. This is not the normal equation for tremendous economic growth. But South Korea had a distinguishing characteristic – it was the first instance where the US and the UN had committed forces specifically to stop the spread of communism, and the US was determined to hold the line. To this end, the US and other UN countries supplied troops and tremendous foreign aid to the development of South Korea. In Chart 10 you can see that during the 1950’s and even into the early 1960’s foreign aid constituted a tremendous portion of the national budget. Just the United States portion of the aid package was at least $200 million per year from the end of the war through the mid 1960s. South Korea used this aid not only to buy humanitarian goods and weapons, but also to begin industrializing the nation.
Wanting to realize independence from foreign aid, the South Korean leaders set about building an infrastructure that would take advantage of their only resource – cheap labor. During the 1950’s and 1960’s South Korea used the funds available in the form of aid and foreign loans to develop labor-intensive industries for exports. The government also used its position as legislator and trade negotiator to diminish the import and purchase of consumer goods, instead favoring investment and the import of raw materials. As the 1960’s wore on, the South Korean government continued fostering industrial development by making concessionary loans and giving tax breaks to chaebols – groups of interrelated companies that were in industries the government wanted to see grow. The government was specific in its goals, it wanted growth in export industries. If you fostered growth and did well in the international markets then you received favorable treatment. If you faltered, favor was withheld. The nurturing worked because the country enjoyed double-digit growth and saw its national income and GDP continue to climb.
Foreign Aid as a Percentage of Total Budget (South Korea)
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rodney johnson 10
In the early 1970’s the Economic Planning Board of South Korea launched the Heavy and Chemical Industries Initiative. This plan pushed the development of the steel industry, shipbuilding, auto manufacturing, and chemical industries. South Korea had made great strides in developing export industries in the past, now it was time to move to the next level by adding more value to the process, thereby increasing the value of exports. This worked very well until the global recession of the early 1980s. The malaise in the international markets caused slack demand in heavy industries. Crippling over-supply led to a negative GDP growth rate in South Korea for 1981, it’s first negative growth since 1962. By this time the country’s population had seen its income rise substantially which was starting to translate into consumer demand for goods and services. Average annual income, which was a mere $87 in 1953, had grown to an astounding $1,600 in 1980 and over $10,000 by 2000. Chart 11 shows the growth in household consumption that resulted from the higher earnings. The government
continued to encourage saving and investment over consumption through its tax structure and legislation, but South Koreans were starting to understand their power as consumers. So the economic leaders turned their attention to consumer goods and electronics, helped by Japan’s foreign investment in this industry.
Then there was the Asian Meltdown The meltdown of Asian currencies in the late 1990’s brought to light several ugly realities about the economic structure of South Korea. The chaebols were heavily leveraged. Years of sub-market rate loans and other concessions had allowed these entities to grow with very little attention paid to the cost of the growth because government loans at favorable rates were just a phone call away. On top of the indebtedness were the corporate scandals and mismanagement of state owned enterprises. South Korea accepted a $58 billion rescue package that required opening its markets to more foreign investment and ownership, more free trade, stricter corporate governance, and a weakening of the chaebol system. While not totally
in place, many of these changes have been affected and have had very positive consequences on the South Korean economy. In a further effort to bail out its economy in the late 1990s and early 2000s, the government tapped into consumer demand by making personal credit easy to obtain. It went so far as credit card vendors setting up booths on street corners and trading credit cards for nothing more than contact information, hoping that the consumer would honor their debt. Just like everything else in South Korea, this heavy-handed government intervention had the desired effect – significantly increasing consumer spending that buoyed the economy – but had tremendous side effects. Roughly 11% of all credit card debt is overdue. One of the largest card companies sold over $500 million worth of credit card debt to lighten its load. Who was the buyer? None other than the South Korean government. In light of the mounting personal debt and bad loans, the government has reversed its views on easy credit and is requiring card companies to lower their bad loan percentages.
From here forward
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South Korea is one of the most wired countries on earth. They are a leading exporter of high tech products and heavy industry. Their growth continues at an astounding rate for both exports as well as consumer demand. The growth is lower than what was recorded from the 1960s through the 1980s, but that is understandable given from where the country started. One of the most interesting aspects of South Korea is its potential given its demographic composition. Chart 12 shows the distribution of the population by age.
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Chart 12
Population Distribution by Age (South Korea) 5,000,000 4,500,000 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000
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Investing in the stocks of South Korea There are several industries in which South Korean companies are proven leaders, including heavy machinery, semiconductors, and consumer electronics. As their economy grows and so do the Asian economies around them, South Korean companies should continue to offer superior investment opportunities. The US State Department publishes a Country Commercial report that should be read by all who are interested in foreign investment. This report can be found at: http://www.state.gov/www/about_state /business/com_guides/2001/eap/korea _ccg2001.pdf But there are factors that dull some of the attractiveness of the South Korean situation. Due to continuous political intervention, the threat from North Korea, the dependence on foreign trade partners for demand, and the basic inexperience of their population in functioning in a free market society, the growth of their economy and their capital markets will be volatile to say the least. Chart 13 shows the KOSPI, the main South Korean Index.
What should jump off the page at you is the tremendous number of people in Korea that are less than 40 years old, with the main group being early 30s. Add to this the greatly increased life expectancy (from a pre1950s of 45 to a current 74), a developed economy, income that is more widely dispersed than it is in the US, and you arrive at a consumer demand forecast that is potentially off the charts!
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South Koreans have shown themselves to be active personal consumers. It has been government intervention that first quelled demand, then created too-easy credit, and has once again pulled in the reins. As the country moves toward an economy more driven by market forces than government policy, consumers should emerge as the driving force in South Korea’s economic landscape.
Obviously investing in this country is not for the conservative investor. In bad times the index can drop like a rock and in good times it can soar. During the Asian Meltdown 19971998, the KOSPI lost over half its value, but then it gained over 250% in the ensuing rebound. The global recession 2000-2001 saw the index lose over half its value again, only to rebound over 100% in less than a year. And of course the North Korean threat that erupted in the middle of 2002 caused the index to once again drop by half before start-
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ed back up again in March of 2003. There is a trend up, but the wild swings up and down mean that this is not an area where you can invest in it and not pay attention. For long-term investment, South Korea still has great potential Our research continues to highlight South Korea as one of the most favorable places for investment. Unlike other Asian powers, the nation is strongly tied to the US and US interests, so it is very likely that government regulation and intervention will continue to dwindle instead of grow. The moves made toward more transparent corporate dealings and increased corporate responsibility for its actions are also very encouraging. And of course underpinning all of this are the demographics that indicate growth in spending for almost two decades. Hopefully as the population gains experience in the free market environment and the capital markets gain experience in weathering political and economic storms the volatility of the economy should lessen, making South Korea a more favorable investment for less aggressive investors as well.
❖
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Sector Updates and Allocations Summary As suspected, the market continued its upward march in the fourth quarter and eventually made the 10,400 range on the Dow as well as topping 2,000 on the Nasdaq. The sideways action near the end of the year reconfirms our forecast of a possible resting period during the first few months of 2003. The risk of course is that those who waited until now to jump back in will be invested just in time for nothing to happen, causing a lot of “nervous” money to be floating around the markets for a few months. We are now on the other side of our comments from this time last year when I wrote, “I know it is repetitious, but we have a great environment for a significant rebound – low interest rates, low or no inflation, continued gains in productivity, and the end of a recession. When we add the long-term technical cycles that Harry Dent outlined above, we should be on the verge of a strong rally.” The first stage of the rally has occurred. We have experience the strong move off the bottom with the Dow gaining over 40% and the Nasdaq over 80%. From here, must keep watch on the technical indicators and not become overly anxious if we have the sideways movements and possible shallow corrections that are anticipated. Harry noted above the elevated risk of terrorist attacks, the reality is that we, as a nation and a marketplace, are going to have to deal with the fact that the threat of terrorism is not going away. This and other geopolitical events/concerns are likely to have a stronger influence in the markets in the absence of real economic news during the first quarter.
There is the possibility of a shallow pullback, especially in the technology area. But from our perspective there is not enough risk to chance being light in the sector when it takes off again. So our current allocations have not changed from last quarter. This makes a full year we have maintained roughly the same weightings. If you have not already, we strongly suggest rebalancing your portfolio to protect some of the gains made throughout 2003.
Allocation Update Our current allocations are as follows: Aggressive Investors 30-40% Technology 25-35% Financial Services 5- 15% Pacific Rim (ex-Japan) 15-25% Large Healthcare 10-15% Large Cap Growth/Multinationals Growth Investors 25-30% Multinationals 20-25% Technology 20-30% Financial Services 10-20% Large Healthcare 5% Pacific Rim (ex-Japan) Pacific Rim (ex. Japan) The KOSPI ran from 700 to 800 in October, and has fluctuated there ever since. The sideways action reflecting full valuations for the current level of economic activity, which we have forecasted for the US, has already taken hold in South Korea. With economic activity slowing slightly both on the business and the consumer front, this region should be an average performer. Technology The NASDAQ, shown in Chart 14, has lost some zip even as the other indices have moved higher. It is the first signs that the markets need to
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Chart 14
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rest before moving up yet again. We still have a ways to go before we approach the “fair market” middle line of the channel. Look carefully at the stocks that are moving the indices…and what stocks are not. It probable that the growth stocks of yesterday, such as Microsoft and Oracle, will have to make way for a new group of rising stars.
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Healthcare (Pharmaceutical) The healthcare industry is still in the doldrums. Our weighting remains low because there simply is no action here right now. Multinational The Multinational sector, as represented by the Dow and shown in Chart 15, is a big winner this year with gains of over 20%. While we’ve given significant coverage this issue to our view that the markets will rest in the first part of 2004, we still see strong gains for the index as we move further through the year.
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Financial Services The Financial Services index shown in Chart 16 marched up to its midchannel line and then promptly began tracking the slope of that line. We have watched this sector with a possible eye toward lowering its allocation, but the growth has remained consistent and currently shows no sign of weakening more than any other sector before the next leg up.
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H.S.DentForecast The Economic Guide for Effective Financial Decision Making
▲
inside
Feature Articles
The Recovery Has Been Stronger than Most Have Expected, Now It’s Likely to Moderate...........1
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Review of the Recovery............. 2
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A Review of Recent Forecasts....3
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Looking Forward into the Next and Last Great Bull Market...........5
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Using Cycles to Approximate the Next Great Bubble Peak................7
Extras ▲
South Korea–Where Everything Happens at the Speed of Light.... .9
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Sector Updates and Allocations......................... ...........12
Get the New Special Report Demographic Trends in Real Estate Harry's comprehensive analysis of the real estate industry all wrapped up in one publication. Place you order now
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Likely Mild Pullback Ahead After Achieving Our Initial Targets for the Stock Market Recovery of 10,000 – 10,400 In brief: The markets finally did break up above 10,000, and we warned in our 12/11 update that the Dow would probably keeping moving up towards a ceiling of about 10,400. The Dow hit just over 10,450 on 12/29. More revealing is the fact that the Nasdaq and many growth sectors topped out between early November and early December and have just barely made new highs after moving sideways while the Dow advanced more strongly. This “divergence” more into basic stocks (The Dow) suggests that this rally is nearing its end for now and that valuations, especially in the growth stocks are getting ahead of themselves. Hence, we think this rally is very near its end near-term and our best target for the Dow is around 10,490 – 10,500 in the first days of January. But it more and more looks like the 4th wave correction off of this strong 3rd wave rally since early March is about to begin. This would suggest a mild correction for the next few months, likely seasonally into February. The best downside buy targets would be 9,600 on the Dow – and the correction is not likely to break much below 9,000 at the worst. The Nasdaq would have its first and most likely support around 1880 to 1890 and worst case around 1780. So, we’re not expecting a big correction, just a healthy sideways movement for a while before advancing
towards 10,800 to 11,300 on the Dow into April or later this year. We do not consider this enough of a downside correction to be worth longer-term investors taking defensive measures. The market’s tendency in recent months is to keep going up a little higher than anyone thinks. But if we do see a mild correction, as seems likely soon, it will provide an opportunity to invest new monies or to get more aggressive.
The Recovery Has Been Stronger than Most Have Expected, Now It’s Likely to Moderate Economic growth surprised everyone (but us) in the third quarter coming in at a revised 8.2% rate. That was because business and capital spending finally kicked in on top of already strong consumer spending as we had been forecasting by fall. But we have been warning that home sales would finally start slowing just as the broader economic recovery got under way due to peaking demographics in mortgage interest and trade-up home buying. Since a strong August peak, home sales have been slowing. We expect this to be a longer-term trend with autos, furnishings and home improvement expenditures to help make up the difference over time. But looking at broader indicators and a slightly weaker than anticipated Christmas season, consumer spending does seem to be slowing a bit. And, there is no way that we would
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harry s. dent, jr. 2
line fashion on average. Straight-line progressions only 14 look straight-line 10 until you look at them more long 6December 19, 2003 term. Bubble-like 2progressions are only -2 obvious in extreme -6 short-term cycles like Dec-02 Mar-03 Jan-03 Sep-03 Dec-03 1995 – 1999, but this always happens, just Source: www.businesscycle.com Chart 1 to different degrees see a continuation of 8.2% growth in short-term and longer-term, and weaker and stronger cycles. rates in GDP.
Weekly Leading Index (growth rate)
Our Weekly Leading Index in Chart 1 has been moving sideways for a number of months after a strong advance. This would suggest as well that we will not see growth quite as strong in the coming quarter or so. We also have rising threats near-term from Al Qaeda and a pledge from Osama bin Laden for a major U.S. attack by February. These threats have enough credibility for the U.S. to have substantially increased security measures across the board. In summary, moderating growth (but still strong) plus rising terrorist threats would also be consistent with a short-term correction just ahead.
Review of the Recovery, Our Past Forecasts and Our Evolving Forecasting Methods We want to use this issue to review our forecasting methods, how they have evolved and why they are proving to be increasingly effective. Then we want to re-look at how this next and last great bull market will likely unfold. The truth about life and the markets is that things grow exponentially and then collapse, but we would all like to believe that life and the markets just grow more in a straight-
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Our longer-term demographic cycles are very fundamental and projectable, but the gyrations around them are exponential – up and down – due to human nature. We started out in the late 1980s using very long-term fundamental demographic projections and technology cycles to predict everything from the collapse of Japan, to the early 90’s slowdown in the U.S., to the strong recovery in the 90’s, to falling inflation trends, and a balanced federal budget by 1998 to 2000. (See: Great Boom Ahead: Ten Years Later) But over the years we have increasingly used cyclical indicators -- ranging from the 1-year to 4-year to Decennial cycles -- and technical indicators -- ranging from the Dow Channel on the broader horizon, to Elliott Wave Patterns, to short-term overbought/oversold indicators like volatility indicators including the VIX, and broader valuation measures like the Fed model (yields on 10-Year Treasuries vs. the S&P 500). These indicators help us to forecast the huge swings that occur more exponentially short-term and long-term. Since we started with the more powerful fundamental indicators, it has taken us some time to refine them
with these more cyclical indicators to greater advantage. We look at many such cyclical and technical indicators, but we work religiously to distill down to the few that actually seem to work over time, and that also correlate effectively with our broader fundamental indicators. After having much success with our broader fundamental indicators after we started this newsletter in 1989 we feel that this last year has proven this unique combination of fundamental, cyclical and technical approaches to forecasting. We still always remind our subscribers and followers that the more we move from long-term, deterministic fundamentals into more probabilistic cyclical and technical indicators that our chance of being wrong in the short-term grows. The best technical indicators are only right 60% – 70% of the time, and that has been our experience even with our best indicators. But this combined approach, starting with the fundamentals and then moving progressively to the cyclical and technical indicators does give us better forecasting abilities. Hence, when we say in this newsletter that the odds are that the markets will take a short-term correction – that is our best guess from near-term cyclical and technical indicators. It is not as likely to occur as our longstanding predictions that this boom will continue into the latter part of this decade based on demographic spending and inflation trends, and our SCurve and four-stage cycles in technology and new economy trends. These fundamental trends are more “cause and effect”, and hence, more predictable in reasonable long-term
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time frames. But even in the strong long-term trends we have been the most successful at predicting, since the late 1980s, we have tended to under-forecast the targets due to the inevitable bubble nature of all trends, and especially strong trends. Despite major corrections in the stock market like 1987 and 2000 – 2002, the long-term fundamentals keep winning out and that is the most important insight for long-term investors. Holding even through these major corrections has and will very likely continue to be very rewarding. If you are jumping out of the markets all of the time, history has proven you will more likely lose than gain, as you will get out of a bull run too early or late, and then get back into the next bull market too early or late. But our research has added a unique longterm insight that holding equity investments through long-term demographic slowdowns in spending is very unrewarding, and even disastrous! Now we have clearer recurring cycles and technical indicators that allow you as an investor to better time such long-term changes in direction, as well as when to get more aggressive or more defensive in the short-term, especially as new monies become available to you or you are forced to make short-term withdrawals. Our investment philosophy has always been longer-term and based on fundamentals, but we don’t deny that cyclical and technical factors make a difference as they clearly do. It’s just that there are so many of them and they are often conflicting and changing.
short-term, and why we’ve learned to whittle technical indicators down to the most reliable ones. We aren’t stock pickers as that is a very different discipline and we don’t consider that to be very fruitful in an era where you can buy index or mutual funds with proven risk/return track records, and now ETFs. Why add the work of analyzing individual companies against the best analysts, and take the risk that despite your best research you end up with an Enron! So that is the focus of this newsletter: To identify the best sectors to invest in and how to re-allocate them over time, especially during major “season” changes in our economy – from long-term boom to bust – and from inflation to disinflation. The last year or two has given us greater confidence in our forecasting models now that we feel we are starting to develop the right balance between our fundamental, cyclical and technical indicators. So we wanted to start with a review of our forecasts and how they have worked out in the last year or so as our indicators have proven to be more accurate than ever.
A Review of Recent Forecasts Our Dow Channel and technical indicators first warned that a top was approaching in early 2000. At that time we did not expect the severity of the downturn that actually occurred, especially in the Nasdaq and tech sectors. But we did warn in our February issue of 2000 that the Internet bubble seemed to be peaking, and then in the April issue of 2000, that it was time to allocate more out of the greater performing sectors like technology and Asia exJapan and more into health care, financials and multinationals. After a sharp correction into mid-2000, the markets rallied steadily and then retested those lows again in late 2000. Up to that point this looked like a normal, healthy “A-B-C” correction pattern and we were hoping for a continuation of the rally. But in November of 2000 in Chart 2, we started warning that if the Nasdaq didn’t hold near its fair value point in the middle of its Channel, but instead began to break down that we would
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Chart 3
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be likely to test the bottom of the Channel near-term or as late as late 2002. The markets did deteriorate sharply into December of 2000. Then in January of 2001 we warned that from technical indicators that the Nasdaq looked like it would fall back to its bottom up-trend line from late 1990 around 2080, and if it broke that it would likely fall back to its late 1998 lows of 1350 – 1400. So we did start getting progressively more bearish in late 2000 and early 2001 due to technical indicators, and the market did break 2080 on the Nasdaq, and the Dow and Nasdaq proceeded to test their bottom channel lines and 1998 lows by late September of 2001 with the 9/11 crisis. And all along we were warning that even if things did get worse, we would still see a strong rebound by October of 2002 on the 4-Year cycle.
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We first gave buy signals in late 2001 just after 9/11 when the Dow tested the lower-end of its channel around 8,200 and the Nasdaq first tested 1350 – 1400. We gave buy signals again, a little lower on the Dow at the bottom of its Channel again, and the Nasdaq in July of 2002. Those signals were premature (and we did warn of further weakness many times throughout the first half of 2002), but still profitable given the strong rebound since late 2002. In late 2001 we also revealed unique research that explained why this “tech wreck” was occurring on the S-Curve cycle, and why it was almost identical to the tech wreck of the early 1920s that lead into the greatest “buy opportunity” and bull market in history from 1922 to 1929. We gave our strongest buy signal in the history of our newsletter in early October of 2002 as we got the strongest confluence of technical,
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cyclical and fundamental indicators ever – and the bottom did indeed occur there. We later gave another strong buy signal in March with the pullback in the Dow into the 7500 range on a “technical” reverse headand-shoulders pattern that proved very accurate and with Nasdaq targets of 1250 – 1280 much above its lows in October of 2002. Most forecasters back then were calling for new lows in the Dow and possibly new lows in the Nasdaq. In Chart 3 we show our forecast back in the February newsletter of 2003 with the head-and-shoulders projection for
a bottom around 7,500 – and then a projection for the first major rally off of that to go to 10,000 to 10,400 on the Dow. That rally has occurred right into our targets recently, but took longer than we first anticipated. But again, this shows how you can use technical forecasting methods to improve the accuracy and targets of stock market moves within larger fundamental and cyclical factors. The reasons we gave our strongest buy signal in our history in October of 2002 was that technical indicators (like the VIX and Fed Indicator) were screaming off the charts for an oversold panic by investors, and the
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Chart 5
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before moving sideways again into much of 2004 before the next great bull run into 2005 and 2006 (similar to the rebound in the early 1990s in Chart 5). We also argued on the 4-Year Cycle that you typically see an approximate 50% rebound from the lows in the mid-term year into the highs of the next or third year in the Presidential Cycle. The Dow now approaching 10,400 is up 44% from its low in late 2002 and the Nasdaq is up 81% from the lows of early October 2002 when we gave our strongest buy signal ever. So, this cycle, like the Decennial Cycle has been very useful in anticipating shorter-term moves in the markets around our longer-term fundamental trends that point strongly up into the rest of this decade.
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Looking Forward into the Next and Last Great Bull Market
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Decennial cycle had bottomed in June/July of 2002, followed by the 4Year cycle bottoming in October of 2002. All of our key fundamental, cyclical and technical indicators had lined up in October of 2002 unlike any time we had seen in decades! Then in the May issue of 2003 we presented the new Deloitte Leading Index of Consumer Spending (Chart 4) that suggested a stronger recovery into the fall of 2003. This represented another new indicator that we found made sense and was likely to be predictive in the short-term. In successive issues we argued strongly that this recovery would not be jobless
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(that jobs followed on a relatively predictable lag) and that this recovery was following a similar path to the early 1990s recovery and stock market boom in Chart 5 from the November 2003 issue. We also argued for many months that that capital and tech spending would lag, but turn up by the fall – and all of these factors have indeed coincided to produce the stronger economy and continued stock rally into December. But despite these positive factors, the stock market has largely already discounted these trends and is now likely to move sideways into February until it turns up again
We will now go back again 80 years or so to the scenario of the Roaring 20s with the tech-lead crash and the recovery out of the first tech bubble into the next greater one into 1929. In Chart 6 we look at how the Automotive Index peaked in late 1919 and then crashed into early 1922 – very similar to the recent tech crash that we described in depth in past issues of our newsletter. The Nasdaq is recovering pretty similarly to what happened back then. The correction went a little deeper and a little longer, and has been a little slower to recover. But the pattern is still very similar on an 80-year lag. This chart would also suggest that there is likely a bit more to come of the present recovery rally before we see a 4 to 6-month minor setback. But it suggests something more
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Chart 7
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important: This whole cycle seems to be occurring on an 80.5 year lag, which means this rally could last a bit longer than the one that occurred from early 1922 into late 1928 in tech stocks. This means we could see a peak well into 2009 in tech stocks, and then a much later peak in the broader markets like the Dow as we will discuss ahead.You would normally expect, like in early 2000, that the Dow or broader markets would first peak and then that the tech markets would peak later as everyone rushed into them in the final stages of the bubble. But that did not occur in the late 1920s or second great bubble in the last technology revolution!
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Small Cap Growth and Value vs. Dow 1926 - 1932
This shows a clear progression in the past that could and is likely to repeat in the future on an 80-year to 80.5year lag or close. Small cap growth stocks will surge again with the next S-Curve cycle that emerges in the 60% to 90% second growth surge. We will see arenas like broadband, digital cameras and appliances, Wi-Fi, and later stage-biotech innovations
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Small Cap Value 2.500
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emerge from 2005 – 2009 – among others. But the small cap growth stocks would naturally peak earlier as they have to sell or merge into larger companies that are winning the broader race for leadership in this new economy cycle as their S-Curves are coming later and moving faster. As this race for leadership intensifies even small cap value could start to fade – who wants failing or lagging companies at this late stage of the revolution even though they aren’t as overvalued? But here’s the key insight from the late 1920s bubble and how it played out. The investors who inevitably were sucked again into the next great
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Chart 7 shows how the Automotive Index greatly out-performed the Dow from 1922 to 1928, but then peaked in early 1929, about 8 months before the Dow peaked in September of 1929. This represents an important divergence that we could see in the next bubble that could help us gauge when to start getting out of tech stocks first, and then broader stocks later. We can also see in Chart 8 that the higher growth small cap stocks also peaked earlier than the Dow. We only have indexes on small cap stocks back to 1926. But they show clearly in Chart 8 that the small cap growth stocks peaked first around March of 1928. Then small cap value peaked in late 1928 just before the automotive index peaked around early 1929.
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bubble in tech and small cap stocks, started to remember the prior bubble and crash only a decade before (from late 1919 into early 1922). They can’t and won’t resist the unbelievable returns, like in 1995 to 1999. But they start thinking – the last time this happened, the tech and growth stocks got hit the hardest. So, they decide to stay in the markets, but switch more to broader-based stocks like the Dow. Hence, there was a reverse divergence between late 1928 and late 1929 as greedy, but bubble-wary investors switched first out of the highest growth small caps into small cap value and then tech stocks, and then finally into more
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harry s. dent, jr. 7
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The Decennial Cycle (averaged over the last century) has been strongly influenced by a few major crashes like late 1987, 1937 and 1907, that aren’t as typical in most decades. The 1995 – 1999 and 1925 – 1929 bull markets and bubbles didn’t see such dramatic setbacks in the 7th year of the
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We have already noted that this cycle in tech stocks is tending to occur about 80 years and 6 to 9 months later than the last major new economy and technology cycle. The last technology cycle peaked in
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It may sound like a simple thing to move systematically from growth and equity investments to high quality bonds and defensive investments around late 2009 or so to avoid the next “great winter”, but it’s not that easy in real life! The nature of bubbles is such that if you get out 6 months to a year or more early, you can miss 50% or more of your potential gains. But conversely, if you get out 6 months, or a year too late, you can lose 50% or more of your gains. The best strategy would therefore be to phase out systematically over a short period of time – but even that takes timing – and that is where technical and cyclical factors can again help.
Chart 9 shows a composite of our two key cycles -- the Decennial and 4-Year Presidential cycles – and how they are likely to play out over the rest of this decade. They again, have already been instrumental beyond technical indicators in calling the bottom of the last downturn between July and October of 2002. These two cycles would call for a short-term minor setback and then slightly higher stock prices into early to mid-2004 towards 11,000 in the Dow plus or minus. Then there would likely be a correction into the summer of 2004 (back to around 9600 or so) before we see the next major 3rd wave surge in this bull market from around late 2004 into early 2006. Then there would be a flattening or correction into late 2006, and then perhaps a sharper correction into late 2007 before we see the final bubble and peak into around late 2009.
We will also be looking to our Dow, Nasdaq and other channels to help gauge such a peak, as well as to shorter-term technical indicators that can only be evaluated at that time. But our cyclical indicators can also help us start to gauge in advance when this bull market is more likely to peak, as well as how this bull market is likely to emerge over the rest of this decade. And they would suggest a peak by late 2009.
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Using Cycles to Approximate the Next Great Bubble Peak
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When it comes to timing the rough peak in this last great bubble and bull market, we will be looking for such divergences. But we will also look to our technical and cyclical indicators that have been working so well for us in recent years. Every bull market and bubble peak works out a little differently and always has. Being closer to timing the top of this next, and perhaps, greatest bubble will be critical.
September of 1919, while this one peaked in March of 2000 – 80 years and 6 months later. The last tech crash bottomed in January of 1922, with this one in October of 2002 – 80 years and 9 months later. So, this approximate 80-year new economy cycle seems to be occurring 6- to 9months later on the time clock of this decade. Again, that alone would suggest that this boom could peak a little later than the one did in late 1928 for tech stocks and late 1929 for the broader markets back then. We could see a peak in tech stocks more like the spring to the fall of 2009, with a slightly earlier peak in small cap growth, and then a peak in the Dow and broader markets more like early to mid-2010.
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stable and broader Dow-like growth companies in the last year of the bubble in 1929. But that was the beginning of the end that lead into the greater crash and Great Depression of the 1930s and early 1940s.
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harry s. dent, jr. 8
decade. Hence, we think that the 4Year cycle down into late 2006 will be more dominant, but that there still could be short, but sharp setbacks into late 2007 and late 2008 on the way up to a volatile peak in late 2009 or early 2010. These cycles suggest a peak around late 2009. But remember before that the larger 80-Year cycle seems to be playing out 6 to 9 months later than the last one. A number of the Decennial cycles have turned down in the early part of the new decade rather than by the end of the decade. The 1960s boom only saw a recession and downturn in the stock markets in early 1970. The 1990s decade saw a recession and a downturn in the stock market that only began in July of 1990. So, it is clearly possible that this 80-Year cycle could peak a bit later into early to mid-2010. But considering all of our cycles, it could peak by late 2009. Our present best estimate of the peak of this next bull market and bubble is between August of 2009 and September of 2010 – about a 1-year time frame for phasing out. The peak would be more likely to
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occur in the Dow and broader markets between October of 2009 and April of 2010 – a six-month time frame. But the peak in the tech markets and Nasdaq could come earlier, say between March of 2009 and August of 2009 and that would represent an early warning signal and a reason to start shifting out of tech stocks earlier. Small cap growth stocks are likely to peak even earlier in the cycle as they did in the late spring of 1928. Our approach will be to continue to broaden our research and to monitor all of our fundamental, cyclical and technical indicators as we approach the end of this decade and the beginning of the next. We continue to think that this period will represent the most important transition in your financial and personal life. We hope you will stick with us through the great bubble and bust ahead and let us guide you with these fundamental, cyclical and technical indicators. We will obviously continue to refine all three as we move forward and get better information and tracking of their accuracy.
© Copyright 2004,H.S. Dent Publishing
rodney johnson President of H.S. Dent Investment Management 9
from the January 2004 issue of the
H.S. Dent Forecast monthly newsletter
South Korea–Where Everything Happens at the Speed of Light History has not been kind to South Korea. The country has been ravaged by war, occupied by foreign forces, and for the past fifty years has been continuously threatened by its neighbor, North Korea. So how did this pint-sized, war-torn country with an oversized population and few natural resources become an economic force in less than half a decade? By leveraging its assets – people and foreign aid. From there the country remade itself several times and is currently on the verge of another revolution – responsible corporate governance and democracy. These changes, along with the extremely favorable demographic composition of its population, will continue to aid South Korea’s move into the top echelon of economic powers in the world – and will continue to present favorable investment opportunities even as other economies begin to stumble later this decade and into the next.
Recent History In 1953 South Korea hit bottom. The cease-fire agreement with North Korea had been signed, but the country had endured three years of devastation and heavy casualties in the preceding war, which had come on the heels of a 35-year occupation by Japan from 1910 through 1945. In 1953 the average annual income in South Korea was a mere $87. The country had scant natural resources, a large population to feed, a standing army to maintain, and almost no
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industrial infrastructure. At that time, 70% of the population was involved in agriculture. South Korea was a nation of farmers. This is not the normal equation for tremendous economic growth. But South Korea had a distinguishing characteristic – it was the first instance where the US and the UN had committed forces specifically to stop the spread of communism, and the US was determined to hold the line. To this end, the US and other UN countries supplied troops and tremendous foreign aid to the development of South Korea. In Chart 10 you can see that during the 1950’s and even into the early 1960’s foreign aid constituted a tremendous portion of the national budget. Just the United States portion of the aid package was at least $200 million per year from the end of the war through the mid 1960s. South Korea used this aid not only to buy humanitarian goods and weapons, but also to begin industrializing the nation.
Wanting to realize independence from foreign aid, the South Korean leaders set about building an infrastructure that would take advantage of their only resource – cheap labor. During the 1950’s and 1960’s South Korea used the funds available in the form of aid and foreign loans to develop labor-intensive industries for exports. The government also used its position as legislator and trade negotiator to diminish the import and purchase of consumer goods, instead favoring investment and the import of raw materials. As the 1960’s wore on, the South Korean government continued fostering industrial development by making concessionary loans and giving tax breaks to chaebols – groups of interrelated companies that were in industries the government wanted to see grow. The government was specific in its goals, it wanted growth in export industries. If you fostered growth and did well in the international markets then you received favorable treatment. If you faltered, favor was withheld. The nurturing worked because the country enjoyed double-digit growth and saw its national income and GDP continue to climb.
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In the early 1970’s the Economic Planning Board of South Korea launched the Heavy and Chemical Industries Initiative. This plan pushed the development of the steel industry, shipbuilding, auto manufacturing, and chemical industries. South Korea had made great strides in developing export industries in the past, now it was time to move to the next level by adding more value to the process, thereby increasing the value of exports. This worked very well until the global recession of the early 1980s. The malaise in the international markets caused slack demand in heavy industries. Crippling over-supply led to a negative GDP growth rate in South Korea for 1981, it’s first negative growth since 1962. By this time the country’s population had seen its income rise substantially which was starting to translate into consumer demand for goods and services. Average annual income, which was a mere $87 in 1953, had grown to an astounding $1,600 in 1980 and over $10,000 by 2000. Chart 11 shows the growth in household consumption that resulted from the higher earnings. The government
continued to encourage saving and investment over consumption through its tax structure and legislation, but South Koreans were starting to understand their power as consumers. So the economic leaders turned their attention to consumer goods and electronics, helped by Japan’s foreign investment in this industry.
Then there was the Asian Meltdown The meltdown of Asian currencies in the late 1990’s brought to light several ugly realities about the economic structure of South Korea. The chaebols were heavily leveraged. Years of sub-market rate loans and other concessions had allowed these entities to grow with very little attention paid to the cost of the growth because government loans at favorable rates were just a phone call away. On top of the indebtedness were the corporate scandals and mismanagement of state owned enterprises. South Korea accepted a $58 billion rescue package that required opening its markets to more foreign investment and ownership, more free trade, stricter corporate governance, and a weakening of the chaebol system. While not totally
in place, many of these changes have been affected and have had very positive consequences on the South Korean economy. In a further effort to bail out its economy in the late 1990s and early 2000s, the government tapped into consumer demand by making personal credit easy to obtain. It went so far as credit card vendors setting up booths on street corners and trading credit cards for nothing more than contact information, hoping that the consumer would honor their debt. Just like everything else in South Korea, this heavy-handed government intervention had the desired effect – significantly increasing consumer spending that buoyed the economy – but had tremendous side effects. Roughly 11% of all credit card debt is overdue. One of the largest card companies sold over $500 million worth of credit card debt to lighten its load. Who was the buyer? None other than the South Korean government. In light of the mounting personal debt and bad loans, the government has reversed its views on easy credit and is requiring card companies to lower their bad loan percentages.
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Change in Personal Consumption Chart 11
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South Korea is one of the most wired countries on earth. They are a leading exporter of high tech products and heavy industry. Their growth continues at an astounding rate for both exports as well as consumer demand. The growth is lower than what was recorded from the 1960s through the 1980s, but that is understandable given from where the country started. One of the most interesting aspects of South Korea is its potential given its demographic composition. Chart 12 shows the distribution of the population by age.
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rodney johnson 11
Chart 12
Population Distribution by Age (South Korea) 5,000,000 4,500,000 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000
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Investing in the stocks of South Korea There are several industries in which South Korean companies are proven leaders, including heavy machinery, semiconductors, and consumer electronics. As their economy grows and so do the Asian economies around them, South Korean companies should continue to offer superior investment opportunities. The US State Department publishes a Country Commercial report that should be read by all who are interested in foreign investment. This report can be found at: http://www.state.gov/www/about_state /business/com_guides/2001/eap/korea _ccg2001.pdf But there are factors that dull some of the attractiveness of the South Korean situation. Due to continuous political intervention, the threat from North Korea, the dependence on foreign trade partners for demand, and the basic inexperience of their population in functioning in a free market society, the growth of their economy and their capital markets will be volatile to say the least. Chart 13 shows the KOSPI, the main South Korean Index.
What should jump off the page at you is the tremendous number of people in Korea that are less than 40 years old, with the main group being early 30s. Add to this the greatly increased life expectancy (from a pre1950s of 45 to a current 74), a developed economy, income that is more widely dispersed than it is in the US, and you arrive at a consumer demand forecast that is potentially off the charts!
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South Koreans have shown themselves to be active personal consumers. It has been government intervention that first quelled demand, then created too-easy credit, and has once again pulled in the reins. As the country moves toward an economy more driven by market forces than government policy, consumers should emerge as the driving force in South Korea’s economic landscape.
Obviously investing in this country is not for the conservative investor. In bad times the index can drop like a rock and in good times it can soar. During the Asian Meltdown 19971998, the KOSPI lost over half its value, but then it gained over 250% in the ensuing rebound. The global recession 2000-2001 saw the index lose over half its value again, only to rebound over 100% in less than a year. And of course the North Korean threat that erupted in the middle of 2002 caused the index to once again drop by half before start-
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rodney johnson 12
ed back up again in March of 2003. There is a trend up, but the wild swings up and down mean that this is not an area where you can invest in it and not pay attention. For long-term investment, South Korea still has great potential Our research continues to highlight South Korea as one of the most favorable places for investment. Unlike other Asian powers, the nation is strongly tied to the US and US interests, so it is very likely that government regulation and intervention will continue to dwindle instead of grow. The moves made toward more transparent corporate dealings and increased corporate responsibility for its actions are also very encouraging. And of course underpinning all of this are the demographics that indicate growth in spending for almost two decades. Hopefully as the population gains experience in the free market environment and the capital markets gain experience in weathering political and economic storms the volatility of the economy should lessen, making South Korea a more favorable investment for less aggressive investors as well.
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Sector Updates and Allocations Summary As suspected, the market continued its upward march in the fourth quarter and eventually made the 10,400 range on the Dow as well as topping 2,000 on the Nasdaq. The sideways action near the end of the year reconfirms our forecast of a possible resting period during the first few months of 2003. The risk of course is that those who waited until now to jump back in will be invested just in time for nothing to happen, causing a lot of “nervous” money to be floating around the markets for a few months. We are now on the other side of our comments from this time last year when I wrote, “I know it is repetitious, but we have a great environment for a significant rebound – low interest rates, low or no inflation, continued gains in productivity, and the end of a recession. When we add the long-term technical cycles that Harry Dent outlined above, we should be on the verge of a strong rally.” The first stage of the rally has occurred. We have experience the strong move off the bottom with the Dow gaining over 40% and the Nasdaq over 80%. From here, must keep watch on the technical indicators and not become overly anxious if we have the sideways movements and possible shallow corrections that are anticipated. Harry noted above the elevated risk of terrorist attacks, the reality is that we, as a nation and a marketplace, are going to have to deal with the fact that the threat of terrorism is not going away. This and other geopolitical events/concerns are likely to have a stronger influence in the markets in the absence of real economic news during the first quarter.
There is the possibility of a shallow pullback, especially in the technology area. But from our perspective there is not enough risk to chance being light in the sector when it takes off again. So our current allocations have not changed from last quarter. This makes a full year we have maintained roughly the same weightings. If you have not already, we strongly suggest rebalancing your portfolio to protect some of the gains made throughout 2003.
Allocation Update Our current allocations are as follows: Aggressive Investors 30-40% Technology 25-35% Financial Services 5- 15% Pacific Rim (ex-Japan) 15-25% Large Healthcare 10-15% Large Cap Growth/Multinationals Growth Investors 25-30% Multinationals 20-25% Technology 20-30% Financial Services 10-20% Large Healthcare 5% Pacific Rim (ex-Japan) Pacific Rim (ex. Japan) The KOSPI ran from 700 to 800 in October, and has fluctuated there ever since. The sideways action reflecting full valuations for the current level of economic activity, which we have forecasted for the US, has already taken hold in South Korea. With economic activity slowing slightly both on the business and the consumer front, this region should be an average performer. Technology The NASDAQ, shown in Chart 14, has lost some zip even as the other indices have moved higher. It is the first signs that the markets need to
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rodney johnson 13
Chart 14
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rest before moving up yet again. We still have a ways to go before we approach the “fair market” middle line of the channel. Look carefully at the stocks that are moving the indices…and what stocks are not. It probable that the growth stocks of yesterday, such as Microsoft and Oracle, will have to make way for a new group of rising stars.
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Healthcare (Pharmaceutical) The healthcare industry is still in the doldrums. Our weighting remains low because there simply is no action here right now. Multinational The Multinational sector, as represented by the Dow and shown in Chart 15, is a big winner this year with gains of over 20%. While we’ve given significant coverage this issue to our view that the markets will rest in the first part of 2004, we still see strong gains for the index as we move further through the year.
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Financial Services The Financial Services index shown in Chart 16 marched up to its midchannel line and then promptly began tracking the slope of that line. We have watched this sector with a possible eye toward lowering its allocation, but the growth has remained consistent and currently shows no sign of weakening more than any other sector before the next leg up.
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