Little to Cheer in the New Year

While the bear appears to be in hibernation, technical factors suggest a lackluster 2003 for stocks

By Mark Arbeter

The attempted transition by the stock market from bear market to bull market failed at the end of 2002. And while the worst of the bear market is most likely behind us, the major indexes are likely to tread water at best during 2003.

There are two main factors that leave us less than bullish for the upcoming year. First and foremost, there has been little evidence that a new bull market has started and the current bear market has been put to rest. Second, the action of other markets including the dollar, gold, oil, and Treasury markets, suggests that the bigger picture that has favored stocks during the 1990s may not return anytime soon. It also signals that stocks may be in a protracted period of underperformance relative to historical stock returns and relative to other investment vehicles.

We have identified eight different characteristics that mark the end of a bear market and the beginning of a new bull market -- and we'll be looking for them during 2003. None has emerged so far.

The first characteristic of a new bull market is that the main equity indexes usually trace out major, bullish reversal formations, and most often they are double bottom patterns that develop over a two- to six-month period. While the major indexes appeared to trace out double bottoms during July and October of 2002, they did not complete these formations because the indexes did not break above the interim high of the formation that occurred in August. A completion of a major reversal formation breaks the bear market pattern of lower highs and lower lows.

Second, the major indexes will break above the downward sloping bear market trendline. This is a trendline drawn off the peaks (lower highs) during the bear market. Many times this will occur on very strong volume. A break above this trendline usually is the major signal change technicians look for as the market moves from bear market to bull market.

Once the major indexes complete major reversal formations, they usually take off and never look back. This is quite common after a double bottom and catches many market pundits by surprise. The complaints that the market has moved too far too fast, and moved into a very overbought condition, suggest just the kind of action that is typical early in a bull market.

Unfortunately, the market has not exhibited the kind of price strength that is so typical of an early bull market. In conjunction with this price burst, the S&P 500 has demonstrated an ability to put in very high price rate-of-change (ROC) readings fairly early in a new bull market. The beginnings of major new uptrends over the last 70 years have all demonstrated very high ROC numbers over both a 50-day and 100-day timeframe. This shows that not only has the market blasted off following the end of a bear market, but also the indexes will hold or add to their gains over a 20-week period.

During the start of a new bull run, both overall trading volume and volume breadth statistics will be very strong. This shows during the early weeks of a new advance that institutions are aggressively accumulating stocks, something desperately missing during the last three years. High and consistent volume levels are the weapons of the bulls and without it, the market is not likely to move into a sustainable trend higher.

A group of new stocks will emerge to lead the new bull market higher. Frequently, the new leadership will exhibit high growth characteristics including rapid growth in revenues and earnings. The leaders of the past bull market will not rise from the ashes and resume a leadership role. I would be hard-pressed at this point to identify a new group of stocks that have the potential to take this market higher as there have not been enough high-growth issues breaking away from the pack to the upside.

While we do not profess to be devoted students of the Elliott Wave theory, bull markets are not confirmed until the market exhibits a five-wave advance. Taking a look at all the rallies since the bear market began, they are all three-wave advances, and that is very typical bear market action. When the primary trend changes from bearish to bullish, most likely there will be a five-wave advance that is very visible on the charts.

Finally, we get to market sentiment -- one of our favorite market analysis tools. Since the market low in October, sentiment has once again moved to highly bullish levels. While this in itself is not a good thing, what really bothers us is a longer-term view of sentiment in light of what has occurred over the last three years. One would expect that market sentiment would be very bearish, and stay bearish for a long period of time after the carnage in equities. That is what happened during the bottoming process in 1990 and 1994, as sentiment got extremely bearish and stayed bearish for a long period of time.

But during the last six months, when the market was attempting to bottom, bearish sentiment barely exceeded bullish sentiment on the poll conducted by the Investors Intelligence newsletter, and sentiment did not stay bearish for very long. Until the majority of market participants move to the sidelines and develop a real distaste for stocks for an extended period of time, the chances of a new bull market developing are slim.

Taking a look at other markets (intermarket analysis) that can either influence the stock market or run counter to equities does not give us a lot of confidence that we are about to make a major trend change in stocks. Quite the opposite, the action of these other markets suggest that the stock market may be in for some rough sledding this year and probably well into the future.

The dollar (as measured by the U.S. dollar index) completed a massive topping formation in 2002 and appears to have rolled over into what could be a long-term bear market. The dollar index just recently broke below a bullish trendline that has been in existence since 1995. The rise in the dollar since 1995 just happened to coincide with the phenomenal rise in the stock market during that period. While there are some positives from a slowly depreciating currency, we believe a declining currency at this point shows that foreigners are pulling funds out of the U.S. markets and that this will not be positive for equities going forward.

Treasury bonds remain in an incredible bull market, and basically for the last four years, they have moved in the opposite direction of stocks. In our opinion, a strong break higher in Treasury yields would be bullish for the stock market for two reasons. First, it would suggest that money is finally being allocated away from the safety of Treasuries and into stocks. Second, it would imply that market participants see better times ahead for the economy, a sure positive for stocks and earnings.

Certain commodity prices have been on a tear of late, breaking out of long-term bearish patterns, and these markets usually move counter to stocks over the long term. The Commodity Research Bureau index recently broke above a bearish trendline that has been in effect since 1980. Since 1999, the CRB has traced out a very large, bullish double bottom formation and this pattern was completed late last year. Spurring the CRB index of late has been large breakouts by both oil and gold prices. The last great run by the CRB index occurred during the 1970s, which was not a great decade to be in stocks.

Our best estimate for the upcoming year and possibly beyond is that the stock market has entered a period of consolidation and base building. While that scenario will offer traders great opportunities, it doesn't offer much comfort to the "buy and hold" investor.

Arbeter is chief technical analyst for Standard & Poor's