Down Goes the Dow?

That's the prediction from Chris Johnson of Schaeffer's Investment Research, who also talks about his stock-picking method

If most investors -- and analysts -- are pessimistic about a stock, that may be the stock to buy. That's the approach taken by Chris Johnson, director of quantitative research for Schaeffer's Investment Research, who practices what he calls "expectational analysis." And because of the general optimism about the market these days, Johnson feels a pullback may be coming, and he suggests that by midyear 2004 the Dow may be back in the region of 9000, the S&P 500 at 975, and the NASDAQ at 1975.

"Expectational analysis" leads Johnson to describe Microsoft (MSFT ) as "kind of like the full theater just before someone yells 'Fire!'" He notes that 93% of analysts rate it a buy -- and none a sell -- which is one of the factors leading to the stock's underperformance, in his view, and also a reason for the dim view he takes of it.

However, Johnson does like some stocks in the small- and midcap tech and gold sectors, citing in particular Advanced Micro Devices (AMD ), KLA-Tencor (KLAC ), and ADTRAN (ADTN ). Asked to pick one favorite, he names Research in Motion (RIMM ), creator of the BlackBerry pager.

These were among the points Johnson made in an investing chat presented Dec. 4 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Chris, are you as bullish as the market seems to be becoming?

A:

Unfortunately, I'm not. At this time I think there's some room for the sellers to take charge and for the market to take back some of what it has given us over the past few months.

Q: What are the major factors influencing market sentiment now -- and leading you to expect a pullback?

A:

Currently, as we look at market sentiment, a number of indicators are beginning to show signs of overly optimistic activity. The first is activity in the CBOE Volatility Index (VXO ). This gauge has moved to its lowest level in multiple years, showing not only that option premiums are low but that investor optimism is becoming high.

Other signs of this optimism can be seen by looking at activity in the equity put-call ratios, which remain relatively low. There are also the investor polls, which have remained very high for quite a few months. With the market nearing the 10,000 mark on the Dow and the 2,000 mark on the NASDAQ, we may begin to see investors lock in profits, which will increase selling, which may begin a trend in the sentiment indicators.

Q: Chris, how would you define your analytical style?

A:

My style of analyzing stocks is called "expectational analysis." It's the combination of analyzing a company's technical activity, its fundamentals, and how favored or disfavored a stock is by investors. An example: A company that has poor fundamentals, poor technicals, but investors love, is the company that I want to stay away from. Continued weakness in technicals/fundamentals will only disenchant investors who have held out for it, and will cause selling.

The ideal bullish candidate, according to our approach, is a company that is performing well technically, sees fundamental strength (is doing the right things to grow its business), but that investors view pessimistically. The last point is key, as that pessimism almost always equates to sideline money which will later flow into the stock as investors begin to notice its fundamental and technical strengths.

Using expectational analysis allows me to be one of the first on the bullish bandwagon for a stock, rather than the last. We use sentiment in a contrarian manner. The reason we do this can be summed up in the words of Humphrey Neill (author of The Art of Contrary Thinking) who stated, "It's best to be most optimistic when the crowd is least optimistic, and vice versa."

Q: With 2004 being an election year, do you see the pullback being short and the market then trending back over 10,000?

A:

Yes, I do see this initial pullback being short-lived, and thus it will present itself as a buying opportunity for traders.... Despite the fact that election years are normally very strong, we do believe that the market next year will run into some serious issues and could see some lower broad-market index figures by midyear.

Q: You predict some "lower broad-market index figures by midyear." What should we brace ourselves for?

A:

First, let me explain why we feel there will be lower broad-market numbers. Looking at the blue-chip indexes as we move into 2004, expected earnings growth reaches the 10% to 15% range for the S&P 500, which we see as too aggressive. Plus, its valuation at 24 times trailing earnings is quite high by historical standards. From a technical perspective, both the Dow and the S&P 500 have rallied to levels at which major price resistance will continue to assert itself.

In addition to that, sentiment has become quite complacent, which leaves the market very vulnerable to disappointment. This disappointment will obviously encourage selling among investors.

Lastly, as if we needed something else, geopolitical risks will remain a concern for investors and a potential negative wild card for the market. That being said, we're expecting that we could see the Dow somewhere in the region of 9000 by midyear. We also believe the S&P 500 may see the likes of 975 at the same time -- finally, the NASDAQ composite in the 1975 mark by midyear.

Q: You've been recommending high-tech stocks over nontech. Are you still high on tech?

A:

At this point, even though my overall market bias points to some weakness, I do believe we'll continue to see small- and midcap tech and gold stocks outperform the market. I believe this is a trend that will continue into early 2004, and any weakness we see in the near term, such as perhaps a 5% to 10% pullback, should be seen as a buying opportunity in these areas for the intermediate trader.

Q: You say you like mid- and small-cap tech -- any names for us there?

A:

First, let's start with sectors that I'm focusing attention on. The two that continue to be at the top of my radar are the semiconductor and the networking sectors. Looking among these sectors, companies such as Advanced Micro Devices (AMD ), KLA-Tencor (KLAC ), and ADTRAN (ADTN ) continue to show signs of upcoming outperformance.

Again, these outlooks are based on the fact that these companies have performed well against the market (relative strength leaders), show continued signs of fundamental improvement, and have signs of investor pessimism, such as high put-call ratios, short interest, or low analyst recommendations.

Q: What are your feelings about General Electric (GE )?

A:

I see General Electric as fitting the mold (or making the mold) for the blue-chip indexes and thus being very vulnerable. This is one of the companies that, through some time through the bear market, investors continued to cling to, as it was one of the "safe" companies that offered a place to hide from the rampage that tore the NASDAQ apart.

As a result, investors remain very optimistic for GE's future, and that optimism, combined with recent weak technicals and lackluster fundamentals, will continue to see GE be outpaced by the rest of the market. This is a company that will be a relative-strength lagger moving into 2004.

Q: Microsoft (MSFT ) -- is that a software stock you like?

A:

No! This company at this time fits the mold of a bearish play, according to our approach. Year-to-date, Microsoft has continued to be a relative-strength lagger against the rest of the market (both the S&P and the NASDAQ) -- they have been stricken by the same problems that I pointed out on GE. On a technical basis, Microsoft continues to struggle. Fundamentally, they're treading water, and from a sentiment aspect, investors have remained overly optimistic.

One example of this optimism can be seen in the current levels of analyst recommendations on Microsoft. At this time, 93% of the analysts covering the stock rate it as a buy or higher, while no analysts have the stock as a sell. This type of overly optimistic opinion toward the company is one of the larger catalysts for its recent underperformance.... In other words, Microsoft is kind of like the full theater just before someone yells "Fire!"

Q: Nextel stock (NXTL ) -- where do you think it's headed? Any hope for telecom, especially wireless?

A:

I believe there is hope for telecom, and Nextel is presenting itself as one of the companies for the sector to keep up with. Currently, Nextel's put-call ratio is in the 99th percentile for the last year, which means that put investors have been very active. As a result, pessimism remains very high.

In addition to the put-call ratio activity, the stock's short interest also remains fairly high, indicating that those shorting the stock are pessimistic. Nextel's current short interest ratio is just above 5, which is the highest it has been since June, 2002. I see this as healthy for the stock, looking forward, and as a result, I would own the stock.

Q: Going back to your "expectational analysis," can you give us a stock or two that did well for you by buying when everyone was pessimistic?

A:

Certainly. One of them...was Juniper Networks (JNPR ). Earlier this year, I was attracted to Juniper after it broke above its weekly moving averages and displayed qualities of a company that is not overloved by the Street. Namely, the put-call ratios were high, and analyst recommendations were very low.

Another company that met the same criteria was Frontier Airlines (FRNT ). This is a company that, in early March, broke above key trend lines and also showed signs of extreme investor pessimism. To date, the stock has run from just over $5 up to $17.

Q: What are your top picks right now?

A:

At this moment, if I had to give one stock pick for 2004, it would be Research in Motion (RIMM ). The manufacturer of the BlackBerry has been doing all of the right things fundamentally. They've adapted their product to meet demand of the market, which is beefing up their sales. As a result, the stock has recovered less than 25% of its decline since its peak in 2000 (177 was its high).

Therefore, there's plenty of room for the analysts to begin upgrading the stock, moving RIMM to higher levels. Currently the market cap is $3.5 billion, which is modest when you compare it to others such as Nokia (NOK ), with a market cap of $80 billion. I believe that this is a company you'll want to watch in 2004.

Edited by Jack Dierdorff

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