SELL: Stocks appear to be setting up for an October crash

In our last Report we said stocks were probably setting up for a tumble. Market action during the past couple of weeks or so reinforces the probability that there is a significant decline under way and also that there is a high probability of it gathering speed, as has happened so often during October.

On the technical front, The NASDAQ 100 stock index completed a simultaneous monthly, weekly and daily sell signal as of the close of business on the last day of September. Many of the leaders in the NASDAQ index are now in confirmed bear markets. These leaders include Microsoft, which alone represents perhaps 15 percent of that index. It also includes Cisco, Dell, Intel and Worldcom. It is notable that CSCO now has its first M on the monthly line chart in 15 years! While there are some stocks that have not yet joined the bear market, several of these stronger ones, like Sun Microsystems still do not have charts that encourage one to consider retaining the stock.

It is worth going through some of the key characteristics of a bear market.

The majority of stocks form a declining zigzag on the monthly chart. They will also be trading under their 200 day moving average which itself is pointing down. Many, many substantial stocks meet this condition. Among the increasing number of stocks looking to complete fulfillment of this condition are stocks like JDS Uniphase, the previous market darling. Notable too about JDSU is that many of the founders and principals have been selling a lot of stock recently.

There can be substantial rallies that look like the starter of a new leg up, but however powerful the rally appears to be, it fakes out and prices goes to a new low. The rally last Thursday looks to have been such a fake-out.

Markets fail to go up on apparently good news and they fall hard on bad news, as occurred on Friday with Apple, which almost halved in value in a single day.

Once a bear market becomes entrenched, it keeps ratcheting lower. A bear market comprises a succession of lower highs and lower lows. It is the reverse of a bull market, which comprises a succession of higher highs and higher lows.

Once a bear market really becomes entrenched, there's no knowing how far it may go or how long it will last. You can guess but the chances of guessing right are no better than when trying to guess how high a bull market might climb.

There is a history of bear markets having to go down a very long way when there has been a long bull market preceding it. The excesses to be worked off are that much the greater and they have to be the more brutally wrung out of the system if people really go carried away on the upside.

A minimum duration of a bear market is normally about 18 months before it hits bottom, but the decline can last longer and sometimes for several years.

Bull market tops occur when business conditions are good. Business conditions can continue good for a long time after stocks have started heading down.

In current market conditions, you can be certain that there is still a huge constituency of people that will be prepared to buy into declines. The buy-the-dips approach worked wonderfully during the long bull market. However, in due course conditions change. What worked before will eventually stop working, except for the definitions of bull and bear markets respectively. Say it again. A bull market consists of a succession of higher highs and higher lows. A bear market consist of a succession of lower highs and lower lows.

At the top of a bull market, institutions and mutual funds are certain to be almost fully invested. that means they have little or no cash with which to meet their obligations and fund redemptions. Contrary to popular wisdom, investors do not continue averaging down forever into a declining market. After a time they realize that buying into a declining market is a mug's game. So they start selling, not buying. A declining market therefore feeds on itself just as surely as does a rising market.

One of the key factors in a bear market is the unwinding of margin debt. People who bought stock with borrowed money have to repay their loans when the value of their collateral declines. Their selling adds to the pressures that keep pushing the price of stocks lower.

In a general bear market, something of the order of 9-0 percent of all stocks decline. There are sometimes rare instances of a sector where stocks within that sector advance, such as used to occur with gold mining shares and, we believe, can occur with oil stocks now. The probabilities are extremely unfavorable for thinking you can find the few stocks that buck the trend. It's just not worth the candle to try and find stocks likely to go up when the majority of stocks are going down.

There are reasons why even apparently strong stocks representing strong companies go down in a bear market. One is that when stocks generally are going down, people sell what they can sell because some stocks become unsaleable at any price. Another reason is that there is a general lowering of the criteria for valuing stocks. Why buy a stock at 50 times earnings when conditions are questionable, let alone one selling at a price/earnings multiple of 500, like Juniper Networks?

One a bear market becomes entrenched, there is a tendency for people to feel less rich. Therefore, there is less mad money to spend and business contracts accordingly. Even a dot.com millionaire is less likely to go out and buy a new Porsche if his stock portfolio just dropped a few million dollars.

Among the excesses of the Internet and the dot.com millionaires, it's worth noting that perhaps no more than 10 percent of the small speculative dot.com businesses now in operation will still exist in five years' time.

What's actually happening

So much for what generally happens in a general bear market. Now some of the things we are currently seeing.

We have been saying for some time that the bull market in energy is both real and that it has staying power, unlike many of its predecessors. For all practical purposes there is now no capacity shut in that can be brought on stream to quench the thirst of rising demand. This is not likely to change any time soon. Even if there were an increase in output of crude oil, the world has not expanded refining capacity to keep up with demand. Up to ,a point you can use unrefined crude oil instead of heating oil. But you can't use unrefined crude instead of gasoline.

The current relatively high price for petroleum, heating oil and gasoline is the result of fulfillment of the adage that the cure for low prices is low prices. What happens is that low prices discourage capital investment and, indeed, lead to retirement of old and unprofitable capacity. When demand at last closes in on supply, the supply side cannot meet demand. Unprofitable operations have deterred the investment required to meet the newly expanded demand. On all counts the price of energy has responded as one would expect to a long period of depressed prices.

The corollary of high energy prices is that both consumers and manufacturers have to spend more on energy whether they want to or not. Therefore they have less to spend on other things. Although the world economy is affected less than it used to be by high oil prices, the effect is nonetheless real. If, as we assume will occur, the price of crude oil remains above $25, and never mind a price above $30 or $40, then it is guaranteed that the strength of the economic expansion will slow and, most likely, reverse into a full-fledged recession.

The remedy for our scenario is twofold. First, sell all stocks on the general list. Second, spread the balance of one's investments between medium and short-term money market investments on the one hand, and selected energy stocks on the other hand.

You never get enough of a return from the money market and treasury bills when that is the place to be. However, we are not looking for double digit returns from this investment. We are looking only for a parking place for our money until the time comes to buy stocks again.

New and Renewed Recommendations

All our energy and oil service stocks are a new buy in our judgment right here. There has been quite a decline off the top in the price of crude oil and the products but it looks as if there is now most likely a correction low forming. Our stocks have come off the top quite a bit but they are mostly hanging in near or somewhat above our entry price levels. Long to medium term potential is a double over the next year or so while we rate the downside risk from here at perhaps 10 percent or so. In sum, we like what we see here.

One word of caution we suggest is that if there is in fact a general and sharp decline in stocks over the next few weeks, even energy stocks will likely not go up sharply even if they decline only a little. So there is likely no need to rush to make an overweight commitment to this sector.

We would like to be looking for some short sale candidates but we are not really comfortable with trying to find stocks with longer term downside prospects. In our view the general market is at too early stage of a bear market for one to be able to sell stocks without a substantial risk of a sharp and uncomfortable rally. Take a stock like Microsoft or Worldcom, for example. Yes, they are in confirmed bear markets. However, there will always be buyers at this stage ready to jump on the stock on the assumption that they have reached bottom at last. The bottom line is that the immediate future holds an almost even prospect of a ten percent gain in any individual stock versus the prospect of a ten percent loss, even though there may be the eventual prospect of a decline of 50 percent or more.

Stocks to Sell/Exit

None

List of Current Stock Recommendations:

Action Ratings

The following is the legend for designating immediate action for our stock recommendations. The first is B, meaning the stock is timely to buy but the case for doing so right here is not overwhelming. Either the stock may have got ahead of itself and may be vulnerable to a retracement or else the stock has been performing disappointingly but may simply be regrouping. B+ and B++ indicate stocks for which there is a technical case to buy now, with plusses adding weight according to how many there are, up to a maximum of five. Stocks rated H are ones to hold, awaiting confirmation to buy more or to sell. SELL, of course, means what it says. It seldom pays to override this designation.

Stocks marked # are eligible for Canadian RSP funds. Otherwise there is a 20pc restriction on foreign stocks held in these accounts.

First bought Entry Last

5/15/00 Alberta Energy(AOG)# 38.63 41.63 B++
5/15/00 Apache Corp.(APA) 59.88 59.13 B++
5/15/00 British Petroleum Amoco(BP) 54.44 53.00 B++
5/15/00 Chieftain Development(CID)# 20.50 20.69 B++
5/15/00 Global Marine(GLM) 26.38 30.88 B++
7/10/00 Suncor(SU) 23.06 20.69 B++
8/7/00 Talisman(TLM) 32.25 35.06 B++
5/15/00 Transocean Sedco(RIG) 51.13 58.63 B++

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