BCN ADVANTAGE: 2006 ANNUAL REPORT
We are in the late stages of a 4-year bull cycle that began in October 2002. This is the 5th longest bull market in the past 75 years. This is the 2nd longest period in the history of the S&P 500 without a 10% correction. And this is now the longest period in over 107 years without a 2% intraday decline in the DJIA. The late stages of any cycle (whether bull or bear) are always the most difficult to navigate, because we must act CONTRARY to the crowd. When everything looks rosy and complacency runs rampant, beware: a major decline is usually around the corner. “Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival,” wrote Gerald Loeb, the legendary stock trader who sold just prior to the Crash of 1929. Loeb argued that investors should not buy until the profit possibilities greatly outweigh the risks. We could not agree more. All major bull markets (such as the long secular bull run from 1982 – 2000) are followed by long periods of consolidation, typically lasting a decade or more. As we emphasized back in January 2003: “likely now is a pattern similar to the one we experienced from 1966 through 1982, when the Dow spent 16 long years butting its head against the ceiling at 1000, in the process going through repeated cyclical bull and bear markets.” This channel theory is central to our overall investment strategy. If the markets hold true to their historical norms, then the DJIA should be forming a channel roughly from 12,000 to a low of 7,200. (Since 2000 – seven years). The Nasdaq should form a channel roughly from 2,400 to 1,400. (Since 2001 – six years). And the S&P 500 should form a channel roughly from 1,400 to 850. (Since 2001 – six years). If the indexes hold to their historical norms, declines of 20% to 40% should come as no surprise. The four horsemen? The U.S. housing market is now in uncharted territory. The 3.6% decline in median sales prices marked the first yearly decline in home prices since the Great Depression. But the real key to housing is the effect declining (or simply flat) real estate values may have on the consumer. All cycles essentially fuel themselves, and this one has been no different: so long as their home prices rose, consumers (whose spending now comprises more than 70% of annual GDP) could borrow against equity and continue to spend; with consumer spending strong, corporate profits could continue to rise (with 13 consecutive quarters of double-digit earnings growth); with stock prices on the rise, companies could use their stock to buy other companies (2006 saw near record activity in IPO’s and leveraged buyouts). But this cycle has been fueled almost entirely by debt. After 17 consecutive rate hikes, lifting the Fed Funds rate from 1% to 5.25%, has the Fed taken away the punch bowl? Over the last 50 years the Fed has made a series of tightening moves 10 prior times: 8 have led to recessions and 9 to bear markets. “Significantly, in all 9 instances where the Fed tightened and the yield spread dropped below 50 basis points, a bear market followed…” The yield curve is now technically inverted, with the short-term Fed Funds rate more than 50 basis points HIGHER than the 10-Year Treasury Constant Maturity Rate. In each of the four previous instances where short-term rates have exceeded long-term rates, a recession has followed soon afterwards. The Fed ended its 2-year series of interest rate hikes on June 29, 2006. Two weeks later, on July 14, 2006, oil peaked at $77 per barrel and began a precipitous slide that has seen the price of oil fall by 35%. These two events do much to explain the sudden reversal in the stock market – from severe correction to the mostly uninterrupted bull run that began in mid-August. Much like the inverted yield curve, oil may be forecasting an ominous outcome: a U.S. (and global economy) on the verge of a major slowdown.
