FSO Editorials: What Will You Do on the Next Leg Down? by Robert B. Gordon 12/15/2003

What Will You Do on the Next Leg Down?
A Crucial Question for My Readers
by Robert B. Gordon, Sc. D.
December 15, 2003

The market is at a very critical juncture. We have had a 13 month bear rally that has just about turned every analyst and investor into a raving bull. Alan Newman, a veteran market observer, has concluded from the current market data that the 2000 mania is still in full sway. Despite the mutual fund scandal news, large cash flows have been going into the unaffected funds. There are now, according to recent reports, thirty five million families making monthly investments into mutual funds. What will these novice investors do with their fund assets when the DOW, which hit 10,000 as I write, closes below last October’s low of around 7000?

CNBC commentators and the press in general are convinced the market is going higher. But the bullish majority is wrong again according to the experts that I respect. What will you do on the next leg down? This is not a trivial question, so we plan to devote this essay to discussing possible answers.

For the past two years we have spent a very considerable part of our waking hours reading the views of experts on the world economies and stock markets. We have written many essays on a variety of subjects, all of them aimed at helping our readers understand the future and take the right actions to avoid a very real disaster. Unfortunately, we get very few letters that fully describe the thoughts and actions of our readers. Most of them ask questions concerning subjects we are not free to answer. So, in this essay, we will have to pose a number of possible future reader actions and then discuss their probable outcomes.

A new, expanded edition of Robert Prechter’s Conquer the Crash is now available at a modest price. I hope every one will buy or steal a copy from someone. Although Prechter continues to have his detractors, he is in my judgment, a brilliant thinker and writer on very controversial subjects. His views may be a little early but in the end most of them have happened about as he predicted. He continues to expect a depression greater than the one after 1929. My only question is about the timing as I believe it can only happen after the real estate and debt bubble has burst.

The 13 month bear market rally, now ending, was somewhat surprising in its size and duration but not beyond the range of rallies in previous bear markets such as that of Japan. We are nearing the top of a large Wave 2 structure and will then go down in what is expected to be a very large Wave 3, usually the longest of a five wave structure. So everyone needs to be properly positioned for this coming significant downturn. Any of our recent suggestions for a long term bear market portfolio should do quite well. This means a significant position in well selected bonds for a safe reserve and smaller amounts of diversified volatile components expected to do well in bear markets. See our recent essays for the details.

Now, it is very important to remember that no bear market ever goes straight down. Every impulse wave, either up or down, must have five Elliott waves. So, after this third wave down is completed there will be a corrective wave 4 up and then a final wave 5 down. The time to complete this five wave sequence is always unknown. This is very hard for most investors to understand. The Elliott Wave Principle describes a number of permitted wave forms but tells us nothing about the time to complete them. This is why, to take advantage of the wave information, an investor must have patience. And, along with the patience, a successful investor will have a portfolio consisting of a balanced mix of those asset classes expected to do well in a bear market. This is exactly what we have been teaching our readers for many months in numerous portfolio examples.

In this summary of the Elliott Wave picture, I would be remiss if I left out the fact that Robert Prechter, its greatest proponent, continues to insist in print, and by other means, that he expects the DOW 30 to eventually bottom below 400! There is no missing zero in this number. He is predicting the DOW below four hundred but the date of this event is totally unknowable at this time.

If your answer is yes, at this moment, you are in a very large group of investors most of whom have absolutely no idea of what they are doing. In a recent poll, a group of investors, displayed an unbelievable amount of ignorance about the differences between stocks and bonds, and the effect of interest rates on bond prices. For instance 70% of those investors quizzed by Vanguard did not know that rising interest rates caused bond prices to fall. A smaller percentage thought that "somebody" was insuring stock funds against a loss.

I am quite familiar with the buy and hold type of investor since it is typical of many of my retired neighbors who are very attached to their stocks and who have told me they do not intend to sell them. It is important to note that their purchases are perhaps 40 years old but none of them date back to the 1929 Crash. So perhaps some of these stock holdings will be liquidated in coming years despite their owners present intentions. These well-to-do retirees are quite different from those mentioned immediately above .They actually own what was once a very good stock although its glory days are over.

How do you define a buy and hold investor? First of all, he or she is probably not an investor but rather is someone who has bought and holds securities with no present intention to sell them. This may be the right definition for many of the many millions of current buyers of mutual funds. I think it is misleading to call anyone an investor just because they are buying one or more mutual funds. So lets, for this essay, call them mutual fund buyers.

I have been thinking and writing about people, who have pushed a little way ahead of the crowd. They have actually built at least a modest portfolio of stocks or funds and have owned it thru at least one up cycle and one down cycle in the market. They have also probably sold and replaced one stock or fund for poor performance or because they found something else they liked better. If they had these credentials, even if they were 21 years old and just out of school, I would call them an investor, one who has made a start in the right direction. The present day use of computers and the huge amount of information available on the internet has greatly shortened the learning time, at least to achieve a minimum functional level.

The very small number of investors, who will survive this bear market with their assets essentially intact, will be in a small group of experts who will be able to teach their children and grandchildren the finer tricks of the trade, as I have been doing for some time. History clearly says that the vast majority of losing investors in the years ahead will do anything and everything to avoid sending money to Wall St. again. It took 25 years after the 1929 Crash for the Dow to reach its former high. This time will surely be worse but I hesitate to make a guess as to when a mass of new investors will invade Wall Street.

Let me stop here and make an important point. Despite my 63 years of heavy experience with the simpler aspects of stocks and funds. I have never been in a bear market climate that remotely resembles today’s. My first hand 1972-74 experience does not help too much in this one. Here, after 4 years, we still have bullish investors, millions of them, buying stocks and funds almost feverishly. As Alan Newman has recently written, the Mania still lives!

So when does a fledgling investor gain enough confidence to make the necessary decisions for the difficult years ahead? In my view, it is when he or she has the market experience to recognize, and the confidence to correct, a portfolio that is not performing well in the existing market. Do not aim for a perfect, trouble-free portfolio but choose one whose performance is easy to measure and correct if and when it becomes necessary. When you start with 50% stable and 50% volatile components and do not like the results over a reasonable time period, you can change the ratio and, if necessary, change some of the asset classes. Our portfolio suggestions always have this built-in correction capability. A skilled investor always cuts any losses short, makes needed changes and moves on with an improved portfolio.

Later on, we will provide some portfolio ideas that will be both easy to set up and to modify if circumstances so dictate. We will provide a simple model, one a little more complex and finally a more complete growth portfolio. Your learning period would be shortened if you choose to do two. The amount of money involved could vary from modest to quite large depending solely on your personal circumstances.

Do you meet the minimum qualifications given above to be called an investor or are you just one the many millions of mutual fund buyers? Do you know that interest rates are rising and bond prices are falling and have been doing so for the past six months. Do you believe that some one or some agency will protect you against losses in your stocks or mutual funds?. There are no angels to protect investors from their errors of omission or commission, believe me!

In our previous bear markets in 1929 and 1973 there were no 401K plans that deducted fund purchases from your pay check. Will you ever decide to stop buying as bear market losses mount? Have you investigated whether you can withdraw from you plan and what the costs are? Do you know that, using short positions in accounts outside your 401K, you might be able to reduce the losses from your losing funds? If you don’t know the answers, ask for them today.

Does the fact, that the brightest Elliott Wave mind in the world predicts a DOW below 400, bother you?. It should! That is 9600 points below where it is today. When are you going to prepare a personal plan for the survival of your retirement assets? Most stock and fund buyers, irrespective of whether they qualify as investors, are extremely bullish right now so there is little chance they will be looking for a good selling point in the near future.

Taking into account the enormous unknowns, I can only guess that, most fund buyers will (1) continue to buy until half way to the ultimate market bottom and (2) will later sell all their shares slowly until the ultimate bottom, some unknown years in the future. History, and my 1974 experience tells me that the ultimate bottom will only come with a dearth of both sellers and buyers in an atmosphere of deep gloom.

Readers of my words over the past two years have had ample warnings from me about the major problems ahead. I know very well from my letters that a large number of readers have taken actions to protect their assets. I am very worried about the youth or seniors in many families who have not gotten the warning and consider it to be far-fetched and ridiculous. They had better get on board the right path before it becomes to late. It’s up to other family members to help them.

So, to all my readers young and old, my message is very simple and straight forward. There is real danger ahead. Take the path to caution and reason and protect your assets in every way within your abilities.

We have selected asset classes favored in our recent essays whose market performance continues to be very good. We tabulate their performance below in no special order:

STABLE ASSET CLASSES	00%Total Performance to 12/9/2003
ASSET CLASS	2 YEAR	1 YEAR	6 MONTHS
Hussman Total Return Fund	N/A	11.46%	7.30%
Global Income Fund with Gold	48.60%	19.88	8.49
Foreign Govt. Short Bond Fund	42.95	22.84	3.15
Hussman Strategic Growth Fund	34.37	19.33	16.15
Precious Metals Fund	239.52	122.73	93.21
Diversified Energy Fund	30.75	28.55	10.77
Short 30-Year Treasury Bond Fund	-19.02	-2.82	18.94
Short Equity Fund with Gold	60.49	-4.12	7.51
Short NASDAQ Index Fund	-3.96	-30.97	-15.50

        40% Hussman Total Return Fund
        40% Global Income Fund with gold
        20% Short 30-Yr. Treas. Bond Fund
      100% Total

This is a portfolio you can sleep with. Recent gains totaled 20% / year thanks to the fine performance of all 3 funds. These gains are hedged against loss in the dollar and increases in U.S. interest rates. The gold holding in the Global Income fund is a modest 6%.

         40% Hussman Strategic Growth Fund
         25% Global Income Fund with gold
         25% Short Equity Fund with gold
         10% Diversified Energy Fund
       100% Total

A conservative equity/bond mix with1 year gains of about 15% with weak performance only in the short equity fund which is improving recently. The gold position in two funds is about 9%.

          20% Hussman Total Return Fund
          20% Hussman Strategic Growth Fund
          20% Foreign Govt. Short Bond Fund
          10% Short 30 Yr Treas Bond Fund
          15% Short NASDAQ Index Fund
          15% Precious Metals Fund
         100% Total

The one year performance of more than 25% comes primarily from the superb performance of the gold fund which should not be expected to continue. In the next market down turn, the best performers will most likely be the short funds. This portfolio contains 6 of the asset classes of the eleven used in a very recent essay. But it is an excellent place to start for serious investors.

Every single one of my portfolio suggestions for many months has been designed for periodic rebalancing, either once every year and a day in taxable accounts or in tax-free accounts more than once per year at peak prices in volatile assets like gold. As you will find out by doing it, the job is very simple and has a huge pay-off. Here is what it does over a period of years:

1. Captures temporary peak profits in volatile assets and transfers them to safety in the stable reserves or to another asset that is temporarily undervalued.

2. Transfers assets from the safe reserves to other classes that are below their desired percentage in the portfolio.

4. Prevents a volatile asset class from growing far beyond its planned level, thus eliminating the possibility of large losses at a later date.

6. Over time, rebalancing can definitely increase the overall portfolio performance.

As we close this essay, the stock market looks like it is trying to make a top at about this level. In my opinion, this is a very appropriate time to take a critical look at the current status of your savings or retirement portfolios. Although I have not given specific complete names for all the funds used as examples, those that are unique are named in one or more recent essays. The others can be found, if you wish, by phoning your favorite mutual fund company and asking whether they have a gold fund or an energy fund or a foreign government bond fund. If they have a specific fund, ask for literature and performance data.

Your inaction, at this particular market juncture, could make it one of the most disappointing decisions in you entire life. Those readers still holding left-over assets from the bull market will live, in my opinion, to regret not taking corrective action right now. Choose one of the bear market portfolios given above or in recent essays and start building a new future for your assets. I will be happy to answer your e-mail and give you any help that I can on your portfolio ideas. The experience of many others is that, to make a new portfolio truly yours, you must select the components and take responsibility for its management.

Make some serious resolutions for the New Year and enjoy the rising value of your financial assets over the next 12 months. May you and your family enjoy good health and prosperity.