Cult of the Bear III: Getting to Dow 6800

Part I of this series reviewed our stimulus driven, real estate-reliant, post-bubble economy.

Part II looked at the cycles of bull and bear markets, and how history suggests trouble ahead for U.S. stocks — despite the strong start to 2006, prior to Friday’s wicked selloff that is.

Today we focus on how it could all come together or, as the case may be, come apart. I’ll detail how to get to my 2006 target of

Dow 6800 — the lowest (by far) in the Business Week survey — and lay out a scenario for how the S&P 500 could take a 30% haircut this year.

Before the Fall

With everyone so focused on the bearish year-end forecast, many have overlooked my  expectations for early 2006. As the Business Week survey shows, my first half Nasdaq prediction of 2620 was the single most bullish in the group, while my mid-year S&P call of 1350 was in the top 10 of nearly 80 forecasters. I also forecast Dow 11,800 by mid-year. (For the record, the survey was conducted in early December.)

Why the bull call before the fall? Because that’s how market tops get made: In the 12 months leading up to the October 1987 highs, the Dow ran from 1800 to 2700 (a 50% gain), while the S&P 500 sprinted from under 240 to about 340 (about 42%). From October 1999 to March 2000, the Nasdaq nearly doubled. Although I don’t expect anywhere near those gains in the first half of 2006, the pattern could be quite similar: A leap to new highs on some widely held assumption, which subsequently turns out to be false.

In the present case, several suppositions potentially fit the bill: The widespread expectations that the Federal Reserve will halt tightening sooner rather than later and that the U.S. consumer will keep spending. And do you know anyone who doesn’t believe earnings will remain robust?

Barry fielded some tough questions on his thesis from TheStreet.com’s Aaron Task. To watch the video, click here.

The Case of the Overdue Correction

One oddity of the move off of the prewar lows in 2003 is that the S&P 500 has yet to have a 10% correction. During the bull market period from 1996-2000, there were six corrections of 10% or more. Since the bottom on March 5, 2003, the S&P has sustained only three corrections of more than 6% and none greater than 9%.

Regular corrections serve a purpose for healthy markets: They cleanse the excesses that tend to develop, allowing further gains to proceed.

The lack of a 10% correction reveals high levels of complacency — something the CBOE Market Volatility Index (VIX) has been implying for quite some time. This creates “air pockets” — soft spots in the base of support that can potentially become more vulnerable to selling in the event of a test. As the 1966-1982 chart shows, broad trading ranges typically experience much greater than 10% corrections. Considering how regularly markets pull back and test support, the longer we go without that 10% correction, the greater the possibility of a steeper and deeper downturn.

The suggestion of a 30% fall in the S&P 500 has engendered widespread disbelief; investors broadly discount the mere possibility of such a correction. But as the nearby chart shows, there were five corrections that ranged in strength from 25% to 45% from 1966 to 1982. That averages out to one major correction every 38 months or so.

The S&P’s last major correction was a 33% drop from March to July 2002. That was 42 months ago — implying we are overdue for another steep decline.

Structural Imbalances Create Vulnerability

Past crises such as the Asian currency crisis and the Long-Term Capital Management meltdown were able to be managed because of economic strength. When they occurred, markets were in the midst of a bull run and the economy was growing organically. The Fed had lots of room to add liquidity. The economy shuddered a bit, but handled these shocks well.

Today, the economy has far greater structural imbalances. As the markets get further extended, they become increasingly less able to absorb what has become euphemistically described as “an externality.” As the current account deficit rises and the U.S. fiscal deficit worsens, so too does our ability to shake off an economic disturbance. Nouriel Roubini, professor of economics at New York University’s Stern School of Business, calls this an “increased probability of a systemic risk episode.”

Getting to 6800

What would have to occur for 2006 to be the strong year for the Dow many are expecting? Forget Goldilocks, we would need a Cinderella scenario, where nothing goes wrong, and many things go precisely right: Earnings must stay robust, while energy prices and inflation moderate. The consumer would have to keep spending, despite signs of tiring. Businesses would need to build on third-quarter capex spending, and begin to hire in earnest. All of the vulnerable Dow stocks would have to avoid their major issues, or even a minor hiccup.

None of the negative “externalities” currently contemplated — from a major bird flu outbreak to protectionist legislation or other policy mistake to an energy shock to a dollar crash to a geopolitical crisis over Iran’s nuclear ambitions — can come to pass, much less something currently not on the radar. Finally, equities would somehow manage to avoid the regular corrections so common in secular bear markets.

If Cinderella fails to show, how might the Dow work its way down toward 6800?

The momentum from the beginning of the year should carry stocks higher into February. But a series of earnings disappointments and a few negative surprises from select names — think

DuPont (DD) and Alcoa (AA) — creates a wobbly market. Disappointments after the close Tuesday from IBM (IBM), Intel (INTC) and Yahoo! (YHOO) won’t help matters and may prevent the early 2006 momentum from carrying as far as I originally thought.

Investors start to gradually recognize that all is not well in the economy. The P/E multiple compression discussed in part II only adds pressure to stock prices, as does options-expensing. Companies on calendar years are required to expense options, starting this quarter. The effects of expensing options will be seen in first-quarter and full-year guidance.

This scenario won’t collapse the market, but makes it vulnerable.

Perhaps the first-quarter rally has trouble gaining traction in the second. A modest downslide starts, as first-quarter earnings are reported. The bulls declare it a mere retracement and buying opportunity. But it turns out not to be; by the second quarter, the cyclical high for 2006 already has been put in.

How does this possibly get us to 6800? The Dow is calculated via a divisor, currently 0.12493117.

A point of each Dow stock’s movement is equal to a little over 8 points on the index. It’s not too hard to imagine that as earnings slow, stocks begin to soften. A loss of 5 points on each component adds up to a Dow drop of 1,200 points (40 points times 30 stocks = 1200) — that brings us to Dow 9800. And that’s only 5 points; a 10-point-per-Dow-stock drop would drive the average to 8600.

All it will take will be a modest earnings slowdown, and the Dow slips below 10,000. That happens, and apprehension levels rise in earnest. Dip-buyers who bought stocks 1,000 points higher are upside-down.

Now imagine what happens if any of the highfliers — say Google (GOOG) or Apple (AAPL) has a miss, or simply lowers guidance to reflect the slowing consumer. Or perhaps Home Depot (HD) and Lowe’s (LOW) feel the pinch of slowing housing and refinancing activity.

Given the heavily promotional holiday-price cuts, I expect that many retailers — Wal-Mart (WMT), Target (TGT) on the low end, Tiffany (TIF)  and Nordstrom (JWN) on the high end — will see the margin pressure impact earnings.

The spillover effect will be substantial. And if the same happens in any one of the pricier Dow components — Boeing (BA), United Technologies and 3M (MMM) are all vulnerable — we can easily see a day when the Dow is down 300 points.

In Japan, an investigation into Livedoor — hardly a premier Internet company — was a convenient excuse to whack the Nikkei 225 stock index down 462.08.

If breaking 10,000 will make traders nervous, below 9000 the fear levels will be palpable. At that point, any one of our laundry list of negative catalysts might come into play. In my

war-gamed scenarios, the dollar doesn’t have to go into crisis, and the avian pandemic need not kill millions; instead, the investing public need only become alarmed that something nasty might occur to take fear levels up toward panic.

The move from Dow 8800 to 6800 won’t be a rational, calmly contemplated affair. No one will be quietly wondering about option-expensing or multiple compression. Instead, it will be a severe overreaction to some external event.

If and when that happens, it likely will be the best buying opportunity in the markets since the October 2002 cyclical lows.

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Barry Ritholtz is the chief market strategist for Ritholtz Research, an independent institutional research firm, specializing in the analysis of macroeconomic trends and the capital markets. The firm’s variant perspectives are applied to the fixed income, equity and commodity markets, both domestically and internationally. Other areas of research coverage also include consumer, real estate, geopolitics, technology and digital media.