The year 2005 has been like a bad soap opera for the U.S. equity market, with one cliffhanger after another. The story lines were numerous and well publicized, including crude oil prices, the continued housing bubble, a surge in commodity prices, two of the worst hurricanes in American history (and a third raging in late October), and a Federal Reserve that seemed determined to “fix” all problems by raising short-term interest rates beyond what the bond markets would suggest. What seemed like a constant flow of bad news in one form or another has conspired to hold stocks in a muted trading range since early 2004.

This trading range follows a frustrating history of three years of declines from 2000 to 2002, with a classic reverse head-and-shoulders pattern bottoming in October 2002. In March 2003, the Dow pulled itself out of the right shoulder and proceeded by January 2004 to jump nearly 50 percent from its lows. But now it has moved sideways for the past two years, trading in a range of 9,700 to 10,900 with the higher end of the range last hit in March of 2005.

Our forecast called for a strong second half of 2005 based on cyclicals, technicals and demographic trends. While those trends are still in place and the end of the year holds promise, it has seemed like a new hurdle – higher and harder to clear – appeared with each new turn in the markets this year. As painful as the year has been, the underlying equity market trends remain firmly positive. In the face of all the setbacks, the economy has continued to post solid growth, and earnings still are increasing by double digits.

And that long, frustrating trading range is actually a very good sign. Long sideways trading ranges have preceded every major bull market bubble in the last century, so, in our view, the next lift-off should have tremendous strength.

A Year of Disasters
For the first half of 2005, most of the factors holding the market down were man-made. After waning at the end of 2004, the price of crude oil moved back up early this year and became the chief preoccupation of investors. Since then the markets have more or less moved in (negative) reaction to swings in the price of crude, which at this point has more to do with speculation than supply and demand fundamentals. Mostly in reaction to oil, stocks corrected strongly throughout most of March and April, dropping a quick nine percent before finally finding support at Dow 10,000. At the same time, the other major bubble of recent years – housing – began to get increasingly speculative. These two situations brought about the specter of inflation, which, of course, leads to increasing short-term interest rates by the Federal Reserve.

The Fed has spent this entire year trying for a hat trick – curbing the housing bubble, quelling the inflation brought about by the soaring energy prices and trying to rebuild some cushion after lowering rates to an unsustainable one percent.

The problem is that adjusting interest rates to guide the economy is like using a machete in surgery – it’s not very precise, and a misstep can have disastrous results. If the Fed raises rates too much, the economic recovery could be stalled and take the financial markets with it. If the Fed raises rates too little, the chances of a bigger housing bubble and a surge in inflation are increased.

With the Fed already having raised rates from 2.25 percent in January to 3.75 percent as of October, market participants are holding their collective breath to see when the increases will stop. Given the Fed’s rhetoric of late, rates are likely to rise to 4.25 percent and possibly 4.50 percent before this interest rate cycle is finished. Meanwhile, the housing bubble is showing signs of deflating, which should be a positive for the equity markets as investors shift their assets back into stocks again in 2006 and beyond.

Hedge Funds Playing Around
As if the Fed, a commodity bubble and natural disasters were not enough trouble for stocks, some market participants have created trouble for themselves out of thin air. Readers may remember the “can’t-lose” hedge fund trade for the year was to go long General Motors bonds and short the company’s stock, believing that the bonds would retain their value and the equity would drop given current woes in the domestic auto-manufacturing world.

Then in the first week of May, S&P reduced GM’s bonds to junk status, causing them to plunge, and Kirk Kerkorian announced his intentions to purchase almost nine percent of the company’s shares at a hefty premium to the current market price; this sent the share price soaring. This left many hedge funds scrambling to close their trades, turning the “can’t-lose” trade into a “can’t win.” Interestingly, hedge fund short covering contributed to a market rally that lasted into late June, when the crude oil price began to surge again.

Of Katrina and Crude
Just as it appeared that the price of crude might have been reaching a peak in mid-August, the destruction of the Gulf Coast and its oil infrastructure by Hurricane Katrina sent the price of oil and distillates shooting to slight new highs, causing equities to drift mildly lower. Even though oil appears to have peaked at the end of August, the equity markets continue to be wary of energy prices. Katrina, of course, decimated the city of New Orleans and other Gulf locations along with a substantial amount of the oil refining capacity of the U.S.

The speculation as to how long it would take to get oil refining and shipping back on line has only been outdone by the speculation on how much in government funds will be wasted in the rebuilding of that region.

The markets reacted curiously to the devastation of Katrina – first a downturn in equities with fuel prices rippling through the economy, then a surge up as market participants saw an economic bonanza with potentially hundreds of billions of dollars flooding the region in the rebuilding phase.

As of press time, the U.S. drilling and refining is not 100 percent back on line, but it is improving rapidly. The rebuilding of the region has yet to begin. When the rebuilding does begin, it will require vast amounts of durable goods and infrastructure, the very types of purchases and productivity that propels an economy forward.

A Little Good News
Amid this year of disaster and gloom, U.S. companies have continued to post expanding profits. According to Bloomberg, third-quarter earnings for the S&P 500 were on pace for a 14.6-percent improvement from 2004 earnings. And don’t forget that 2004 was most certainly a strong year for earnings.

While the S&P 500 is up 50 percent from its 2002 lows, earnings have more than doubled over the same period, bringing price/earnings (P/E) ratios down to levels not seen in years. The comparison of stocks (the P/E of the S&P 500) versus bond yields (the 10-year Treasury bond), unofficially dubbed the “Fed Model,” is at an extreme level of stock under-valuation similar to the lows in October of 2002.

Worth mentioning is that these increased earnings are being reported in the face of Sarbanes-Oxley, which makes corporate chieftains criminally liable if their firm reports false or misleading numbers. So it is arguable that our economy is getting a clearer picture of company earnings than we ever have in the past – and the reports are very positive.

Long Trading Ranges Are A Very Bullish Sign
Many analysts and economists view the recent long trading range as a sign of limited potential for the economy and stocks in the coming years. We believe this view could not be more wrong. True, stocks have not significantly risen in nearly two years, but given the magnitude of the crises of the past year, it is a major sign of strength that they have managed to hold their position.

Furthermore, the solid growth in earnings in a period of flat equity prices clearly builds fundamental strength. In addition, every stock market bubble in the last century – 1915 to 1919, 1925 to 1929, 1935 to 1937, 1985 to 1987, and 1995 to 1999 – was preceded by pattern of a major correction or crash, a strong initial recovery rally, and then a one- to two-year trading range sideways.

The Case for Dramatic Equity Gains Ahead
When new technologies first accelerate their market penetration into the mainstream economy, they bring strongly rising productivity rates and new growth industries that generally develop into two bubbles before they peak, not one. We believe the greatest bubble very likely will occur from mid- to late 2005 into mid- to late 2010 on an 81-year lag to the last technology boom and rising demographic cycle of spending into the Roaring ‘20s, pointing to a Dow of around 40,000 into 2010. Our bullish view stems from an understanding of demographics, best illustrated by the spending wave (Figure 1).


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Our spending wave, based on consumption data provided by the U.S. government, simply lags domestic births, adjusted for immigration, for the peak age of consumer spending – around age 48 today. That model, heavily skewed by the massive baby boom generation, has continued to point strongly up into around 2010 towards a Dow around 40,000 and explains the broad, unprecedented nature of this boom. Despite the crash of 2000- 2002, we are predicting a Dow of 35,000 to 40,000 around the end of this decade.

The greater insight, however, comes from our long-term technology cycles. Every other generation, approximately every 80 years, we usher in radical new technologies – like electricity, autos, phones and radios – that create long-term growth in productivity. The current radical technology trend centers around personal computers, wireless technologies, the Internet and broadband communications. These new technologies change business models and create accelerating productivity as they move in an S-Curve cycle into our mainstream economy – as occurred from 1914 to 1929 and 1995 to 2010.

In October of 2002 we gave our strongest buy signal in the history of our newsletter (which began in 1989) right at the bottom and demonstrated how the 2000s “tech wreck” was directly comparable to the auto industry and tech crash of the 1920s – the last major technology cycle on an 80- to 81-year lag – and would lead to one more great bubble boom ahead from late 2002 into 2010. We forecast the boom to continue until the technology cycle and demographic-induced spending trends peak between late 2009 and mid-2010. In early October of 2005 we have our last major buy signal ahead of the next strong advance in the stock market.

How could we be forecasting a Dow of 40,000 by 2010 in an era of growing federal deficits, hurricanes, terrorism and seemingly the never-ending war in Iraq? Consider other examples. We faced a similar environment in the early 1990s, and the Dow hit highs that previously were unimaginable – until you consider demographics and technology cycles.

Sectors to Watch
In the last several years, bonds, real estate investment trusts, homebuilding stocks and energy stocks have led the market in a lackluster period overall. We see a dramatic reversal in trends with small-cap and large-cap growth taking over leadership from value, and with the strongest performance in technology, biotech, health care, financials, Asia, durable goods and consumer discretionary. We are predicting that the Dow will rise from 14,000 to 15,000 by August of 2006, similar to the strong advance we predicted in March of 2003, with much greater gains in technology and small caps. The next year and next five years should be very exciting and profitable for stocks and the growth sectors! But leading sectors of the past like bonds, energy, commodities, REITs and homebuilders will lag. Energy and commodity sectors may see a final bubble and resurgence from 2007 into 2010.