E-mail this article Printer-Friendly

Guiding investors through the Danger Zone

History tells us we may be headed for a dangerous market decline according to this U.S. fund advisory — will it be a waterfall or a crash?

This may all sound a bit like numerology, but according to historical precedent, the numbers do add up. And those numbers are telling us that a significant stock market decline may be just ahead.

That, at any rate, is the assertion of the Growth Fund Guide, published in Rapid City, South Dakota. This advisory has carefully calculated the timing of stock market declines in a table going back to 1856.

Entering the Danger Zone

It is called the Danger Zone table. And a Danger Zone has cropped up in the sixth or seventh year of every decade (that’s right — every decade!) over the past century and a half. (The early figures come from the Clement Burgess Index of Stock Price, the rest from the Dow Jones Industrial Average, which began in 1896.)

There’s more. “The table also shows that nine of the 15 Danger Zone declines ended in the 10th month of the 7th year, or later, but never extended beyond the third month of the 8th year.”

Got it? Let’s proceed. “So history is suggesting that the most likely time frame for a final low point of a possible large Danger Zone market decline is within a rather tight six month zone extending from October 2007 to March 2008, with the most probable month for the low being October 2007.”

We’ll give you a few of the numbers. The largest decline, not surprisingly, was 49 per cent during the Depression year of 1937. Since then the largest has been 36 per cent in 1987, the year of the worst stock market crash since World War II. 10 years ago, the decline was 13.3 per cent.

In both 1987 and 1997, the decline started in August (bridging a long gap from the last time that had happened, in 1857).

The advisory thinks that will happen again: “The strongest indication that our historical table is giving us from this point is for the possibility of a large decline beginning in August and ending in October.”

Waterfall or crash?

The August-to-October time frame raises two alternatives, says the advisory. “That would suggest some kind of waterfall decline like those that took place in both 1857 and 1997, or possibly a crash type situation like we had in 1987.” (A “waterfall” is a steep decline — the chart looks like Niagara — which pulls up short of a full crash.)

This isn’t just a numbers game. There are good and sufficient reasons, says the Growth Fund Guide, to expect one of these two results.

“A mini-bull market top at this time or directly ahead would register the second highest overvalued S&P 500 P/D [price/dividend] Ratio at a market peak in history. The market is currently overbought and the extremely bullish complacency of the investment and trading crowds is at an extreme.”

A dollar’s worth of dividends

The price/dividend ratio, by the way, was devised by Mr. Walter Rouleau, the publisher of the Growth Fund Guide, as a way of gauging an oversold market. Based on dividend yield, it basically tells you how much you will pay for a $1 worth of dividends. When the price is around $20, the market is undervalued. When it goes over $30, the market is overvalued.

Every time this ratio has reached the 30s over the past century, a market decline has followed. The advisory’s projections have that ratio climbing to 55 in the months ahead.

One last warning sign. Of the longest time periods the Dow Jones rose before suffering a sharp correction, the advisory notes that “the current rise is the second longest time period to date without a 10% correction.” Which is enough “to make any investor a bit nervous at this time.”

Certainly, the Danger Zone doesn’t account for all the market mishaps in history; not the devastating bank panics of 1873 and 1893 (although it does dovetail with the panic of 1907), nor of course, the granddaddy of them all, the Great Crash of 1929. But it is right on line with the worst crash in recent memory, that of 1987.

In short, the circumstantial evidence is substantial. So how does one prepare oneself for an oncoming waterfall, or crash?

Looking to buy on weakness

For interest’s sake, let’s see how the Growth Fund Guide operates in the face of an impending decline. Their fund selections are American, of course, and therefore not liable to find their way into Canadian portfolios, but it’s the nature of the investments we’re after.

We’ll pick the Aggressive Portfolio, the most successful of the advisory’s three portfolios (it’s down 3.6 per cent so far this year, but up 253 per cent since the turn of the century).

Here are the funds and their weightings: GAMCO Gold, 32.8%; Prudent Bear, 21.1%; US Global Investors World Precious Minerals, 17.5%; ProFunds UltraShort OTC, 9.0%; Tocqueville Gold, 8.3%; US Global Investors Global Natural Resources, 5.9%; ProFunds UltraShort Small Cap, 3.5%; Fidelity Japan Smaller Companies, 1.5%.

For an aggressive portfolio, it has a good deal of prudence built in. The UltraShort funds have not been helpful, says the advisory, but of course hedge positions “never are helpful until they are. We use them as an insurance policy against what we perceive as market bubbles facing a building hurricane that could blow up, resulting in abrupt market declines.”

Concludes the advisory: “We expect it won’t be long before something causes market bubbles around the world to begin to break, either one at a time or simultaneously. If we are correct, it won’t be too long before we are once again looking for ‘buy on weakness’ bargains.”

So if the numbers are right, we enter the Danger Zone six weeks from now and emerge in about four months. But don’t despair: if you play your cards right, there could be a windfall waiting behind the waterfall.