Jon Markman

SuperModels5/19/2006 12:00 AM ET

Why the market bears are back

Continued from page 1

Because Mr. P deals with major European, Arab and Asian investors all the time, he understands how important foreigners are to our stock market. You see, most U.S. pension and mutual-fund managers are already fully invested in our market. They steadily get more fund flows from U.S. workers' retirement plans every month, but that only really keeps the machine rolling at a steady pace. To get the market moving dramatically higher, Wall Street needs incremental new inflows from overseas pension-fund managers.

Political worries

Foreign investors are very sophisticated about U.S. politics. Most have gone to the best schools in America, travel here frequently and pay a lot of money for top consultants. They are not naïve. Foreign investors care a lot about leadership, Mr. P says. They don't really care if a Democrat or a Republican is in control of the White House. They just want someone firmly in charge so that they can have confidence that the money that they are entrusting here is safe.

When events transpire to make our government appear less secure, foreign investors get nervous. They don't necessarily withdraw funds. They just send less, which has the effect of making a rising market pause.

So what is the issue now? It's not just that the Bush administration is suffering from the weakest polling numbers in recent years. It is that foreign and other sophisticated investors smell the potential for major changes following the midterm elections, including the possibility of a Democrat takeover of Congress and the potential for tax-law changes and impeachment hearings. While a strong market always climbs a wall of worry, history has shown that investors do not like the impeachment process one bit. The dreadful bear-market years of 1973 to 1974 were the classic example. Yet you only need to look back to 1998 and 1999 at the President Clinton impeachment process. The market ultimately rallied big in both of those years, but there were several death-defying 10% slides along the way.

There should be little doubt that if the Democrats' message finds a receptive ear among the public, Mr. P says, there will be investor-paralyzing hearings well into 2007. This is particularly true if, as rumored over the past week, key presidential aide Karl Rove is indicted for his role in the Valerie Plame affair. It's therefore a good time to get cautious on most industrials and consumer cyclicals. He sees the potential for a slide of as much as 20% over the next nine months.

Dangerous time for market

Of course, from a cyclical point of view, this makes sense. The midterm election year of a second-term president tends to be one of the most dangerous for the market. And this year, the ugliness may be amplified because of President Bush's low poll results. According to Ned Davis Research data, since 1950, the market has lost 3.5% during the period from April 30 to Sept. 30 during midterm election years, versus a gain of 0.9% in the period in all years and a gain of 5.6% in the other half of the year -- Sept. 30 to April 30. In other words, we are now entering what is historically just a bad, bad time for stocks.

So how do the poll numbers fit in?

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The Gallup Poll Presidential Approval Rating is now 34%. According to Ned Davis analysts, a low presidential approval rating can sometimes be a positive in a contrarian sort of way -- meaning that there is excessive pessimism afoot. Yet they hasten to add that when it is this low, "it's so bad that it's actually bad." During the rare period when the approval rating has been under 35%, the Dow Jones industrials have declined at a negative 6% annual rate.

Now, where it really gets ugly is when you notice that there is only one other precedent for the twin demons of low presidential approval and a midterm election year happening at the same time. That was in 1974, when the market would ultimately slide 45% to a 12-year low amid the Watergate scandal, impeachment hearings and the resignation of President Nixon, not to mention a gasoline-supply and price shock.

The rise of mercantilism

But that's not the only big problem that Mr. P sees. He also frets over what he refers to as "neo-mercantilism." Mercantilism, you may recall from economic textbooks, was the main paradigm that characterized world trade in the 16th and 17th centuries, before capitalism shifted into high gear. It's a view that politicians, not business leaders, should guide international trade -- and that trade policy should serve strictly political ends.

Modern mercantilists include Vladimir Putin of Russia, Hugo Chavez of Venezuela, Evo Morales of Bolivia, and in some regards the governments of Germany, China and Japan. Examples are Putin's withholding of natural gas from Europe; Chavez's takeover of foreign oil and gas interests; and Morales' nationalization of energy and mines.

Mercantilism is an unsettling type of economic warfare, says Mr. P -- an attempt to restore power to governments that was stripped from politicians by capitalism. You could almost call it the "weaponization of finance." If it swells, much of the market freedom that we know today will shrivel, he fears, as countries withdraw into their shells and restrict world trade.

On a more practical level, Mr. P says his models show that the industrial metals are four times more expensive than they have been historically, and consumer durables are twice as cheap as they normally are. He believes the gap will close, which means he thinks you should at least take advantage of the recent surge to sell your aluminum, zinc and nickel stocks.

Fine Print

To learn more about mercantilism, visit the Concise Encyclopedia of Economics or Wikipedia.

Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman did not own or control shares of companies mentioned in this column.

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