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A Look at The Downside of Upsides When Investing in a Boom Market

By  +Follow May 9, 2013 3:00AM
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Harry S. Dent Jr.As stocks continue to run into record highs with seemingly little to no resistance, investors may need to beware of potential triggers that could bring the party to a screeching halt. In Equities.com's latest interview with demographics and economics prognosticator Harry S. Dent, Jr., we discuss new red flags in the global economy, Dent's targets for potential tops in the coming months, and what he thinks will be the big winners of the eventual recovery after the next great crash.

Dent is the author of The Great Crash Ahead: Strategies for a World Turned Upside Down, and editor of the free newsletter Survive and Prosper. You can read our previous interviews with Dent here, and learn more about his work at www.harrydent.com.

EQ: Last week, the S&P 500 closed above 1600 and the Dow right at 15,000. These were key resistance levels that you were watching. What do you expect now that this has happened?
 
Dent: We’re looking for a bubble to peak later this year, probably during the summer. Right now, we haven't seen signs of a top yet, or of the divergences and things that we normally look for. Our first target for that to happen was the S&P 500 at 1600, but w’re seeing stepped up stimulus in Japan, following stepped up stimulus from the Federal Reserve in late 2012, as well as the same from other central banks. Then the employment number finally came in more positive than people thought, with upward revisions for February and March, which was a surprise to us. So it’s not clear when or if the economy is slowing with the sequester cuts and tax rises, but it’s clearly not slowing yet. So the markets, with so much stimulus coming in, want to go up.
 
But the reason why we we saw the first resistance right at 1600 on the S&P 500 is because of the megaphone pattern, and we noticed that would be a hard level for the S&P 500 to get above. We call this a megaphone pattern and some people call "the jaws of death", but it’s when you see stocks keep going up, making higher highs, and then crash, and every bubble goes to a higher high, and every crash goes to a lower low. That’s what we’ve seen since the early 2000 top in the Tech Bubble. Then we had a big crash, followed by a slight new high in the S&P 500 in the 2007 bubble. Then it crashed to lower lows.
 
We have these megaphone patterns in many U.S. stock indices like the Russell 2000, the Dow Jones Industrials, Dow Jones Transports, etc. The next big resistance level on this type of pattern would be around 16000 on the Dow, and 6700 on the Dow Transports. That’s about 7 percent higher than current levels. That means the S&P 500, which now has no resistance since it’s at all-time highs, would be around 1700 to 1720. We think stocks, even though they’re due for a correction any time and you never know what’s going to happen when it’s constantly being stimulated by new money, but basically stocks are likely to go about 7 percent higher into the summer, and then we’ll see if that’s sufficient resistance, because there are at least three major indices that hit resistance there, so it’s stronger. But the market would have to be hit by bad news like Cypress or the March job numbers in order to go down.
 
It was significant that the markets broke 1600, however, because it means we’re probably heading to the next major resistance level. This was a major sign of strength for the market and we do think they’re headed higher over the next few months. Bubbles just keep going up, and they keep getting propped up by the "experts", but that’s the way it always looks at the top of the bubble. We saw it in 2007, early 2000, and even 1987, and bubbles burst anyway. So we’re still looking for a bubble burst to start later this year, but right now, stocks are going up.
 
EQ: What are your thoughts on how the gold market is playing out while stocks have hit all-time records?
 
Dent: That's the other very important trend right now. Gold had a huge surge into September 2011, and then went sideways for almost two years. I tell you, I have watched chart patterns for 30 years, and when a market surges like that and goes sideways, nine out of 10 times it breaks up, not down. Well, gold broke down out of that channel out of $1,525. That was another big line in the sand that we had. If gold breaks below $1,525, then the next support level is $1,250, and ultimately it could go lower. So gold did break that, and it had a major bounce. It could go back up and test that $1,525 level, but it’s in a very questionable level.
 
If it can break back above $1,525 and hold there, then it could still make a new high with escalating stimulus coming from Japan, Europe, and who knows who else. But if it can’t break above there, it’s likely headed down. The one thing we’re very clear about is we don’t know quite where this stock bubble is going to burst, but we are very clear that commodity prices peaked in April 2007. That’s when we got people out of silver, which was around $49 an ounce at the time.
 
Commodity prices create a vicious cycle where, when they go down, it hurts the exports and profits of emerging countries in their strongest industries. That in turn hurts China’s exports to these countries because they are now the majority of China's exports; more than Europe and the United States. Well, when China’s exports slow, then they’re not consuming as many raw materials and commodities, which causes commodity prices to go down. So I’m starting to think, for the first time, that the next crisis in the next year or so may actually be triggered by the emerging markets, if they keep tanking. So that might end up happening first over the failures from Spain, Greece, or some country from Southern Europe, which keeps getting worse.
 
The emerging markets are already under-performing the U.S. and the best European stock markets like Germany and England. So maybe its the emerging markets, commodity prices, and a slowing Chinese export market that actually triggers the next global downturn. That is something nobody is thinking about right now. Everybody knows Europe is weak, and that the U.S. is only growing from massive life support from the Fed--$2 trillion a year in stimulus to create $300 billion in growth is a horrible ratio. But nobody is really thinking about China and the emerging markets--which do have better demographics, especially outside of China--but commodities are killing them.
 
EQ: Considering the additional 7-percent upside for stocks from your initial projection, does this mean that when stocks hit their top, the downside is more pronounced?
 
Dent: Yes because the more you bubble, the bigger the burst, and that’s what these megaphone patterns always suggest. The megaphone pattern with higher highs on the Dow suggests a peak of 16,000, but also suggests a low between 5,000 and 6,000 depending on where it hits in the next several years. Sometimes you break below that, but generally the higher the high means the lower the low. For the S&P 500, if we go up to 1700 and 1720, then that makes a whole new pattern. It means that this wave now is no longer a megaphone pattern, but rather a major fifth-wave peak. That creates more of a potential downside as well. Again, the logic of bubbles and the logic of people talking in financial media is to draw everybody in, and when everybody gets on the bought and there is no one left to buy—no hedge funds on leverage, no average Joes on Scottrade—that’s when it collapses.
 
Bubbles don’t normally collapse because the economy goes down first. They normally start to collapse like the way the housing bubble did in late 2005. Prices just get so high and everybody’s already bought in, so the collapse of the bubble actually impacts the economy negatively. It’s the same thing with Japan in the early 1990s. So you don’t know exactly when it will collapse. There are so many things that could trigger this, just like the subprime mortgage crisis in the U.S. triggered the last global collapse. It’s not that the subprime mortgage crisis was the only problem, it’s that the whole system was so stretched by slowing demographics and rising debt ratios, all it took was something to trigger it. It doesn’t take much.
 
If Spain blows up, or China’s real estate bubble starts to burst and their government can’t control it, or Japan’s interest rate starts going up, and people realize these situations are not sustainable, something’s going to blow. That’s why investors need to realize that even though stocks can go up 7 percent in the next few months, and you can chase that as a short-term investor, but do not chase that as a long-term investor because we could be looking at a 50-percent to 70-percent downside when this bubble bursts.
 
EQ: It seems like the catalyst right now for U.S. stocks is that there just isn’t any other alternative. Is that a good enough reason to be in the market as a long-term investor?
 
Dent: It’s not and that’s exactly what causes bubbles. It’s the same thing when I go around the world and talk about real estate bubbles. Everywhere I go, people say their bubbles haven’t burst yet because they’re special and so different, but all bubbles burst. So the fact that the Fed is making it impossible to go into fixed income and safer investments because of negative returns adjusted for inflation, and pushing people into stocks and commodities, that’s a very bad reason for those markets to be going up. The fact that it’s taking $2 trillion--$1 trillion in fiscal deficits, and $1 trillion in monetary injections—just to keep our economy growing at an anemic 2-percent rate on average, it makes you wonder where our economy would be without this $2 trillion in stimulus. We wouldn't just be in a recession; we’d be in a depression without this. So for stocks to be going up when the fundamental trends of debt and demographics are going in the opposite direction is just setting up for a bigger fall. It’s a horrible reason for things to go up. But without bad news and with this much injection, the markets will just keep creeping up and businesses will continue to seem fine. But it’s like plastic surgery; it’s just not real.
 
The bubble will keep going until something pierces it. Then afterward, people will say how obvious the bubble was. But when it’s going up, no one realizes. When some people are crazy, the rest of the population will recognize it. But when everybody is doing the same thing, it’s no longer considered crazy. When everybody is doing it and it seems to be working, people think it’s fine. For example, I am astounded that Warren Buffett, the smartest investor in all of history, has become a cheerleader of the government and the Fed doing what they’re doing. I just don’t get it. So we have a bubble burst coming in the next several years. It’s just a matter of how high the market goes before it happens.
 
So our next target where we might top is 16000 on the Dow, 1700 to 1720 on the S&P 500, 1050 on the Russell 2000, and 6700 on the Dow Transports. If we get above those levels, then we are really in a bubble. From our view, the higher it goes then the scarier it gets on the downside. When the bubble creates prices so high, and young people can’t afford it—this is especially true in real estate—then the bubble bursts. Again, the bigger the bubble, the bigger the burst. This is true whether you’re looking at Tech stocks, emerging markets, real estate, gold, or anything else. So in actuality, people should worry the more stocks go up.
 

EQ: You’ve been doing quite a bit of traveling over the past month and one of the conferences was the Demographics School in Arizona. Can you share a few highlights of that event?

Dent: Well, the big thing is Demographics School was initially developed many years ago to attract financial advisors for our advisory network, and it worked very well. We spend a day and a half with attendees and go through our whole body of work from, A to Z. We discuss not just demographics, but S-curve progressions, technologies, and global demographics of emerging countries, which are different. They advance on urbanization even more than demographics, so when you look at emerging countries, they have different metrics than developed countries.

Over the years, the subscribers of our newsletter wanted to go to Demographics School, and they started coming and joining our network. For the first time in our history, we had 80 percent of the audience of Demographic School that were not financial advisors, but high net worth investors and business owners. That was a great thing for us because what we do is basically give them a mini MBA in economics. I tell people that you can take a four-year course in economics for a Master’s degree and still not know much or be able to forecast much. We tell you most of what people need to know about economics in a day and a half.

So in that aspect, it was probably our best Demographics School ever, largely because we got a lot more input from small business owners, entrepreneurs, and high net worth investors instead of just strictly from financial advisors.

EQ: What were some of the major topics that were discussed?

Dent: One of the things is you have to look at the emerging world in the future because it is the future. All the demographics are in the emerging world after this decade of difficulty plays out. The second point is we have major charts around the world hitting these major resistance levels. So this bubble is getting close to peaking.  If we have to estimate when it’s going to peak, it would probably be around the summer.

I also had an old cycle recreated. Ned Davis is a great cycle guy. He documented a four-year political cycle a long time ago, and then a decennial cycle where he averaged out stocks over the last century and found that most of the major lows in the biggest stock crashes happened in the first two to three years of every decade while most of the gains were created in the last five years of every decade. This is a cycle I’ve used for 20 years now. It worked until 2010-2012, when we were expecting the next great crash.

What I found recently is Paul McCulley, who was a major $12-billion fund manager for PIMCO before he retired, came out in Barron’s recently and said, “You know what saved me in the 2000-2002 crash? Sunspot cycles.” I’ve heard about sunspot cycles before from really respected people in the industry, but I disregarded them because it’s an 11-year cycle. I have studied history and have never seen anything correlate on an 11-year cycle. But when Paul McCulley said this, I went back and I looked at the sunspot cycles over the last century. They go back to the 1700s. So if you go back that far, it does average 11 years.

I went back over the last century, and it actually averages out to 10 years, so right on the decennial cycle. So maybe this is the reason. When solar radiation is higher, there is more energy. This is a serious cycle that people in agriculture and NASA track and forecast with because it can knock out satellites and telecommunication systems. So it has some impact, maybe similar to wolves howling to full moons. But I found that it’s a 10-year cycle over the last century, and here’s the twist: It’s a 10-year cycle, but it could range from eight to 10 years.

The last cycle went down longer than usual and is now recovering. NASA and many other experts predict that this one is going to peak in mid-2013, somewhere between May and September. That would explain why we didn’t have a major crash and downturn, and why the sunspot cycle now turns down from about mid-2013 into late 2019 or early 2020. This is right in line with our demographics cycles that are at their worst by 2020, and our geopolitical cycle, which is at its worst by late 2019.

So this just says that the Fed and governments may have kept this bubble going this far, but the demographic trends and geopolitical trends are not getting better. This sunspot cycle, though, is probably the biggest reason I would say that after this year, you better watch out because this is the last of our major cycles to turn down. Then the four-year cycle from Ned Davis bottoms in late 2014 or early 2015, and again in late 2018 or early 2019. Our biggest thing now is we just can’t determine exactly when the bubble is going to peak, and when the biggest crash is, but we’re saying these are the danger periods when we look at all of our long-term and intermediate cycles.

That’s important for investors because we may be in a long-term downturn, but stocks go up and down. So every time there’s a crash, you have to have the guts to buy when things are at decent valuations. Every time there’s a bubble and things go back to new highs like they are now, you have to have the guts to get out even if you get out a little too early. When things crash, it gets really ugly. We saw what happened in late 2008, and the only thing that went up was the dollar and U.S. Treasury bonds.

Well, I’m not sure Treasury bonds will hold up in the next crash, but I think the dollar should be able to. Everything else will collapse. We’re in tumultuous times, and we’re going to see bubble, burst, bubble burst until we get out of this “Winter season” and move into the next global boom, which will be led more by emerging countries and commodities in the early 2020s.

For now, I think commodities are down for the next decade, and I don’t even like most emerging countries. I do like Mexico if there’s a crash because they’ll be a major manufacturer. I like India because they’re not dependent on commodity exports like many other emerging countries. I like Southeast Asia too. I don’t like emerging markets like Latin America, the Middle East, or African countries in a time when commodity prices are going down. You have to be very selective, but if we have another crash, that would also mean we’ll have another big rally.

EQ: Where can people get more information about the most recent Demographics School?

Dent: If people go to HarryDent.com, we now have a free daily newsletter with high content that’s not as much market forecast, but focused more on education content and current events. That’s for free. If you go to HSDent.com, we sell an audio version of Demographics School for people that couldn’t come. Those are the two things I would recommend right now. Get on our free newsletter because you can’t go wrong with that, and if you’re interested in Demographics School and a broader view of what we do, go to HSDent.com.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.


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By  +Follow May 9, 2013 3:00AM
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