The Investor Sentiment Index is 82
The Investor Sentiment Momentum Index is 52
The Investor Sentiment Uptrends Index is 20.3
The Sector Rotation model switches from Energy Services to Banking

What a week in the markets!

These are the times that try men's soul's, and their pocketbooks.

I think today I will give you some insight into the mind (and stomach) of a market timer. You will find it instructive.

Next week I am going to share a simple Income Model that will become part of our weekly discussions. This model will show you how to make an average 10% per year in a conservative income program switching between just 3 mutual funds! This program will be an ideal place for your cash or for the bond/income portion of your portfolio.

Is It Different This Time?

I have written that I am a market timer. We use a system that was designed over 20 years ago, and has been very good, if not excellent. Of course, it has had some difficult periods where performance was not up to par, but overall in most years it does quite well, outperforming its benchmark. It only trades or switches about 4-5 times a year. Each switch is from long to short (with few exceptions), so even in bull markets we get short signals, and in bear markets we would get long signals. It is not a "trading" system, per se. It tries to catch major changes in direction, and more or less ignores the up and down market "noise". In volatile sideways markets, it tends to ignore the volatility and tries to find the true trend. It can be a "character test" in these type of markets, as my Dad would say. Do you trust your system even when the talking heads on television tell you different?

Today our system is long, and I am watching the markets fall through the floor. I remarked to my colleagues in the office that yesterday morning the market would be at an interim high, and it was going down from here. I did not, and do not, have any idea how far down it will go this cycle. But our system is currently telling us to wait for the markets to go higher before we reverse our positions. As a "trader" I might have thought I would see the market going down in the near term and would have gone short to take advantage of the volatility. As a disciplined timer, I follow my system, even though I know in advance that a certain percentage of the time it will be wrong. I know in advance that there will be times when the markets will give me acid indigestion.

I have written to you that there is a sea change coming, and that I think there is a serious possibility of a recession. I suggested last week that you use any move up in the markets to get out of stocks and into some other quality instruments.

So why am I still long? Because I have a system. It is the most successful system that I know of. If I knew of something better I would use it. And today that system says there is still some upside in the markets. If it is wrong, we will hit our stops and lose some money, and wait until the next opportunity. If it is right, and the market recovers from here and goes back to higher ground, we look like geniuses.

But whatever happens, I am neither market genius nor market dunce. I am simply trying to be a disciplined investor who believes that over the long term his system will help him achieve his goals. If I let my emotions or hunches control my investing, I will invariably do the wrong thing at the worst times.

This is why I urge you to have a system of some kind that gives you disciplined buy, trade, switch or sell signals. Maybe you buy value stocks and sell at certain points. Maybe it is a stop at 15%. It could be a momentum or trend-following model. Maybe it is taking a percentage of profits. Maybe it is a simple 39 week moving average. Maybe it is something complex like my system. Maybe you like wild rides and use a sector rotation model. Maybe you want steady earnings and simply use income models. There are lots of ways to be successful in the investment world.

But get a system, and stick to it. The last 18 years taught a lot of investors that markets always corrected themselves and went on to new highs. Last year has shown that is not the case in tech stocks. I point out that in 1974, it took 18 years for investors to get back to even (after inflation). Of course, during that time, lots of money was made in lots of sectors and by lots of systems. Buying at the bottom in 1974 would have been a genius move, but was most likely luck for most people who did so.

Buy and hold is not a system. It is a blind faith assumption that markets (or at least your investments) always go up over time, and that you have lots of time.

That "system" only works when the market goes up. I know that many of you believe we are in a New Era in which markets only go up 15% a year, forever and ever, world without end, amen, (with maybe brief interruptions to catch our breath.)

The next ten years will not be so kind as the last 18. Shiller, in his book Irrational Exuberance, which I wrote about extensively last year, shows that historically we should expect much less performance than we have seen the last ten years. In fact, if we had 5% compound growth for the next ten years, it would still be above historic levels from the levels we are currently at.

Does that mean we have to settle for 5% annual returns? No, of course not. But we will have to change investment strategies for this next decade to those which work in periods of value investing. In growth stock periods, such as we have just been through, buy and hold made everyone a genius if they just held on to their tech stocks. It will not work as well in the next ten years.

The Four Most Dangerous Words in the World: This Time It Is Different

These words have been spoken prior to every major market turn. Japan, the tech bubble last year, gold in 1979, etc., etc. People who believe those words do very well right up till the end, and then they tend to hold on right to the bottom, because they "know" it is different this time. Someone on TV or in a magazine told them so.

Let me tell you something I have learned from my studies: it is almost never different. If you believe that we will not have a recession because this time Greenspan will lower rates and the country is too diverse and poised to quickly correct things you could be in serious trouble.

Maybe we will not have a recession. I deeply hope we don't. (More below.) But we don't know for sure, and to make your investment decisions because "this time it is different" will ultimately hurt you, perhaps seriously. Maybe not this time, maybe not even next time, but the "this time it is different" crowd always -- I mean always - gets hammered in the end.

Those who have disciplined systems designed to take advantage of whatever opportunities present themselves, tend to be the ones who prosper over time.

Right now, our system is telling me we should see another leg or two up. It could be wrong, of course. But as I said last week, use these legs up, like the move this week when Greenspan lowered rates, to lighten up on your equity exposure.

But if we are wrong, we have a very disciplined stop loss. We will sell and get out. You should have a stop loss as well. If it goes back up, I expect that at some point our system will go short, and then I will watch the markets drop and smile. And when the markets rise I will worry. I should point out that our system tends to be contrarian, so when we switch, it will probably be at the time when everything looks like we are going to be just fine.

That is why you have to have a system, and you have to follow it, because there are times when your system will not feel right. Ignore those feelings. Trust the system. (I do admit to sometimes feeling like Luke Skywalker as Obewan Kenobe tells him, "Luke, trust the Force".)

My Next Book

One of my New Year resolutions is to actually write my long promised next book in the first half of this year. It will deal with investor psychology and helping investors find the right systems to match their personalities. I will be posting chapters on the web as I get them done. Many of the chapters will deal with investment systems: what they are, where to find them, when they work and when they don't and how to choose them. I have been a student of systems for years, and will share what I know with you.

I hope to do a chapter or two each month. We will see if my market discipline can carry over into my writing discipline. ( I just looked at the computer screen. The markets are down even more. Do I care? You bet! But I can't let it get to me. I will not live long if I do, or at least my stomach won't. "L-u-u-k-e, Trust the System!" See why I can below.

Good on the Fed

I wrote in my forecast that we need to see three things happen to avoid a recession. We need the Fed to aggressively lower rates, we need a serious tax cut and we need lower oil prices.

The Fed has made it clear we will get lower rates soon. We could be down at least 1.25% by the end of the summer. That is good, as that is when the yield curve tells us a recession should begin, if we are to get one. If it takes 6 months for a Fed move to take effect, Greenspan is cutting it close, but he has at least started.

Bush is aggressively pushing his tax cut. Gephardt is starting to sound like he will go along with something bigger than the Gore proposal. I think it is likely we will get a tax cut. I hope it is big.

Frankly, I think Bush should simply look Gephardt in the eye and say, "Ok, you are worried about the lowest wage earners in the economy not getting their fair share. I'll tell you what. Why don't we just eliminate taxes for the bottom 40% of tax-payers? They will pay nothing. Then give me the rest of my $1.3 trillion for the top 60% to distribute as fairly as I can."

Make the offer very public. I can guarantee you the country will wonder what is wrong if Gephardt rejects that offer, especially those who would see their taxes go away. In fact, many will think it is unfair that that large a percentage pays no tax at all. But they pay only a small part of the total now. The stimulus will be the same, which is what we need, and everyone benefits.

Why Tech is Going Lower

Computers are in 85% of homes making over $70,000 and with kids. 60% of all homes have PC's, but the rate of expansion is slowing. PC sales only rose 12% in 2000, the smallest rise since 1990. Revenues were up just 8%. Margins are down to 5% on business PC's.

The fiber optic phone network is overbuilt. Wireless phone companies are offering much more competitive rates. I now get 3,000 minutes, two phones, no long distance charges and a few bells and whistles for $105 per month. Five years ago that would have cost $750, at least. Long distance is now a nickel a minute. Smaller competitors are offering lower rates to businesses to switch their basic systems.

And so on and so on. Are these businesses going away? Are they doomed to bankruptcy? Of course not. They are good businesses and will do quite well, thank you. But they will not grow at 25% per year forever, that should be clear. They are currently priced for 25% or more growth for a number of years.

Forbes reports that unit sales of refrigerators and freezers have grown about 9% a year since 1997. Maytag sells at a P/E of about 9. Intel sells at 23 while it is near a year long low. Microsoft sells at 27. Cisco sells at 100. I think you get the picture. At the end of the day, if Dell only grows at the same rate as Maytag, why should I want to pay a higher price for it in terms of P/E? Maytag makes boxes and so does Dell. They are both very good at it. They will both grow and be profitable.

If you want spectacular growth, let's look for the next Dell in some other new up and coming industry or for an under-valued stock in a familiar one.

I think the stock prices of these companies will come down a great deal as the year wears on and we see a shift to value investing. It will be hard, and it will be tough on those who hold on because of some sense of perceived loyalty to the stocks which made them so much money. I read Bill Gates and Paul Allen have sold $10 billion of their stock recently. Maybe you should too.

At some point, we will be buyers of these tech stocks. They are great companies. But in a world switching to value investing, they are over-priced stocks.

Sector Model Switches

At the close of the day on Friday, we will switch from the Energy services sector fund (RYVIX) to the banking fund (RYKIX). We hit our 6% stop loss, and I expect it will go down further today. Banking is now the #1 sector, but it could be subject to losses as well. It is getting hit today (that is good as we will not be in it till Monday morning.)

I have had several readers write and tell me they like the idea of a sector rotation model and ask if our firm manages money using this model. I tell them we will do so in the future, but today I will not take their money. If we are going into a recession, sector models are likely to keep switching into the least bad fund. That means you simply lose less. One of the ways we will know we are at a bottom is when this sector model starts giving us a few good trades in a row. When that times comes, those of you who can stand the volatility might want to put some of your Las Vegas money into a sector model. We will be sending out our signals for you. Right now, let's just watch and wait.

You can go to my web site and see how each of the sectors rank against each other. We will change these about twice a week, especially after volatile days. We will always change the listing after a sector fund switch. Simply go to http://www.2000wave.com and click on the sector fund button.

Investor Sentiment is Schizophrenic

Large institutions seems to be driving the wagon. If they are bullish, the market goes up, if they are bearish, the market goes down. Mutual funds just keep buying, as they have to put money to work. TheStreet.com reports money flows were negative for the first day of this year for mutual funds. Normally large inflows in January contribute to the "January Effect", which is that stocks tend to go up in early January. They certainly did on Wednesday. It would be unusual for the January effect to be a one day event. Investor Sentiment as we measure it is still quite high. I would expect to see the markets try to make another run up, although we are seeing more volatility in other segments of the investing market as well.

But we are seeing more day to day volatility in sentiment. The overall average is quite high, but the volatility is beginning to concern me. The large traders and mutual funds have stayed bullish, but institutions and individuals are switching back and forth, like bears trapped in a cave waiting to get out. If mutual funds ever stop buying, this market is going down fast and big.

This latest down phase, if I am right, is a tug of war between the bulls and bears. There are those who believe Greenspan's rate cuts will spur the market. Those who don't take every opportunity to sell when the market rises. So, we have a huge run up and the sellers come out and say thank you. When that selling is done, we will see another run up.

That process will continue until one of three things happen. If those who believe in the rate cuts and the economy growing at a steady rate prevail, the market will break out to the upside or at least hold and move in a trading range with stocks on average moving up. When the soft landing is official, we will see the bull market resume.

If with each advance more and more people take the opportunity to sell, then the market will make increasingly new lows and a true bear market ensues. (This time I am going to get out. I can't take the volatility. Forget the cheese, get me out of the trap.) It will go down more than any of us think, and then resume a bull stance. Getting in then will look smart.

The third thing is we simply trade in a range all year, like we have been doing for the past few quarters. Neither one of these views prevail. The last scenario is the least likely over the long term. Eventually, one side or the other always prevails. History favors the bulls, except in recessions.

The Important Things

A friend of mine went into her attic last week, fell through the ceiling and is now tragically in a coma and not expected to live. It is truly a sad thing. But as I reflected upon the circumstances, I remembered the wreck my wife was in two weeks ago. She walked away from a car which looks like a crumpled coke can. If a truck had been 50 yards behind her on those icy roads, I could be the family member sitting in the trauma room hoping for a miracle. I can't even imagine the way I would feel, or what my friend's family is feeling. My hearts and prayers go out to them.

Remember to tell your friends and loved ones that you love them, and this New Year let's all work less and spend more time with our friends. Let's worry less about our money and more about relationships.

Today I am grateful that it is only the market going down that is my worry.

Your disciplined and reflecting analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

• Investor Sentiment
• Stock Market
• The Fed

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