Seeing a Stumble Ahead for Stocks
Technical analysts find gloomy portents in the market's gyrations--and fret about Wall Street's bullish mood.


(FORTUNE Magazine) - Sitting in a spacious office overlooking his firm's large trading floor, Ralph Acampora is worried. The head of research at Knight Capital Group says he's been having sleepless nights fretting about the stock market, despite its New Year's bounce. There's a long list of things that concern him -- mainly abstract concepts such as price patterns, trading volume, and seasonal trends -- that together make for a particularly gloomy forecast: Acampora is predicting the Dow will drop by as much as 20%, or as low as 8,400, this year. "At some point in 2006, we'll have a decline," he insists.

These days, that's a distinctly minority view on Wall Street. Stocks rose 3% in the first five trading days of 2006, sending the major indexes to 4½-year highs. And while the market has cooled a bit since then, Wall Street's big-name strategists remain overwhelmingly bullish. Abby Joseph Cohen of Goldman Sachs, Henry Dickson of Lehman Brothers, and Tobias Levkovich of Citigroup, for example, all predict that the S&P 500 will rise almost 10%, to 1,400 this year.

So you might be tempted to write off Acampora as just another stock market Cassandra. But the 64-year-old Bronx native is hardly a perpetual bear. During the '90s he made his name on a number of strikingly bullish predictions that panned out. And Acampora, who joined Knight, based in Jersey City, last fall, is hardly the only market pro who sees trouble ahead. Mark Arbeter, chief technical strategist at Standard & Poor's, expects the S&P 500 to fall 10% to 20% in 2006. Rick Bensignor, chief technical strategist at Morgan Stanley, also thinks stocks will tumble, most likely in the middle part of this year. "We will have a major correction, if not a bear market," says Arbeter.

What these three have in common is that they're all technical analysts who use market statistics like trading volume as well as historical patterns--rather than data like profit margins and sales growth--to predict price trends. At a minimum, Acampora and the other technicians can provide a helpful counterbalance to the perpetual optimism of many well-known market seers. If you find their arguments persuasive, you may want to reduce your exposure to U.S. stocks, or at least think twice before making new investments.

What has the chart readers so spooked is the "presidential cycle"--the theory that the market goes through regular ups and downs over the course of a President's term. This year is the second year of President Bush's second term, and second years tend to be rough for stocks. Since 1970, the second year of Nixon's first term, the market has turned down every four years, with the exception of 1986 (the drop came a year late in the '87 crash). In addition, some of the worst bear markets in recent memory--1962, 1974, and 2002--have hit during year two of the presidential term.

What's going on? The theory runs something like this: During the "honeymoon phase" of his first year, the President uses much of his political capital to push through legislation. By the end of year one, the new programs become less popular, the President's influence slips, and his poll ratings start to decline. Sensing weakness, the opposition party gets increasingly vocal as midterm elections in November approach. Consumer confidence wanes, the economy cools, and stocks tumble in anticipation of slowing profit growth. So far, Acampora says, this year is following the usual pattern, with President Bush under fire for the new prescription-drug plan and warrantless wiretapping, among other things.

Of course the downturn in stocks every four years could simply be a random pattern. And one of the big knocks against so-called cycle analysis is that there aren't enough observation points to make it statistically meaningful. But technicians have more ammunition. The current bull market has now lasted 39 months from its start in Oct. 2002, matching the length of the typical bull period since World War II. And it's showing signs of age. Fewer stocks are hitting new highs compared with a couple of years ago. Meanwhile, market breadth--advancing stocks minus declining stocks--has been waning. "There's been a big deterioration in a number of internal measures," says Arbeter. "That's typical in the later stages of a cyclical bull market."

Finally, technical analysts point to a potential warning sign in the CBOE volatility index, or VIX, which measures the market's expectations of near-term volatility conveyed by S&P 500 stock index option prices. When investors are scared, the index soars; when they're optimistic, it tumbles. At its recent reading of 11, the VIX has fallen to a level rarely seen in its 13-year history. And that's a big red flag to technicians. The VIX is virtually certain to return to a normal level soon, they say. And an uptick in the VIX has often coincided with a sharp market drop.

One big question: What will trigger the selloff? The technicians admit they don't know. Acampora says it could be a spike in interest rates. Or a geopolitical event like "this nuclear thing" with Iran. But his best guess is it will be something that hasn't registered on the radar screen yet. "I really think it could be like 1998, when the catalyst came out of left field," he says. "Back then, it was the Russian bond problem and Long-Term Capital."

Acampora says his long-term outlook is still bullish. In fact, his advice to investors is to get ready for a major buying opportunity. "If we are correct, this selloff will set the stage for a major market bottom--a classic four-year low," he says. "Then, I think, the market has a gangbuster move going into the latter part of 2006, all of 2007, and probably 2008."

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