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The Market's Bad Breadth

Market technician James Stack forecast the stock selloff based on its breadth -- the large number of stocks falling even as the market was setting record highs. He thinks we're in for a "garden-variety" bear market.

The stock market clearly telegraphed its ensuing decline just as it was peaking the week of July 16-20, says market technician James Stack. Even as the market was setting records on three of four days, more stocks declined than advanced on those days.

Why should that matter? Stack, president of InvesTech Research, a market research firm in Whitefish, Mont., says the market's breadth -- that is, the number of stocks rising relative to the number falling -- is crucial to diagnosing the market's health. More decliners than advancers was one sign of bad breadth, he says. Another was that stocks of large companies were rising while stocks of smaller companies were falling. A third: Within five days after the market hit its peak, on July 19, more than 20% of stocks hit new 52-week lows.

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That was enough for Stack to sound the alarm. "Bear Market Warning Flags!" his firm's newsletter, InvesTech Research Market Analyst, trumpeted on July 27 even as Standard & Poor's 500-stock index was within shouting distance of its all-time high. "We are moving to a full bear-market defensive mode."

Technical analysts, those who study the market's action rather than the fundamentals of stocks and the economy, don't get a lot of respect on Wall Street these days. But Stack, 55, is a first-class thinker who offers fascinating insights on the market's dynamics.

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But I wouldn't make any drastic moves on the basis of Stack's forecast. Technicians tend to be more bearish than the rest of us -- probably because they're almost never buy-and-hold investors.

Stack says breadth is the most accurate gauge of the market's psychology -- that is, whether investors are brimming with confidence or riven with fear. When investors are optimistic, they'll take chances on a large number of stocks, including stocks of midsize and small companies. As they lose confidence, they flee to a handful of presumably safer blue chips.

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"Market historians call the stock market the ultimate composite of investor hopes and fears," Stack says. So when breadth turns bad, it means investors are getting nervous. And market psychology, he contends, steers the stock market -- not such fundamental factors as earnings or revenues.

So where do we go from here? Stack thinks a bear market is under way. "It most likely will be a garden-variety bear market, with a 25% to 30% decline. We'll also probably have a recession." While the market's valuation gives no clue about when a bear market might begin, it does provide some guidance on the potential severity of a decline. The S&P 500 currently trades at about 16 times the past 12 months' earnings -- right at the historical long-term average. That suggests that any bear-market drop would be average rather than cataclysmic. Stocks of smaller companies, which are more richly priced, could experience a larger decline.

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How long will stocks fall? Since 1929, bear markets have averaged 18 months. Excluding the bear market that coincided with the Great Depression, it has taken the market an average of 3.3 years from its peak to make new highs. And stocks have lost an average of 38% in bear markets -- but that figure includes the big bear markets of 1929-1932, 1973-1974 and 2000-2002.

I didn't see the current decline coming -- and let's not forget that we're nowhere near bear market territory yet -- although I was concerned about the large volume of low-quality mortgages. I don't have a strong opinion about how far the market will fall -- although the selloff feels like one of those sharp declines that last only a few months. But Stack's analysis, as well as Steve Leuthold's (see Time to Sell Stocks?), shouldn't be taken lightly.

Nevertheless, I'm not selling. What I have done -- and what Stack and I agree on -- is that this is a time to invest mostly in large, growing companies or funds that specialize in them. This is no time to be a hero and plunge into shares of, say, homebuilders or other highly cyclical stocks. "Focus on established companies that have proven revenue and earnings track records," Stack advises. He also likes energy stocks, which I also favor.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.

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