Prince Of Tides: A Longtime Market Observer Charts

(From BARRON'S)

An Interview With Walter Deemer

It is his custom to blush, not boast. And he is as preoccupied with the health
of his orange and grapefruit trees as he is with the state of the stock market.
A sensitive man, indeed, is Walter Deemer. For 40-some odd years, this master of
the delicate art of studying stock-market cycles has applied himself with
singular devotion to understanding the secrets contained in such things as
Fidelity sector funds, the relative-strength of various industry sectors as well
as the habits of a certain species of speculator all in pursuit of the best
possible strategies to position institutional portfolios. Deemer is now
following his lifelong pursuit from his riverfront home in Port St. Lucie, Fla.,
where he is his own boss at DTR Inc., sending his daily updates and special
memorandums via e-mail to fans made loyal by his ability to get them in and out
of the market at critical market junctures.
It is a talent he has demonstrated year after year and decade after decade
from the time he was an apprentice to Bob Farrell at Merrill Lynch in the early
Sixties, through his time with Gerry Tsai at the Manhattan Fund in the late
Sixties, through his tenure as head of market analysis at Putnam Investments
during its heyday in the Seventies. For his sense of things now, please be our
guest.
-- Sandra Ward

Barron's: Do you still think the market is in a topping out process?
Deemer: It is. The market went sideways during most of last year and I didn't
think it was strong enough to make the traditional second leg of a bull market
given the unpleasantness of 2001 and 2002. But it was and it staged a rather
broad advance during the fourth quarter. Yet second legs are not as strong as
first legs and they can end more suddenly. Whatever started back in August is
now topping out.

Q: What was behind the second wind?
A: I don't know. Pent-up frustrations? But it was a broad enough advance that
it has to be called a second stage of the cyclical bull market rather than some
lesser rally. There were a lot of areas in the market that hit new highs at the
end of the year. Usually bull markets have a second leg up in which they go to
new highs, though not significantly above the old high. Now the rally seems to
be fizzling and we are in a short-term or intermediate-term topping process,
which by definition has long-term implications.

Q: What are those long-term implications?
A: The cyclical bull market began in October 2002 as the market made a
four-year cycle low. All other things being equal, we are looking at a probable
four-year cycle low in late 2006. Therefore, the high will be somewhere between
the two lows and since we are now more than halfway between the two lows, time
would appear to be running out of the cyclical bull market. A cyclical bull
market, which is a bull market that takes place within a four-year cycle, by
definition is followed by a cyclical bear market. The next act on the stage will
be a cyclical bear market between now and the end of 2006. One of the lessons of
Stan Berge, a market analyst who worked for Tucker Anthony and one of the
foremost institutional technicians in the Sixties and Seventies, was that every
cyclical bear market ends by going below the first intermediate low of the
preceding bull market. The first intermediate low in this cyclical bull market
was in the middle of last year and so the assumption is that the market
averages, sometime between now and the end of 2006, will end up below their lows
of last year. That would mean the S&P 500 goes below 1060 and the Nasdaq
composite goes below 1750.
That's the risk in the market. The problem with more precisely pinpointing a
market top is that at tops, various group and sector performance is spread out
all over the place and top out one by one. Market bottoms usually are made when
all groups bottom at about the same time.

Q: Many groups have been toppling.
A: Right. This current advance is a lot narrower than the advance last year.
Only four of the nine S&P 500 supercomposite SPDRs (S&P Depositary Receipts)
have gone above their December highs at this point, whereas last year just about
everything was going up. The four that have gone up are energy, materials, which
includes metals, utilities and consumer staples. Energy, which is going bananas
these days, is typically the last sector of all to move during a typical
cyclical bull market. When you see strength in energy stocks it is a sign that
you are getting pretty close to the rear of the parade.

Q: Before that happens, do we have to see staples, utilities, and materials go
by the wayside first?
A: Not those so much as the ones that aren't participating in the rally. The
weakest sector is technology. Another one that appears to be turning weaker and
weaker is consumer discretionary, which includes retail and media stocks.
They're peeling off one by one and it leads to the realization that the market
itself is topping out.

Q: Were you surprised by the February advance?
A: No. The January decline was so pervasive and happened, of course, as
everybody was saying, according to the calendar, the market should go up. Also,
the advance in the fourth quarter was so strong and so powerful that it would
have been surprising to see the strength dissipate literally overnight as it did
between New Year's Eve and the first day of trading this year. The market is
still in the process of ending the fourth quarter rally rather than having an
abrupt reversal, although bottoms very often reverse abruptly while tops are
very drawn out affairs and take a while to unfold. The market will have to break
the January 24th lows, 1163.75 in the S&P 500 and 2008.68 in the Nasdaq
Composite, to indicate the decline that began at the beginning of the year has
resumed. If that is the case, the Nasdaq 100, given its recent relative
weakness, is likely to be the first index to break its January 24 low. And if
the Nasdaq futures break their January 24 low of 1484, it will almost certainly
foreshadow a similar break in the rest of the market.

Q: What about the notion that as goes January so goes the rest of the year?
A: I have never put a lot of stock in those kinds of things, because I've been
afraid someday I would come into work and find I'd been replaced by a calendar.
Calendar patterns don't provide much of a sample. For example, if you say that
as January goes so goes the next 11 months, the same thing goes for every other
month, you'll find. In other words, as February goes so goes the next 11 months,
as March goes, so will the next 11 months.

Q: What do you make of the heavy margin account buying that's been going on
and which you've been noting in your daily updates?
A: From a sentiment basis I've always been interested in what people are
actually doing rather than what they are saying on the premise that talk is
cheap. As a market analyst, I'm interested in margin accounts because they
represent a class of investors that is usually wrong at a turning point. In the
old days we would call them boardroom speculators or boardroom traders and they were very often guided by their brokers' recommendations. It turns out by measuring margin accounts, you are measuring what speculators are doing and what brokers are doing. Because their fate is tied so much to the tape, brokers turn
out to be very depressed at the bottom and very euphoric at the top. At the top,
they think the extraordinarily high bonus they got last year is going to be the
same bonus they'll get for the next five years. At the bottom, one broker says
to the other `Well, the market has gone down so much I've just put out a goodbye
list. The second broker says, "What's on your good buy list?" The first broker
says: `Goodbye car, goodbye country club, goodbye vacation' and so forth. At any
rate, according to a major wire house's sampling, margin traders have been
unusually heavy buyers of late. They have been unusually heavy buyers for 11 of
the last 16 days and the last five days in a row. I checked with the person who
puts the numbers together and asked whether there was anything that might be
making the numbers suspect. He said no and so the message apparently is a real
message: Margin traders are unusually bullish on the stock market. From a
sentiment standpoint this is a fairly large negative.

Q: You have been tracking these numbers for 40 years, haven't you?
A: Yes.

Q: And you have never seen such steady, heavy buying?
A: I can't remember a stretch that has been this heavy for this long. But
remember, after 40 years the memory is the second thing to go. I forget what the
first thing is. It would not be unusual to get clusters of two or maybe three
days of heavy buying but without this kind of consistency: 11 of 16 days of
unusually heavy buying and buying on the order of 2 or 2 1/2 to 1, which is
extremely heavy. Usually buying will exceed selling by 30% or 40% on a big day.
I probably haven't mentioned margin account activity in 10 years. Basically, it
was not deviating from the norm and now all of a sudden it has deviated from the
norm.

Q: So this suggests the market tops out sooner rather than later?
A: That's hard to say. Having had a very strong advance in the fourth quarter
of last year and having had a surprisingly strong decline in January, we are
betwixt and between. Since the bull market is more than half way through the
four-year cycle, any short-term decline could end up having longer-term
implications. You never really know whether a short-term decline is going to end
up being the start of a bear market or not until afterwards. The risk however,
is that any decline at this point could be the start of the next cyclical bear
market.

Q: What is activity in the Rydex funds pointing to these days?
A: The Rydex fund activity is somewhat inconclusive. The Rydex numbers
deviated from the norm at the end of December when there was an unusually low
amount of dollars in the bearish funds, giving out a negative signal because
assets in Rydex's bearish funds tend to be unusually low at a top. Now the asset
levels are more or less normal and so we consider it a neutral signal. We don't
try to force indicators to say something all the time. We just were looking for
something unusual and whenever there is something unusual we factor that in with
all the other unusual readings and come up with a market judgment.

Q: Is it time to sell energy stocks then?
A: Anything that goes up about 18% in a month and a half by definition is
overextended. It's an unsustainable rate of gain, which doesn't mean you sell
it, but just realize it is due for correction. Longer term it doesn't look like
they've made a top. Historically, you don't have a problem until they become
overweighted and that may take quite a while. Think back, for example, to how
overweighted technology stocks were in 2000 and compare that with the
underweighting in energy stocks today.

Q: What about financial stocks?
A: As energy stocks are traditionally the last sector to move during a bull
market cycle, the financial stocks are usually one of the first. If you consider
their historic overweighting and couple that with their role as one of the early
groups to top out, it would suggest financial stocks are vulnerable. Maybe some
of the money that will go into energy stocks, which are underweighted, will come
from financial stocks, which are overweighted. So far, financial stocks haven't
really done a whole lot wrong yet on a technical basis, but from an anticipatory
basis one would expect them to have trouble long before energy stocks.

Q: People have been waiting for financials to crack for a long while.
A: Nothing has really cracked except for the poor old technology stocks.
That's the one area in the market that has got secular problems.

Q: What do you expect from small caps?
A: Small-cap and mid-cap stocks were the backbone of the bull market
leadership and, as such, they ought to stay strong until the cyclical bull
market itself comes to a grinding halt. Their strength is just confirmation that
the cyclical bull market isn't ready to roll over and play dead just yet.

Q: Yet you have suggested investors should focus more on the small-cap value
side of the equation?
A: As the bull market ages, history suggests there will more of a move into
value stocks than into growth stocks. From an anticipatory standpoint one should
be buying value rather than growth stocks at this point. So far, growth stocks
are still doing a little better than value stocks, but in the next six to 12
months it will be value that starts to do better than growth.

Q: How should people position their portfolios for a coming bear market?
A: One of the old sayings on Wall Street is when they back the wagon up to the
speakeasy door, they'll take all the girls and the piano player, too. In other
words, in a real bear market there is no place to hide. One of the key things a
market analyst does is look for relative strength during declines, because that
usually tips off where the strength is going to be and where the leadership is
going to be during the next advance. The relative strength in mid- and small-
caps during the decline elsewhere in the market was the big indication they were
going to be the leadership in the next bull market. The question now is what's
going to show relative strength during the next bear market and therefore be the
leadership during the next bull market. If I had to guess, I would say
health-care stocks because they are so down and out.

Q: But you are not seeing any evidence of that yet?
A: Not yet, because the market isn't in a downtrend yet. You've got sectors
going from strong to weak, but not anything going from weak to strong, which is
what you are looking for.

Q: Walter, your view on Japan is hugely contrarian.
A: Most of the global markets at this point are in cyclical bull markets. The
major European markets are all above their December highs, unlike our market,
and the emerging markets are above their December highs as well. They've all had
very good runs from the 2002 and 2003 lows. The exception is Japan. Japan has
been marching to the beat of a different drummer ever since the 1989 high when
the Nikkei was near 40,000. The world enjoyed a huge bull market during the
1990s, and Japan did not participate whatsoever. Since that time, Japan has been
going down and the Nikkei has been trying to base, or establish a solid bottom,
and this time it looks like it is going to be successful. The Nikkei, which is
around 11,500, needs to get to about 12,200 to complete a 3 1/2-year base. If it
does, then it will have reversed its secular downtrend, which is now 15 years
old, and will embark on a new secular uptrend. The fact that Japan was
disconnected from the rest of the global markets during the 1990s makes me
believe there can be a bull market in Japan without a bull market necessarily
anywhere else in the world. It seems like a pretty good bet from a risk-reward
basis. In overseas markets I have favored emerging markets over anything else.
And now I am anticipating Japan starting to do well. The question is, if Japan
starts doing well, does it do well because of the leadership of the emerging
markets, many of which are in the Pacific Rim, or does it do well because
leadership has shifted from emerging markets, which have done so well for so
long, to Japan. In other words, does Japan start going up because the strength
in emerging markets is generating the leadership needed to pull the laggard area
of the global market up, or does the Japanese market go up because strength has
rotated from the strong areas of the globe into the weaker areas of the globe?

Q: Explain your work on Fidelity sector funds? What do you gain from tracking
the percentage of funds outperforming cash?
A: The Fidelity sector fund work is something we started in the 1980s. These
are actively managed portfolios. In analyzing the Fidelity sector funds, you are
analyzing the best-perceived energy stocks versus the best-perceived technology
stocks versus the best-perceived pharmaceutical stocks and so on. You're not
taking an old-cast-in-stone group that hasn't been changed for a while like our
friends at Standard & Poor's have in the S&P 500. What you are doing is taking a
portfolio that can literally be changed anytime. These portfolios run full
throttle at all times. Fidelity does not really care whether their funds do well
or not. They figure that with their 41 sector funds at least one of them will do
well and it is the investor's job to find which one. What Fidelity is absolutely
petrified of is if energy stocks do well and their energy fund doesn't do well.
We follow the funds on a relative strength basis as we follow the various groups
and sectors in the market. From that standpoint, the more sector funds
outperforming cash, the better the market. What that tracks is oversold and
overbought positions in the market as well as group strength and group weakness
and breadth and narrowness in the market. But you are doing it with actively
managed portfolios as opposed to passively managed groups.

Q: What clues are the sector funds providing now?
A: Based on a 16-week rate of change, 78% of the funds are outperforming cash.
Typically, there isn't a problem with the market until that number drops below
66%. The number has been above 66% consistently since the beginning of October.
If we were in a broadly based bear market there would be zero funds
outperforming cash and therefore we would be forced into a cash position. As it
turned out, this is exactly what happened the week before the crash of 1987. If
nothing is able to outperform cash, it tells you something. If you get defensive
areas that are outperforming cash, it tells you something and it tells you where
the leadership is.

Q: Thank you, Walter.
---