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The Dow deserves to be toast
Bernie Schaeffer makes case against headline index

By Thom Calandra, CBS.MarketWatch.com
Last Update: 11:57 AM ET Aug 29, 2002

SAN FRANCISCO (CBS.MW) - Years from now, when the carnage in stocks is over, a handful of U.S. researchers will get passing grades for sticking to their guns about the overpriced market.

Bernie Schaeffer belongs in that small group. Schaeffer's views at Schaeffer's Investment Research make him an easy target for the millions of Americans who are suffering deep portfolio losses in this, the third losing year for U.S. stocks.

"Pessimist, fear-monger, anti-American, I hear it all," Schaeffer told me over breakfast in San Francisco. "But in 1994 they were calling me Bernie the Bull on CNBC."

Back then, if Schaeffer had tried explaining the technical research that is his Cincinnati company's specialty, the general public's eyes would have glazed over. "Imagine my bringing up the VIX in 1995. No one knew about it or cared," Schaeffer said about the so-called fear indicator that measures stock market volatility (VIX) on the Chicago Board Options Exchange.

Schaeffer in person is just as direct as his regular written commentaries, which tell investors they are being way too forgiving of overvalued stock indexes. His main course these days is the Dow - 30 stocks that likely will become chopped liver when the stock market falls off its perch.

"I call the Dow the headline index," he says about the Dow Jones Industrial Average that is destined for toast. "It's what we see every day in the newspaper, have seen for decades. There still is nothing tremendously scary about a Dow number that starts with 8."

That's 8 as in 8,580, which is where the index was Thursday morning. Schaeffer's case against the Dow is practically airtight. Stock market believers had best stop reading now.

Schaeffer sees the Dow as a "stupid" product of a long-gone age, when a small group of industrial companies could somehow represent the entire American stock market.

The Dow is a price-weighted index, unlike other major gauges, such as the Standard & Poor's 500 Index. Essentially, that means that stocks with high dollar prices wield enormous influence. Right now, there is one stock that is holding up the Dow: the only one with a price above $100.

"The single most important stock is a company in Minnesota," Schaeffer says about 3M Co. (MMM). "It's an industrial company with what, a 30 P/E? If 3M stops levitating, just maybe people start getting scared."

Schaeffer calculates that 3M stock, not far from an all-time high of $130 or so, could wreck the Dow if investors end their love affair with the company's shares. If 3M shares were to return to their 1997-'98 lows, roughly half their current level, the Dow would get a 425-point haircut.

That's still not scary enough, says Schaeffer. He believes investors are still far too accepting of their portfolio losses since the Dow peak of January 2000. Schaeffer Investment Research relies heavily on "fear" indicators in options trading, such as the VIX and so-called put-call ratios.

"I get a chuckle about everyone getting so excited when the VIX made it to the 50s" in the July sell-off, he says. "They figured that was plenty scary, and a good sign that we had reached a bottom."

Nonsense. The VIX, a volatility index for the country's 100 hundred largest company stocks, was back-tested into the rough waters of 1987. In October of that year, during that horrible week of selling, the fear gauge hit 175. The indicator Thursday morning, as the Dow resumed its inevitable sell-off, was at 38.

"It gives you an idea of what true panic really is," says Schaeffer.

The New York University mathematics major puts a lot of faith in the idea of a full-scale retreat from stocks. In that regard, his expectation of a market washout, complete with tears, jangled nerves and tremendous point declines, is similar to those of several other pure technicians, including Paul Desmond at Lowry's Reports and his own senior quantitative analyst, Christopher Johnson in Cincinnati.

"I want to see three to six months of heavy mutual fund outflows, not this business of one month of sharp outflows," Schaeffer says, between bites of scrambled eggs and toast. "Look at it like this: The S&P 500 in this sell-off got cut in half. Nasdaq got cut in half twice. For that to happen to the Dow, it has to be at 5,875. It happened in 1973 to '76, so why not now?"

Schaeffer says the Dow's superior performance to the rest of the stock market - since the January 2000 Dow peak, the Dow is beating the S&P 500 by more than 15 percentage points - is "curious."

Does Schaeffer believe in market manipulation? "I'm not going to go as far as Bill Murphy and the gold folks about that subject," Schaeffer says, referring to the chairman of the Gold Anti-Trust Action Committee and a growing belief that commercial banks and governments work behind the scenes to inflate paper values and deflate hard assets, like gold. "But if you are going to manipulate an index, it would be the headline index."

Schaeffer sees gold - and gold mining stocks -- as investments that will fare well in what inevitably will be turmoil in coming months or years for the stock market. "Whether it's a panic or a grind-'em-down bear market, it's going lower," he says.

He recommends buying put options on the Diamonds (DIA), a trust security that trades like a stock and represents the Dow index. Put options increase in value as the underlying security, in this case the bloated Dow, declines.

Schaeffer's business in Cincinnati employs 60 people, thanks to a growing awareness of equity options among Main Street investors. The former insurance executive is quick to admit he makes mistakes.

"My biggest goof of late was being caught flat-footed by counter-trend rallies, in the 1994 and 1998 sell-offs, when I was a bull, and the September 2001 rally," he says. "Oh, and before I got it right, I got clobbered by airline puts."

In February and March, airline stocks soared, leading Wall Street to believe the worst was over for the battered industry. Schaeffer was amazed at the rally, but stuck to his guns - "I travel, and I know the airlines are in pain," he says.

Today, the airline stocks are, collectively, at half their highs from February. "What was with that rally? I want to know. Leave it to Wall Street to parse the travel figures and say, 'Oh, capacity was worse last month than it is now.'"

No wonder no one listens to Wall Street these days, Schaeffer says.

The veteran stock market researcher's views can be found online at SchaeffersInvestment.com.

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