Heading into the final weeks of 2005, at least three investment managers have predicted either a full-blown bear stock market ahead or are pessimistic about the economic outlook going forward.

Are we heading into a roller coaster ride for the economy and an even more turbulent ride for the stock market that could rival the most recent bear market that mauled investors from 2000 to 2002? Let's just say that this trio of managers is recommending that seat belts be securely fastened and motion sickness-fighting Dramamine be close at hand.

"The next several months look very dangerous for us, and our indicators are very, very negative now, by a two-to-one margin, for the market," said Barry James, president of the James Advantage Funds, which are managed by James Investment Research of Xenia, Ohio.

Although James said that for the short-term, his firm's indicators had turned mildly positive, the firm began predicting the resumption of a bear market late this past August, even before the late summer's hurricanes had shown their full raw fury. The firm has relied on the indicators that it reviews weekly for the past 32 years. While not every indicator is negative, his firm tends to base predictions on the majority of evidence, James said.

"The summer rally is ending, and the bear market in stocks is due to resume," the firm predicted in a recent commentary to its investors. Although November, December and January have historically been the best three months of the year, this year will go against that tide, James said in an interview.

A confluence of factors have weighed into that prediction. The Federal Reserve has been raising interest rates, increasing the cost of borrowing money, James said. Moreover, while we are seeing a drop in oil prices from their post-hurricane highs largely because demand is dropping, overall oil prices are still higher than they were nine months ago. Robust oil prices could negatively affect consumers, whose confidence is already low, and cause them to curtail spending in recognition of the fact that they are "living on the edge," James noted.

"Higher energy costs are absorbing some discretionary purchasing power," James Investment Research noted in its investor commentary.

In addition to climbing interest rates, the M1, which is a measure of the country's money supply, is now negative, down sharply from the 6% rate of growth one year ago, before the elections of November 2004.

James noted that his firm also tracks technical indicators, including the relative movements between the Nasdaq and New York Stock Exchange stock markets to see the number of new highs and new lows among stocks. "We had been seeing lots of new highs, but are now seeing fewer new highs and lots of new lows," he said.

There has also been a reduction in corporate earnings levels, James noted. Where many companies had been posting 20% earning increases, that has now leveled off to an average 14% earnings boost. "The E' in P/E is lower now," James said. In addition, cash flow from operations for many companies is half as good as one year ago.

The bottom line? "After two good years, we could see a 20% hiccup here from our recent highs," James said. His firm is currently promoting its balanced fund, the James Golden Rainbow Fund, which has lowered its equity portion and is focusing more on large-cap stocks, and its James Market Neutral Fund, which has both long and short positions to hedge market direction.

Wild Ride'

"This has been one of the most challenging years in the markets," conceded Jeff Malliet, founder and principal of Noble Asset Management of Chicago. "Many macro themes are converging, making investing in the domestic markets a wild ride," he added speaking at a recent media teleconference. "Since then, not much has changed," said Malliet in an interview last week.

Malliet is largely credited as being the father of the syndicated bank loan product and creator of floating rate mutual funds, having purchased the very first bank loan to come to market several years ago. His firm now manages a long-short, multi-strategy hedge fund.

Malliet noted that he is somewhat optimistic and bullish about certain sectors of the market. But he is also very concerned about the economy; the effects of Hurricane Katrina, which has impacted oil production and pumped up oil prices; and the continued tightening by the Fed, which has been raising interest rates since July 2004.

"The nonsensical continuation of the Fed's misapplication of raising interest rates has stifled some industries," he said. "The Fed has overstepped its bounds. The Federal Funds' rate should be at 5-1/2%, one- to one-and-a-half points over GDP growth, which is at 4%," he said. "The Fed, jacking up interest rates, continues to hurt. The Fed is doing everything it can to obliterate the economy."

Malliet thinks Federal Reserve Chairman nominee Ben Bernanke was one of the best choices to appease the market, but one of the worst choices going forward because, Malliet said, Bernanke is more than likely going to continue raising interest rates. "I pray he will take a different tack, but it doesn't appear so. I don't know how long the romance and honeymoon with Wall Street can last," he said.

General Motors may be Bernanke's first real test, especially if GM files for Chapter 11 bankruptcy protection, as rumors have predicted in spite of last week's announcement it will cut 30,000 jobs to save $7 billion, he said. In fact, the combined debt of $500 billion, between both GM and Ford, is "tantamount to a debacle" and has all but destroyed the automotive sector, Malliet said. Adding to that is that higher interest rates have impacted the auto market and the overall transportation sector, including airlines.

As for the stock market, "I think we're in for a lot more volatility," Malliet predicted. "If we see a year-end rally, and I am skeptical about that, then we'll see a change in the first and second quarters of 2006. By about Jan. 10, we could be looking at a bear market," Malliet predicted.

Eying the Yield Curve

The one critical indicator of what lies ahead may be the yield curve, which right now is flat, according to John Lekas, founder of Leader Capital Management of Portland, Ore., and manager of the recently launched Leader Short-Term Bond Fund. The yield curve shows current rates of short-, medium- and long-term bonds and their correlation to each other, as expressed as a curve. Back in April, Lekas predicted that the yield curve would invert, but that hasn't happened - yet, he cautioned.

"Inverted yield curves lead to an economic recession 100% of the time," he explained. And if the yield curve does invert, you can expect costs to go up as the economy slows. "If the yield curve inverts, the question will be, How bad does it get?'" Lekas said.

The last time the yield curve inverted was in 2000, he added, but at that time the Fed started lowering interest rates.

"We think a recession is part of the normal cycle; to get things buttoned up," Lekas said. "It's a necessary cycle to get things in order."

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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