Prepared by

Dohmen Capital Research Institute, Inc.

At this writing, the Dow Jones Industrials had a 10% correction from the August 7 top, which was the time I recommended selling and selling short. During August and September, the index reached the 7600 area three times, and each time rallied up from that. The last time, it penetrated that level on an intra-day basis, but then rallied back strongly the next day. So far, it looks like that was the low for the correction.

However, the Dow Industrials is not the market. The NASDAQ Composite is a much broader index, although it is also dominated by a number of the big-cap stocks, such as Intel and Microsoft. But the index has been making new record highs since September. The Value Line Index, which represents about 1,600 stocks, has performed similarly to the NASDAQ Composite. It's also been making new record highs.

And the Dow Jones Transports skyrocketed upward during September, with huge gains almost every day.

All of the evidence suggests strongly that the Dow Industrials is the lagging index, and that everything else is still in a super bull market mode.

The evidence suggests that a good bottom in the correction was seen, and that once again it was confined to 10%.

The correction this August was only 10% and lasted only several weeks. Was that sufficient to completely rebuild the “wall of worry” that a bull market requires? We should stay on guard for a possible surprise.

The bears point out that the chart of the Dow Industrials now is similar to that seen in the August-September period of 1987. Then, it had what looked like a “W” bottom, with a market rising nicely in September. In fact, just about every one of the major newsletters in late September 1987 was very bullish on the stock market. (Of course, after the crash, they all claimed to have been out of the market.)

Now we have such a “W” bottom, which usually is bullish. But when it aborts, and the market suddenly starts downward, one must get out without hesitation. An aborted “W” formation is very bearish. We will stay alert.

One bullish indicator is the advance/decline line. In September it made a new high, above the high in early August, while the Dow Industrials are still a distance away from their old high. It shows that the majority of stocks are doing very nicely.

You've heard that the small-caps stocks are now outperforming the big caps. Here is a composite chart that compares the relative performance of the S&P 500, which represents the big caps, to the Value Line Index, which represents the small- to mid-cap stocks. Note that, since May of 1996, the big caps were substantially stronger than the small caps. But that changed in July as this chart suddenly declined. It penetrated the trading channel indicated here, which suggests that this may have been an important trend change.

I drew another parallel channel line, equidistant from the other channel, which may represent the new trading channel for this composite. If that's so, then we could see a short period of the big caps doing relatively better again, but only for a temporary move. The last period of outperformance for the small caps in 1996 lasted five months. If this one lasts the same amount of time, and not longer, the small caps should start underperforming again in late December.

The stock market has been extremely volatile this year. According to Bear Stearns, this year 70% of the trading sessions featured moves of more than 1% swings in the Dow. How does this compare with other years? This bar chart shows it. It's the highest since 1987.

Last year, only 38% of the trading days had daily moves of 1% or more in the Dow. In fact, this chart shows that the highest peaks in volatility came in 1987 and 1990. Both were important years for the market. In 1990, a bear market started, coinciding with the Iraqi invasion of Kuwait.

Thus, you have another potential warning signal, which hopefully dampens some of the enthusiasm.

Conclusion: I've been bullish for well over two years now. We've caught the big moves and have participated very nicely. But somehow, I don't feel comfortable with the correction in August, namely that this should be all there is. Stay invested, but cautious.

Enthusiasm is still too high, cash levels at mutual funds are still too low, valuation levels of the big-cap stocks are still much too high, especially in light of what should be continued disappointments in earnings. A bigger readjustment in the market would be very healthy and eventually will be very necessary. But it would primarily affect the big company stocks.

Long term, the one thing in favor of the stock market is what I believe will be a substantial decline in long-term interest rates. Possibly this is what the market is looking at. A 10% decline in rates could justify a 10% rise in P/E ratios.

As you know, I've been very bullish on the real estate market for the past two years. Basically, nothing has been built, while the economy continues to improve. More people can afford new houses, and new business formations require new offices.

Real estate genius Sam Zell controls the largest residential apartment REIT, Equity Residential Property Trust. It's on an acquisition spree and is becoming a giant.

Zell started a new REIT two months ago, Equity Office REIT, which has increased about 60% in price since that time. It is also on a major acquisition spree. It just bought Beacon properties, a multibillion dollar deal. I heard Zell on Moneyline recently. His comments were very similar to mine about the securitization of real estate. Triple A office buildings, which had vacancies of 20% or more in the major cities, now are suddenly seeing shortages. Nothing is being built. He said “The construction crane is an endangered species.”

When buildings are filled up, the landlord has pricing power. That's something they haven't had for seven years. Once rents go up, the implied value of the property increases proportionately. Opportunities for major profits exist immediately ahead.

In a single-family home area I see a similar bullish situation. Inventories of single-family homes are now at low levels normally seen only at the bottoms of recessions. If mortgage rates decline below the 7% level, many new potential buyers can suddenly afford the purchase of a new home.

The available inventory of homes will be gobbled up very quickly. Home builders will have to work very hard in order to replenish supply. The stocks of home- building companies will soar. On a valuation basis, the P/E ratios of home builders currently are very low compared to that of the S&P 500.

Here are a few home builders you could look at: CEN-TEX (CXP), Continental Homes (CO-N), Toll Brothers, (TOL), and U.S. Home (UH).

In case of any sharp downturn in the U.S. stock market, I believe that real estate related companies will fare much better. Should we see a 20% decline in the Dow, we might only see a 5%-10% in REITs. REITs are yielding as much as 6%-8%, much of the yield being tax advantaged, as it is a return of capital. From a risk versus reward point of view, I don't think you could find a much better investment than REITs at the present time. Two I like are Equity Residential (EQR) and Equity Office (EOP).

Germany (DAX Index) is a good representative market for Europe. The chart shows the approximately 15% decline of this index during the correction. The MACD indicator below suggests a bottom was made. The indicator has not yet crossed over to give an official buy signal. If the DAX can close convincingly above the 4100 level, I could be made a believer.

The Madrid stock market has had a sideways consolidation since early July. But a nice bottom that has formed at the 580 area and there is newfound strength lately. The MACD indicator below shows a beautiful new buy signal on this market.

The Japan Nikkei Index plunged right after my sell signal on July 25, but is now giving signals that a bottom, at least a temporary one, may have been reached.

Note that the 17,500 area represents excellent support going back to the April low and the January low of this year. The MACD indicator below has given a positive divergence, by making a higher low recently, while the index went to a new low. That is potentially bullish.

Conclusion: Although for now, at least, the worst seems behind us in the international markets, I still believe that the Asian currency problems present a danger for all the emerging markets, especially South America. I don't trust the Latin America markets at this time and believe that Brazil is especially vulnerable. A 25% devaluation of the Brazilian currency would present a shock to stock market investors. Therefore, I suggest staying with U.S. investments, as they present the best risk versus reward ratio. Avoid Asia and Latin America.

The most important bond market for us is the U.S. long-term T-bonds. This chart is of yields. Note that the scale on the right hand side should have a decimal point. For example, 64 is 6.4%. Note how the downtrend line stopped the rise in yields in early September. Then there was a sudden sharp drop in yields, as the CPI showed a continued, very low inflation.

The MACD indicator below is on a sell signal, which strongly suggests lower yields. 6.3% is support, but once penetrated, yields could quickly be down to the 6% level.

Going to Europe, we can see the British Gilts, which are long-term government bonds. Note the very strong rise recently, as well as the continuous strong performance of the MACD indicator below. This is a very important bond market in Europe, and suggests that long-term bond yields over there are declining as well.

And finally, here's the J.R Morgan Index of the emerging markets bonds. This has been my favorite bond market, and the best performing one. Look at the extraordinary performance over the past two years. The trading channel has been well maintained and right now the chart is in the middle of the band.

Conclusion: Evidence and analysis strongly suggest that long-term bond yields are on their way down. In my opinion, bond yields worldwide are much too high, given the weak economies and the extremely low rates of inflation.

On September 19, we went back to a 100% fully invested position, although in our Smart- Fax service we had been reading off the many bullish indicators for several weeks. But for a monthly newsletter, it's nice to have more confirmations.

The bond market has had a very strong upmove, which to me signals that the long-term trend in interest rates is still downward. In fact, over the next 12- to 24-months, bonds, especially zero coupon T-bonds, which I recommended in our August issue, will probably be the best investment from the risk versus reward standpoint. It has just been revealed that Warren Buffet bought over $10 billion worth of zero coupon T-bonds. I don't know if he's a subscriber to our service, but it's comforting to know that he has a similar view on bonds as I do.

Long-term T-bond yields are now in a 63% area, down from 67% just a month ago, at the time of our last issue. The Dow Industrials had a 10% correction and the 7600 support area was tested three times. The third time it held, which is normally the time that a chart breaks through. The fact that it did hold now suggests that a good bottom is in place. Of course, the small- and mid-cap indices have been much stronger and have been making new record highs for several weeks. That's where the action is right now. That is right in line with my forecasts over the last two months.

I would be careful with international investments, especially avoiding Asia. Latin America will be the next time bomb, and Europe looks good now, but is also more vulnerable. If I had to have some international exposure, it would only be in Europe.

October, 1997Bert Dohmen

Dohmen Capital Research Institute, Inc.

A Division of Dohmen Capital Group

66 Queen Street, Suite 3801, Honolulu, Hawaii

Consensus National Futures and Financial On Line Index

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