Future prophets: investment gurus are predicting a market downturn - and they've always been right before.

Investment gurus are predicting a market downturn -- and they've always been right before.

THE investment-newsletter industry is a peculiarly objective source of political and economic insight during presidential-election years. This is because newsletter editors are predominantly libertarian. (In fact, if there were a consensus favorite among newsletter editors it would be the Libertarian Party's candidate, Harry Browne, who himself is an investment-newsletter editor.) When newsletter editors engage in economic forecasting, we can trust that they are not letting partisanship influence their analysis. Therefore, it should be taken very seriously that the top-performing letters in my Hulbert Financial Digest monitoring service are cautious on the stock market's prospects, if not outright bearish.

Before reviewing the forecasts of these top performers, however, I must first dispense with a theory that is resurrected every four years about this time: the Presidential Election Year Cycle, which holds that stocks will rise and interest rates will fall up through the election. On its face this appears plausible: after all, the incumbent party does try everything in its power to make things look rosy on election day.

However, there is a problem with this theory's basis in historical evidence. As Martin Zweig, editor of Zweig Forecast, wrote: "I'm not sure the long-ago results are so relevant. Before World War II the government was less likely to make the economically stimulative moves it now routinely does to get re-elected." And once we focus on only those elections since World War II, the Cycle all but evaporates. So don't let the Presidential Election Year Cycle lead you to dismiss the best-performing newsletters' caution.

In choosing which newsletters to survey for this article, I focused on those which had been tracked by the Hulbert Financial Digest over the entire 16 years it has been monitoring the industry. Such a focus is especially important right now, since we are in an historically unique period in which bear markets are almost extinct.

However, to state what should be obvious but often isn't in today's Wall Street, a bear market will happen some day. This is why I insist on focusing on those advisors who have proved themselves over long enough periods of time to include a bear market.

I imposed one other criterion on the newsletters: I ranked them on a risk-adjusted basis. Why? Because advisors who lag the market by a wide margin on a risk-adjusted basis are good bets to be big losers in a bear market. Imagine an advisor who incurred twice the market's risk in the process of beating the market only slightly. He will do well only so long as the risk doesn't come to pass.

There are three newsletters that made the cut. The first is the Value Line Investment Survey. This service is best known for its stock-ranking system, which divides 1,700 stocks into five groupings, from the 100 best bets for performance over the next six to twelve months to the 100 worst bets. But Value Line's analysts also project how much these 1,700 stocks will appreciate over the next three to five years. The median of these projections turns out to be well correlated with the market's level four years hence --with one qualification. Because Value Line's analysts (like almost all Wall Street analysts) are too bullish, the median of their projections must be adjusted downward. Value Line itself has found that an adjustment of 20 per cent is necessary; some academic studies place the figure as high as 70 per cent.

Right now, the median appreciation potential given by Value Line's analysts is 55 per cent. If we assume the average amount of adjustment, that means the stock market is projected to be only 10 per cent higher in the year 2000. On an annualized basis that is about 2 per cent per year -- less than you could get with a riskless money-market account.

The last time the median appreciation potential of Value Line's 1,700 stocks was that low was in the summer of 1987, four months prior to the Crash. Before that, we have to go all the way back to the late 1960s to find a lower reading. And that preceded the 1973 - 74 bear market, the worst since the Depression.

The second newsletter that meets my criteria is The Chartist, edited by Dan Sullivan. Sullivan is outright bearish, and currently allocates 80 per cent of his model portfolio to cash. To be sure, Sullivan has been bearish for two years, and is thus guilty of turning bearish too early. But it is testimony to his long-term record that he missed out on the market's 45 per cent gain over the last two years and still is ahead of the market cumulatively over the last 16 years.

In his most recent issue, Sullivan listed 24 major "telltale signs"

that a market top is imminent. One of those signs is speculative froth, shown by the torrid pace of initial public offerings and the aggressive purchase of call options on any dips. Another is the fact that even though mutual funds enjoyed record inflows of new money during 1996's first quarter, the market struggled to eke out a gain. Yet another is that Warren Buffett, perhaps the most successful investor alive today, has announced that he wouldn't invest in his own fund, Berkshire Hathaway.

The third-best newsletter for risk-adjusted performance over the last 16 years is Growth Stock Outlook, edited by Charles Allmon. Allmon has been bearish for even longer than Sullivan, so that his recent performance lags the market by a significant margin. But his long-term rank remains high.

Allmon is a devotee of fundamental analysis, which identifies undervalued companies by analyzing their balance sheets. This form of analysis was made famous forty years ago by Ben Graham. One factor that leads Allmon to be bearish: It now takes more than $45 to buy $1 of annual dividend payments. Never before in history has it taken this much. In fact, whenever it has cost more than $33 to buy a dollar's worth of dividends the market has been sharply lower within 12 months.

Another bearish factor for Allmon: the high ratio of the average stock's price to the book value of the underlying company. Right now that ratio is around 4 to 1, which is also historically unprecedented. As Allmon repeatedly points out, at the trough of almost every bear market in the past, the market has traded at one times book value. If that were to be the case in an upcoming bear market, the Dow Jones Index would go below 2,000.

During the rest of this year you'll no doubt be hearing forecasts that the U.S. financial markets have entered a "new era" in which the old indicators no longer apply. My advice: Don't fall for it. History teaches us that "new era" talk is resurrected at the same point of every market cycle -- in the latter stages of a bull market. The most famous example occurred when Professor Irving Fisher of Yale University proclaimed that stocks had reached "what looks like a permanently high plateau." That statement was made a few weeks before the Crash of 1929.