Markets Hit Bottom: But Will It Last?

By Frank Barbera CMT. March 6, 2007

It has been a wild week in the financial markets, with the sub-prime panic, and Asian contagion sweeping global equities. On Tuesday, equities finally found traction with the S&P 500 closing higher by +21.29 to end at 1395.41, and the widely watched Dow Jones Industrials ending up 154.53 at 12,204.94. For at least the time being, the shelling has stopped. The question now becomes, what’s next?

Will the markets recover and go on to new all time highs? Is the Sub-Prime Mortgage debacle simply an overblown ‘small piece’ of bad credit that will now fade into credit market history as a bad idea where we collectively should have known better? And what about the global financial markets which were supposed to offer diversification in a downturn but actually fell harder and farther? Will they recover?

In our view, a classic trend change pattern is now unfolding before our very eyes. It is a pattern that all should pay heed to do because if I am right, it is leading us into the beginning of the next bear market. In truth, on a secular basis, the real bull market ended in 2000, and what we have seen since has been, and likely will be, a series of alternating cyclical bull and bear moves not unlike the 1970’s. You remember ‘That 70’s Show,’ don’t you? A long secular bull market lasting 24 years from 1942 to 1966 followed by 16 years of “giant sideways” activity, which for the Dow took the shape of a side swinging trading range between 1000 and 500?

On the very long-term trend of the stock market, the 1966 peak really exhausted the growth phase that had been intact for two decades. What followed was essentially one ongoing bear market that had alternating phases of smaller ‘bull and bear’ cycles. Sure the market managed to make token new all time highs in the Dow in 1968 and 1973, but did that really amount to much? In the ensuing bear markets of 1969-1970, 1973-1974, investor portfolios were decimated, with the gains of the cyclical bulls entirely and utterly gone. Could we be on the path to a repeat performance in the years ahead? Well, we certainly saw a sustained 25 year bull market from 1975 to 2000, and while the DJIA has recently gone to a nominal new all time high, most averages like the S&P and NASDAQ fell way short. There is an ugly divergence of sorts that hints at a larger stock market “turn.”

To be sure, the financial condition of the US economic system is today, the veritable house of cards. Did you see David Walker on 60 Minutes this weekend? The US Comptroller General is panicked about what he sees as a ‘bleak’ fiscal outlook ahead. The funny thing is, no one is arguing with him -- it is a case of the Emperor with no clothes. Everyone knows he is right, but no one wants to talk about it. In a report issued by the White House entitled “2005 Financial Report of the United States Government,” a report issued directly in front of the Christmas Holiday to assure less readership, it was revealed that the 2005 Deficit was really $760 Billion dollars, not $318.50 Billion as originally reported, that the deficit was not 2.6% of Gross Domestic Product as we were frequently told, but really 6.20% of GDP and growing rapidly. Worse, America’s debts and commitments total north of $50 Trillion dollars, not the $8 Trillion most frequently commented. In 2000, our total debts and commitments totaled $20 Trillion, and those have now more than doubled in the last five years. The 2003 Medicare Drug Bill all by itself added over 8 Trillion dollars in unfunded commitments to American taxpayers. Your share of the National Debt is already $375,000 dollars and has doubled in the last five years. It will soon double again, unless radical change comes to pass. Certainly, these numbers are chilling, and to his credit, Comptroller Walker is sounding the alarm in an attempt to give us all pause as we are running up the national credit card at an unprecedented rate.

In my view, the current real estate related slow-down has far reaching implications. Over the last few years, the real estate centric mechanism of construction workers, real estate agents, mortgage brokers, household improvement, building supplies, homebuilding has been THE primary driver for employment and by default, economic growth. Ex-this driver, which is now clearly rolling into an extended slow down, it is hard to see exactly where future growth engines will be found. CAPEX shows no signs of aggressive growth. Worse, with many consumers borrowing heavily against their homes in the last few years, and taking ownership via suspect mortgage finance, we have to wonder whether or not the financial system is only now seeing the proverbial ‘tip’ of the iceberg. When we look at the carnage in the sub-prime sector in names like Fremont General (FMT), New Century (NEW), Novastar (NFI), Accredited Home (LEND), Indymac (NDE), American Home Mortgage (AHM), American Capital (ACAS) we have to wonder whether or not the contagion will eventually spread -- will MGIC be affected, will Countrywide be affected? Where will it end? My suspicion remains that despite the likely strong rebound in equity markets in the weeks ahead, there will be more pain in these areas in the months ahead, and we have not seen the last of credit related bombshells for this cycle.

Above: the collapse of New Century Financial….. now facing criminal allegations.

Above: Accredited Home (LEND) in full blown decline.

Above: Novastar Financial — another waterfall collapse.
Above: the collapse of Fremont General

Above: Downside acceleration at IndyMac Corp.

Turning to the Equity Markets, it is clear that at last night's close the stock market, and indeed many markets, were pushing multi-year extremes in oversold activity. To suggest that a rally was overdue was to put things mildly. In the case of the Chinese stock market, which ignited the initial spark to this latest round of carry trade unwinding, a strong recovery rally is likely following the recent nearly 24% decline. From its high of $118.04 on January 3rd, the China 25 ETF plunged to a low yesterday of $89.80 under-cutting both the 50 and 100-day moving averages.

Yet, stepping away from the every short term technical damage, we note that this severe setback took place against the larger backdrop of a rising 100-day moving average which closed last night at $97.98. Typically, this type of sharp decline set against the backdrop of a rising medium term moving average is a strong warning of a trend reversal, but only a part in the process of the trend reversal itself. Put another way, tops involve lots of volatility, and they take a lot of time to construct. In the case of the Chinese ETF (FXI), and indeed, the Shanghai Market, odds are high that a recovery rally will closely approach the former highs in coming weeks. For the China 25 ETF, a .618 fibonacci retracement of the most recent decline would target prices back up to the $107 to $109 area, a 10% gain from current levels near $96.75. Assuming the prices ‘bee-line’ toward the strong resistance zone, a top could take an additional 4 to 8 weeks to actually build and finish, which means a more important primary trend decline may not start in earnest until early June. Thus, a note to all stock market bears, time to pull in the claws in the weeks ahead and attempt to trade smaller swings from both sides of the market, long and short.

Moving around Asia, we note that in Japan the 225 Index held its medium term rising trendline over the set back of the last few days and could now be in a position to retest the former highs near 18,300 seen in late February.

In coming months, the ability of this market to remain “healthy” as it is the primary capital market for Asia will be of paramount importance. In the case of most foreign markets, there is no diversification advantage to be gained by allocating money overseas during a down market. History clearly shows that foreign markets tend to under-perform in bear markets. That said, with the strong growth profile developing in Asia, the real reason to own foreign stock markets is there out-performance on the upside during bull market conditions. In this manner, these markets have been consistent over-achievers for quite some time, with the Nikkei 225 a key barometer for the health of greater Asia. If the global economy is to remain on track, Asia ex-China, and likely Japan, will need to improve and gain strength.

Another important market which could still be in position to manage new highs for the cycle is the Hong Kong market measured by the Hang Seng Index. Note in the chart below that to date, the Hang Seng, despite an 8% decline in the last 5 days, is still well above its more important medium term uptrend line. In my view, it would take months of sideways action for this market to actually build a more formidable top.

Here again I would also note that in many respects, this rather nasty decline seen in capital markets over the past week started in Asia with the recovery also starting in Asia last night. Is the global baton of leadership being handed off? Too early to tell, but there is no question that through globalization these markets have now become far more tightly linked and as we have just seen, events overseas can lead and trigger events here at home. A brave new world, to be sure. Turning to European markets, the outlook going forward may bear even closer scrutiny as the widely watched Financial Times Index appears to have completed a five wave advancing pattern. The ‘Kiss of Death’ for the rally? Too early to tell, but momentum levels in most of the European markets appear exhausted with these markets very likely to start surrendering their long string of relative strength leadership.

In the case of the FTSE, which often leads the DJIA at turns, the rising trendline connecting all of the most important lows of the last two years is currently at a reading of 6,050 and will be rising toward the 6,120 level over the next few weeks. Any breakdown in London, or for that matter Paris or Frankfurt, would probably indicate a global slowdown on the way. We will be watching these markets very closely in the weeks ahead. For the Paris CAC-40 Index, the 5,240 zone looks like important support for the weeks ahead, with a recovery rally likely targeting at least the 5,600 zone. The Paris CAC-40 closed Monday evening at 5,385.00.

In the case of the German stock market, the DAX Index, like the FTSE and the CAC, we see what appears to be a completed five wave advancing pattern. This does not mean that these markets cannot closely approach their recent highs in the weeks ahead and indeed, they most probably will. Yet, if the larger macro-global trend is slowing and the expensive Euro is making ECB exports less competitive, these markets will be a good bet for signs of the next leg down. At present, I would next expect any sign of real weakness to make an appearance before the summer, and most likely sometime early Fall 2007. For the time being, where most global markets are concerned, step back, look at the recent range, and think “trading range” for the months ahead.

I, for one, am very happy that markets have regained their footing, as a new down-cycle with the prospect of derivatives-counter-party issues, debt defaults, and banking system vulnerabilities scares the hell out of me. The sun is back out on Wall Street, and global liquidity flows appear to be returning to normal. This is good news for all of us, as it yields valuable time in which to prepare and rig for what is sure to be foul weather ahead. In the greater scheme of things, this week's global sell off appears to be a warning, the proverbial shot across the bow, and a potential harbinger of more difficult times to come. In the week's ahead, this message should not be forgotten amid the cheerleading voices of a global recovery rally. For most of us, now is a good time to make sure your financial house is in order as the odds are growing that a global maelstrom of immense size and scope is in the making. When, not IF, that downturn really ‘digs in,’ we will all benefit from having had the extra time to prepare.

That’s all for now,

Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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