Tempting Fate The Return of the Bear -- Part II

By Frank Barbera CMT. May 29, 2007

Okay, so we know the market has had a huge advance, and that at the moment it is simply not fashionable to discuss the possibility of a Bear Market. We also know that more often that not, the proverbial discussion of whether or not a market has “turned into a bear” doesn’t normally evolve until prices are down more than 10% from the highs. A lot of good that does most investors!

If you are like most investors, it may be hard to see prices on a stock or a fund tick up month after month, reach a “high-water mark” and then start ticking relentlessly lower. At first you want to be patient during a decline on the belief that the decline is “short-term” in nature, and that a recovery rally could be just around the corner. When that fails to materialize and instead prices continue to decline, most of us then resort to stronger, less plausible doses of HOPE, or DENIAL, moving to the psychology that “if prices would just recover a bit, then it might be easier for me to get out.”

The trick in avoiding some of these serious pit falls is to at least have some idea as to whether or not the market could be near an important cyclical high in the first place so you can begin to properly raise your guard. While we would never suggest front-running or pre-judging the market (selling before it breaks trend), it is nevertheless helpful if one starts with an understanding of where major cyclical peaks begin from, as once a major cyclical peak is seen, a sustained and protracted downturn can begin and continue in unyielding fashion. Contrary to popular opinion, major tops do not develop ‘over night,’ and usually they develop with lots of warning flags flying, at least if you know what to look for.

In this week's report, we are picking up some of the same bear market themes we first wrote about in “The Return of the Bear” at the end of last year, only now the risks seem even greater. To begin our analysis, we will start with a look at the Dow Jones Industrial Average and a trip down memory lane. In the next chart, we are looking at monthly prices for the DJIA, going back to 1915 about 92 years in total or 1104 months. In the lower clip, we have plotted a simple 9 Month RSI, first developed by Welles Wilder. The RSI is primarily a momentum indicator, which on the monthly chart is overbought above +80 and oversold near +40.

Above: the DJIA — 92 years with 9 Month RSI

Because the market has had a long-term growth bias, the RSI has a similar tendency to display an upward ‘scale shift,’ shifting up from the more traditional +70 to +30 overbought/oversold lines which work well on both daily and weekly charts. Focusing on the lower clip, we note that at present, the 9 Month RSI for the DJIA currently stands at a reading of +78.53, which represents the 67th most overbought monthly reading ever seen. That means we are in the top 6% of most overbought monthly readings heading into the end of May. Now a funny thing happens with the monthly RSI. We went back and looked at the majority of major peaks, and with one or two exceptions almost all of them peaked with readings below +82. As it turns out, usually, if the RSI gauge on the monthly chart moves above +82.00, it normally implies extra-ordinary levels of momentum, the kind of bullish kick off that would be seen in the early and middle phases of a bull market. As a result, readings as high as +82 and above on the monthly RSI imply a lot of upside momentum in the market and even higher prices to come. Of the top 69 readings above +75, 24 were above +82 (relatively rare —only 2% of the broader total 1106), while 45 of 69 were between +75 and +82.

Just about the only exception to this rule was the 1987 stock market crash which peaked in August 1987 with a monthly value of +85.22 (see below) which was nevertheless a failing reading relative to the true momentum peak that was seen in March 1986 at +87.63.

In fact, a reasonable argument can be made that because the stock market still had a fair amount of upward momentum behind it going into the blow off top of 1987, this is one reason the market was able to bottom out and begin a comeback so quickly in the wake of the big collapse.

Putting the 1987 experience aside, virtually all other stock market peaks of importance were seen in the zone between +75 and +81 on the monthly RSI. Here are list of the ‘Who’s Who” of Major Dow peaks this past century with the associated peak monthly RSI values: October 1916 +76.45, October 1919 +76.46, August 1929 +81.68, February 1937 +79.09, May 1946 +75.42, April 1965 +76.98 and December 1999 +72.02. These average +76.87 with once again, the May 2007 reading coming in approx. +78.53. Put another way, we are now seeing the kind of readings which are only seen every few years, sometimes not for a decade or more, which tell us that we are “in the zone” for a potentially major top in the DJIA. In every single case where the monthly RSI turned down and failed to move above +82, with the market breaking its rising trend, the declines that follow peak monthly RSI readings in the +75 to +81 zone were brutal, with all of them bettering 20% on the downside.

Above: a close-up view of the 1916 to 1950 time period, where monthly RSI readings near +80 were a big problem and bad for your financial health.

Thus, we now know with some confidence that the market could be in the area where it may be setting up a major peak. In addition to being overbought, markets that reverse down violently and in a sustained manner, also tend to be over-extended. This term means that they have been one directional (i.e. up) for a long time, without much corrective activity along the way. One example, since the lows in October 2005, the DJIA has now been up 15 of the last 19 months, the S&P 500 up 17 of the last 19 months, up 14 of the last 16 quarters -- quite the winning streak. In the case of the S&P, the present streak of 17 of 19 months to the upside rivals some of the best prior winning streaks in both overall time duration and the concentration of advancing months. Some of the prior “Best Streaks” were between September 1998 and March 2000, a period where the S&P advanced 11 out of 18 months, November 1994 to May 1996, a period where the S&P advanced 14 out of 18 months, September 1985 to August 1987, a period where the S&P advanced 16 of 23 months, and December 1974 to September 1976, where the S&P advanced 12 of 21 months. In addition, since 1960, the S&P 500 has never gone longer than 40 months without a 10% correction. In the table below, we show the longest streaks the S&P 500 has managed to go without encountering a correction of at least 10%.

Start Date	Duration	End Date
10/31/1962	40 Months	1/31/1966
10/31/1990	39 Months	1/31/1991
7/31/1984	24 Months	8/29/1986
12/31/1987	24 Months	12/29/1989
7/31/1996	23 Months	6/30/1998
10/30/1998	18 Months	3/31/2000
8/31/1982	15 Months	10/31/1983
3/31/2003	50 Months	Present ?

At present, we are in somewhat uncharted territory as the market has NEVER gone 50 months (thru the end of May 2007) without a 10% correction. Now, a bull could make a case that we have seen two “8% to 9%” corrections within the last few years, and they would be correct. Between March 2004 and August 2004, the S&P fell by 8.69%, and between May-June 2006, it fell nearly 8%. Yet, in neither case, did we see a full 10% correction. Perhaps this is a ‘technicality,' but in our view, it nevertheless speaks volumes about the lack of any real volatility in the stock market over these last few years.

Above: S&P 500 (upper), 9 Week RSI (middle), and Time Span Counter (lower)

Another way we can make the same point is to show the S&P weekly chart going back to 1950. Next, we plot the 9 Week RSI with the standard +70 and +30 overbought/oversold parameters. Notice how the RSI moves back and forth between +70 and +30 like a regular pendulum, “Tick-Tock, Back and Forth, Very Steady, Very Rythmical.” Next, notice that we have NOT seen a reading below +30 on the 9 Week RSI since the bear market ended in 2002. Thru this writing as of late May 2007, it has been a remarkable streak of 242 weeks in which the 9 Week RSI has NOT closed at or below +30. As it stands ‘to the letter of the law’ this would be the longest such streak without a serious sell off seen in the last 47 years! Now, if you wanted to get very picky, we should point out that on August 6th, 2004 and August 13th, 2004, near the bottom of the 2004 “9% correction” we did see two weekly RSI readings of +30.36, and +30.89. Both were very close to +30, but neither really fits the bill in terms of ending the streak which is “+30 or less.” So perhaps there are a few readers who still need more convincing, in terms of the potential bear case? Alright, here goes. If we lift the lower oversold boundary from +30 to +32, it would make it easier for the market to become “oversold.” Essentially, we are lowering the bar by doing this. In the next chart, we highlight the difference by adding on the second “higher” oversold benchmark of +32 to the RSI Chart.

Above: S&P 500 (upper), 9 Week RSI with +30 AND +32 oversold lines (middle) and (lower) Time Span Counter.

At this point, we see the Time Span Counter reset in 2004 at the August lows, which move the counter back to zero, as the two weekly readings of +30.36 on August 6th, and +30.89 on August 13th, 2004 were both BELOW +32. But what about the action since then? Even using the higher ‘oversold’ threshold of +32, we still end up with a Time Span of 145 weeks and counting. On the lower Time Span Counter we have a horizontal line ‘inked in’ at 130 weeks. Notice that even by adjusting the bar in the market's favor, we are still historically overdue for a series of “oversold” values below +32 on the 9 Week RSI, which is another way of saying that we are now very due for a major decline.

While we know that sometimes it is possible to provide too much analysis, there are times like these, when the facts MUST STAND UP and be allowed to speak for themselves. Rarely has there been such an overwhelming case for “Trouble Ahead” in the stock market, and to that end, we beg our readers indulgence for bearing with us through some very technical fine points. Continuing along, in our next chart, we show the S&P 500 and its 200 day Bollinger Bands, adjusted for a Weekly chart. Remarkably, it has now been since March 2003 that the S&P has advanced without tagging its 200 day lower band. Here again, it is important to note that it did come “reasonably” close on two separate occasions, namely the already familiar lows of August 2004 and July 2006. Yet, to make things more generous for the market, to give it every possible bullish “benefit of the doubt,” we widened the band range to a “zone” defined by the lower band AND the the lower band plus one percent.

Above: the S&P 500 — last 7 years with the 200 day Bollinger Bands shown on a weekly chart. The arrow in the bottom, middle of the chart, shows the last time the S&P was within 1% or less of tagging the 200 day lower band.

Above: the S&P 500 with its 200 day Lower Bollinger Band and a +1% zone — at no time has the weekly low managed to move into this zone over the last few years.

The preceding chart shows the S&P with the Lower 200 day Band and the Lower 200 day Band PLUS a One Percent Envelope. On the next chart, we show you the results, once again, going back to 1950, a period of 57 years! In our work, we used “The Price LOW” of each week as the defining characteristic, “Did the Price LOW at any time move into the ZONE between the Lower Band Plus One Percent and the Lower Band itself?” That was the question we posed to the computer, and the result is shown in the Time Span Counter on the lower clip. Remarkably, it has not been 144 weeks since the S&P last entered the zone around its 200 day lower band. As can be seen over the last 57 years, there have only been four other occasions when the market was this historically overdue for “contact with the lower band.” In every prior outcome, these conditions were a recipe for PAIN in the stock market with all four time spans either ending in the middle of, or followed in short order by 20% plus declines. Starting with the August 1956 peak, the stock market sold off for 16 months into a December 1957 low, with a net decline of 19% in 16 months. The Time Span ended at 164 weeks in the outset of that decline in November 1956.

Above: S&P 500 and Time Span Counter — SPX within 1% of Lower Band

Next, we see the Time Span which measured 153 weeks in the middle of 1965, wherein the market held up and made only minimal progress for a few months prior to rolling over into a major decline between January and October 1966, a decline that ultimately measured 20%. Then we see the 1987 Crash outcome, which ended amid the 37% decline of October 1987 with a Time Span of 166 weeks, and finally, the 198 week (record) Time Span ended during the Asia Crisis of 1998, a 22% decline in two months!

At this point, stock market investors should be asking themselves whether or not they are simply “tempting fate” by overstaying this raging bull. In our view, the answer to that is that “Time is Short,” and within a few weeks a major decline is very likely to begin.

In addition to some of these longer range Time Spans, we see lots of evidence on our short-term charts that the market is starting to top. In our view, last week's downside reversal in price is probably the beginning of the end. While we are on record as saying that the stock market has a good chance at holding up into the middle of June, and even mounting one more very small rally back to new highs, it is so late in the game that investors need to be exceptionally nimble. In the next chart, we show our own 20 day Advance-Decline Oscillator based on our universe of 1500 NYSE Operating Companies. The chart is a daily chart and goes back to 1987 with the oscillator overbought above +100 and oversold below —100.

Above: The S&P 500 with the 20 day Advance-Decline Oscillator now pulling back toward zero.

Above: the S&P 500 with the GST 20 Day A/D Oscillator with potential bearish divergence (i.e. what we are on the look out for) sketched in (bold) over the next few weeks.

Given last week's decline, the A/D Oscillator is making its way down toward zero, ending last week at a value of +17.84. From here, we would not be surprised to see some additional short term weakness in the S&P over the next few days down to support in the 1490 to 1500 zone followed by a final rally back up toward at least 1520 and possibly as high as 1540. On the A/D Oscillator, this should work out to a set of readings just below zero, and then a failing rally back up toward the +60 to +100 zone, which we sketched in on the chart to highlight the kind of bearish near term divergence we would expect to see in terms of marking a final and very major stock market peak. In addition to a bearish divergence on this gauge, which should throw a spotlight on the upcoming top of importance, we also note that the 20 day A/D Oscillator has now NOT seen an oversold value since the —104.30 reading of last July 26th, 2006. That means that thru Friday of last week (May 25th), it has now been 212 trading days without an oversold reading.

Above: the GST 20 day A/D Oscillator and a Time Span Counter which tracks the number of days with “no oversold value below —100”. The market is getting historically extended and is coming into the zone, where more often than not, more serious sell offs begin.

In the chart above, we show a long term Time Span Counter that tracks the number of days without an Oversold value of —100 or less on the 20 day A/D Oscillator. Here again, we are getting up there in a hurry, wherein most of three to four prior longest streaks on record ended between 220 and 280 days. In addition, readers should keep in mind that at times the market can be going down for awhile, BEFORE a Minus 100 value was seen, so “adding in” some time for the decline (needed to create the oversold value) is a good idea. Our Bottom Line to Investors: The Stock Market is historically over-extended and coming up against extremely powerful overhead resistance in the area of the S&P’s former highs between 1530 and 1550. At this point, it is so late in the cycle that investors should be poised to make a move for the exit door so as to not be trampled by the approaching ‘mass panic’ of the investment crowd. Gauging by what we see happening in China on a near daily basis, a “Panic” and/or “Crash” in that market is now not far away. The ripple affects and contagion from a drop in Shanghai will likely be felt around the world, and thus, our suggestion to protect yourselves ahead of time; perhaps an idea along these lines would be to consider a move to cash. The DJIA ended Tuesday up +10.00 at a reading of 13,517.28 with the S&P up 2.41 at a reading of 1518.14, while the 10 Year Treasury Note ended at 4.88%. 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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