Iceberg Ahead... SOS!
By Frank Barbera CMT. March 11, 2008
Like the SS Titanic, the global credit markets continue to convulse on a daily basis having hit a massive iceberg last August. At this point, the screws have stopped turning, power is fading, and the pumps are losing their battle as water floods into the lower decks. The ship is down by the bows, and is starting to founder, dead in the water. Such is the case with the US economy, which is no longer growing, but sinking into recession. Among leading banks, credit is by and large no longer being extended, as banks husband what potential lending power they have left to shore up sagging loan-loss reserves. Given the absolutely unprecedented scope of the current credit collapse, already easily the most serious financial catastrophe seen since the Great Depression, we have to ponder the gravity and scope of the bear market that is now underway. To put some potential perspective on where things could be headed, we turn this week to the arcane, but on occasion, helpful concepts of R.N. Elliott, creator of the Elliot Wave Theory.
While Elliott's work is always subject to interpretation, those who understand the Wave Principle and strictly adhere to the basic tenets of the theory usually come to more or less the same basic conclusions. While we cannot outline all of the principles involved in Elliott Wave Theory, in one small article the basic concept is that markets reflect crowd psychology in motion, and that crowd psychology tends to follow a rhythmical pattern that exists in nature. As a result, markets tend to advance in a five-wave sequence featuring three decisive moves up, separated by two intervening corrective moves either down or sideways. Following the conclusion of a five wave advance, markets then reverse into a bear market which unfolds as a three step sequence: a "down" move, an "up" move, and then a secondary (usually even larger) "down" move.
Above: Stocks ended a Super Cycle degree advance dating back to 1932, the Great Depression lows at the peak in 2000, and have ushered in a high order (powerful) secular bear market.
In the case of the S&P 500 and widely watched Dow Jones Industrial Average, there is a high level of consensus among Elliott Wave Theorists that US Stock prices reached the conclusion of a Super Cycle degree advance dating back to the 1932 Great Depression low at the peak in August 2000. Shown in the chart above with circled numerals, Wave 1 peaked in 1937, Wave Two (the first corrective wave down) bottom in 1942, with Wave 3 peaking in December 1965 with this wave itself being composed of five waves of a lower degree. This was what Elliott termed an "extended" wave which is a common result in the advancing third wave position. Following a 16 year bear market into the 1982 low for Cycle Wave 4, the great bull market of the 1980's sprung to life in August 1982, and with it began Cycle Wave 5. This secular bull market remained in effect until early 2000 when it peaked, and in the process ended a 68 year advance of Super Cycle degree dating back to the 1932 Great Depression bottom. Since then, a great bear market has been in effect, with Primary Wave A, illustrated by the 2000-2002 50% bear market decline and Primary Wave B, the subsequent 2003 to 2007 four year recovery rally. Since September of last year, Primary Wave C down has been in effect, with Primary Wave C likely to be every bit, if not more powerful then Primary Wave A.
Above: Some would argue, going back even further, that the peak in 2000 may have even seen the end of a Grand SuperCycle degree pattern dating back more then a hundred years.
There are also Elliott Theorists who make the case that the peak in 2000 may have actually represented an even larger degree Grand Super Cycle Peak, ending the growth pattern in stocks dating back several hundred years, making the current bear market a bear market of even higher degree. The chart above is one of several that could be used to make such an argument, but in our view, the first chart is enough to get the basic message across; namely, the current bear market is likely of a very high order, and thus, is likely to pack quite a downside punch. The analogy to that of the unsinkable Titanic hitting an iceberg of unseen size and scope is perfect when seen through the purview of Elliott Wave. In either case, the chart below illustrates in a "close-up" view the Cycle Degree Wave V seen from 1982 to 2000, and the A-B-C developing Bear Market structure which has followed. At the present time, it is serious business that the trading activity of the last few days is threatening to send prices below the long standing rising trendline connecting the 1982 low and the 1990 low. While several possibilities exist, it is possible that the current Bear Market will be of Cycle or Super Cycle degree, implying that the first [A]-[B]-[C] decline may end up representing only Cycle Wave A of an even larger developing (multi-year) three step pattern.
Above: A reasonable Elliott Count showing the Cycle Wave V bull market and the developing A-B-C Bear Market in its wake.
Above: Detail Wave count within Waves A & B.
In the next chart shown above, we get into a bit further detail for the benefit of Elliott Wave enthusiasts who might be interested in some of the wave labeling for the last few years. In our view, both the 2000-2002 Bear Market and the ensuing 2003 to 2007 "bull" market were essentially "three-step" affairs, with the "bull market" of the last few years really assuming the construct of a very large bear market rally under the Elliott Wave microscope. Flashing forward to the action of the last few months, and more recently, the last few days, prices appear to be breaking down in renewed fashion. While this does not necessarily mean that the stock market cannot find a temporary bottom (it may have done so with today's Fed injection of funds), and perhaps even begin some type of multi-week bounce, overall, the news of late has been extremely negative, with the market reacting strongly to the downside in the face of each negative news release.
At the moment, we are pondering the market and the current set of events in light of both today's Fed announcement and next week's Fed meeting on March 18th. As things presently stand, the Fed Fund futures are pricing in a .50 basis point cut for next week. The question of the day then becomes, "What happens if the Fed cuts .50 basis points, and that is what expectations are?" The point being, we are talking about another very large rate cut, and a wide perception ahead of time that this is what the Fed will do. Hence, we see the risk of the post rate-cut announcement rally being a serious wimp out, another fizzle, that is, if it happens at all. In our view, risk is high and rising that another bout of disappointment is in the offing, especially if "ALL" (cynically) the Fed does is cut .50 bps. Over the next few days, any retracement toward new lows in price followed by a second knee jerk bounce perhaps extending a day or two past the Fed meeting may be all we see from the stock market. That could then be followed, in turn, by a more violent and aggressive sell off to a serious bout of sequential new lows.
Yet another market to ponder is that of the floundering US Dollar. Another .50 to .75 point rate cut is REALLY NOT likely to go over well in the currency market. At the moment, we have a Dollar already in free-fall, definitely NOT an orderly decline. Recent comments by the BOJ and ECB are also not encouraging on either the rate-cutting front or the central bank intervention front, and thus, we wonder what's next for the Dollar? It seems to us that if the Fed does not move back to a more gradualist approach, then the risks will continue the present round of "weak dollar stokes higher oil, higher oil stokes even higher commodity prices, higher commodity prices force slower consumer spending, lower consumer confidence and thus, the Fed ends up feeding a deepening recession." Of course on the other hand, the Fed is desperate to save the banks and on the surface, only slashing short term rates will they succeed in creating the positive carry trade (the vig) needed to re-liquefy bank balance sheets.
Thus, the Fed seems to be caught in between the Falling Dollar/Rising Oil - Falling Citicorp rock and hard place. Which one do we save, which one do we let fail? Either way, it seems there is no palatable way out. Obviously, the Fed is hoping that today's large credit infusion of $200 Billion will allow the banks the ability to resume some lending and free up some capital from the balance sheet defense funds. This would then take some pressure off the need to cut rates as aggressively, and perhaps a quarter point cut next week, less than expected, would have the sidebar benefit of causing a correction in the Oil and Gold markets, both horribly overextended at the current time.
Either way one thing is certain; there can be little doubt that it has been the deteriorating/collapsing credit markets which have been at the epicenter of the stock market bear and the emerging economic contraction. As credit conditions have deteriorated reflected in a widening spread between corporate paper and treasuries, we see that the stock market has continued to move steadily south. We illustrate this on the next chart with the Moody's BBBA versus Treasury Spread plotted inversely and overlaid against the S&P 500. No question about it, the credit markets have been in the lead.
Above: Moody's BBBA versus 10 year Treasury Spread inverted overlaid against S&P 500 Index.
While on the topic of deteriorating credit conditions we note that while there are so many fronts to keep track of, the GSE's, the Monolines, the Banks, the S&L's, the REIT's (Thornburg), the hedge funds (Carlyle), we have to make mention of both Ford and GM, both of which have huge exposure to asset back debt (ABS). Over the last few years, Ford sold so many bonds backed by car loans that it could have its own yield curve. Even more important, Ford has employed the practice of booking "up front," the income it expects to earn over the lifetime of these loans. While it is fine to book these gains as earned income "up front," the potential problem is reached when and if the retained receivables don't deliver the promised cash flow. In this event, if losses are greater than anticipated, higher rates of write down on the loans, then the company, have to go back and restate previously reported earnings. For Ford, the retained loans also include huge chunks of subordinated debt, the riskiest portion of these loans with the total of these low quality loans several times the new value of the total business. This leads us to wonder how a recession and slowing car sales will impact Ford, let alone the kind of distressed lending environment now in full swing as a Force Five Hurricane.
In our view, the overall picture speaks of a great deal more bad news ahead, with companies like Ambac, MBIA, Fannie Mae, Freddie Mac, Ford and GM and possibly several large banks unlikely to survive in present form. For the S&P, it is not at all uncommon for a Primary Wave C to be equal to or 1.618 times the size of, Primary Wave A. In the chart below, we see that Wave Equality is reached at about the 780 level, the area of the 2002-2003 bottom, while a 1.618 times decline is not seen until 500 on the S&P.
Above: Wave C is 1.618 the percentage decline of Wave A at about 500 on the S&P, say late 2009--that's potentially a long way down.
Usually "C Waves" are large five wave declining affairs, with Minor Wave One of C most likely having just bottomed, but with the entirety of Wave 5 likely to target prices down toward 1,000 on the index before a more important medium term low is seen. With today's short covering rally, it is possible that Minor Wave 2 is now underway with today's advance a low degree Wave A to the upside, part of an A-B-C move that could last approximately two weeks. While Bulls may rejoice at what looks like the start of "something serious," chances are high that this is just another short covering rally within the context of a major bear market tightening an already firm grip. Viewed against the likely full spectrum of where prices could eventually go, it is a good bet that we are still early innings of the bear market, which could have as much as 50 to 70% still in front of us, (ex: 1576 peak to say worst case low 500, 1076 S&P points total, 1576 to 1272 recent low = 304 Points down so far, 304/1076 28% of potential worst case total or 71% of bear still ahead of us.) both in terms of running time and total price decline. While such predictions are by nature subject to constant review and possible changes, from what we can tell, this looks like a monster bear market underway with a lot of room to run.
At the close, the S&P 500 ended higher by 47.28 index points to close at 1320.65, a gain of 3.71%, while the DJIA ended higher by 416.66 index points or 3.55% to close at 12156.81. For the NASDAQ, Tuesday saw the index gain 86.42 index points or 3.98% to finish at 2255.76. The 10 Year Bond ended with a yield of 3.60%, up .16 basis points, while nearby Gold ended at 973.70, up 1.90.
© 2008 Frank Barbera