Seeking Neutral Ground

By Frank Barbera CMT. November 11, 2008

In today’s Wrap Up, I want to start by acknowledging all of the rotten and miserable things that are taking place in the economic/financial world. Retail Sales are in a head long nose dive - the worst decline in years, car sales have collapsed, consumer confidence is plumbing the depths of 50 year lows, unemployment is skyrocketing, the banks are loaded with bad debt, central bank liquidity has exploded, and worse, outwardly none of it appears to be having much affect as the central bank ‘money printing’ seems to be disappearing into the ‘black hole’ of a bottomless debt trap. At times, of late, it has truly felt like ‘the sky is falling’ and that the soup lines of the Great Depression are dead ahead. Perhaps this will be so, and perhaps Deflation will carry the day leading the global economy into a self-reinforcing downward spiral of ‘beggar thy neighbor’ currency devaluations, rising protectionism and contracting global trade. Perhaps, everything will be undone.

For me, the fear of this collapse had been a daily rumination for all of 2005, 2006, and 2007. For anyone who knew me personally all during that time, I was one of the few very negative, and at times, very lonely super bears. It just seemed that the credit bubble had to bust, and that housing prices were due for a terrible hard landing. At many times, the very thought of a housing bust seemed inconceivable -- as to most people back then, you were a lunatic to even question whether Real Estate would ever come down.

It was the middle of 2005 when some friends of my wife -- who I love dearly -- bought a home with a no money down deal. At the time, my wife knowing that I made a good living, wondered out loud to me as to why we could not buy a home and take advantage of these ‘great deals’??! A few heated debates later, we moved into our rental home, where we have stayed put ever since. Back then it was not easy to believe that the bubble would pop, and that bad day’s would eventually come. Yet, it is always difficult to run against the crowd. And so here we are today, in the depths of recession, the markets beaten down, and virtually everyone has entered the deflationary depression camp.

Just yesterday, I received a phone call (no names) from an old friend in a panic, ready to sell out his entire stock portfolio. In many cases, there were companies that were selling at good prices, in some cases, outstanding values. There are a lot of companies in this market that are now good value. Yet, for every argument I presented to suggest potentially that now may not be the best time to sell, I was greeted by an even more impassioned counter argument as to why stocks were still miles away from any type of major low. It is a funny thing, but markets in particular, always work this way following a kind of perverse cycle that feeds on human emotions.

In a piece on Financial Sense back in December last year, I wrote about the “End of Denial,” as usually ‘Denial’ gives way to ‘Fear’ and then eventually, “Panic”, “Capitulation”, and a “Depression.” In talking to many people, I hear a lot of those latter three emotions right now, and it is interesting because the market is not making new lows. Over the last four weeks, stocks have been in a trading range, yet the feeling I get from most people is more negative now than it was back in mid October.

Mind you, none of this means that the markets are necessarily near a final low, or that the downside risks in the economy will not persist and even get worse. Yet, within powerful trends, even Great Depression sized trends, there are periods of pause, periods of downside excess, and periods where psychology is given to mean revert. In my view, I believe there is a chance that markets will base out and then recover, and that perhaps the Great Depression of 2008 will end up being stretched out over a period of many years. Ultimately, the country may end up in a depression, but it may end up being a currency devaluation, and runaway inflation that brings on the real financial pain. For now, it is all too soon to tell. For the time being, the best place for the average investor is to move the mental mindset back to the middle ground. It is time to, at least temporarily, step back from the ultra bearish camp, and time to give the markets a chance and see how things develop. Earlier this week it was announced that China had unveiled a new $586 billion stimulus package, a move oriented to keeping the masses employed and building up the domestic economy. In my view, this is precisely the best approach for stabilizing the global economy and giving us all a chance at avoiding a self reinforcing economic downward spiral.

China stimulus plan fuels hopes for new investment

(11-10) 13:43 PST BEIJING, China (AP) -- China's $586 billion stimulus package is its "biggest contribution to the world," Premier Wen Jiabao said Monday, as hopes rose that heavy spending on construction and other projects would help support global growth by fueling demand for imported machinery and raw materials. The massive Chinese spending plan — the largest ever undertaken by the communist leadership — was motivated by growing alarm at an unexpectedly sharp downturn in the country's fast-growing economy that raised the threat of job losses and social unrest. Sunday's announcement staked out a bold position as President Hu Jintao prepares for next weekend's meeting in Washington of leaders of 20 major economies to discuss a response to the global financial crisis.

Sticking with the theme of China, Monday’s news prompted me to pull up some charts of the Asian stock markets. It was June of 2007 when the pages of this column first began to throw a spotlight on the Shanghai Exchange as a potential accident waiting to happen. In my piece, “Chasing Rainbows and the Greatest Hits of 1930” (August 7th 2007), I drew the parallel of the Shanghai market and the US market in 1929 suggesting that like the 1929 market, China was headed for a serious crash. We stated,

“We end this week's article with a look at what is very likely the final iteration of the Top Out Parade for this cycle the only remaining question being when the Shanghai market begins to decline in earnest. In our mind, the parallels to the Chinese stock market of 2007 with the US stock market of 1929 are striking with the odds building that the bulk of the downside selling pressures are still ahead of us. Yes, 'Happy Days' may be here again, but this time, it looks like the 'Happy Days' are here for Short Sellers.”

Above: From “Chasing Rainbows and the Greatest Hits of the 1930’s” -- the Shanghai Market in 2007 aligned against the DJIA in 1929, we could be very late in the game for the Chinese stock market.

A few weeks later, I did another piece entitled “China, Commodities and U308” where I argued that,

“the Chinese stock market, which has been to this point singularly immune to the problem besieging other capital markets, remains a serious accident waiting to happen. While some may argue that China is the next secular bull, and we have the field of view to potentially agree, in the closer time frame of the next 1 to 2 years, we still remain of the view that China will turn into a serious bust, with the stock market rolling over and taking back a large portion of the gains seen during the last two years.”

Above: From “China, Commodities & U308” – Shanghai Composite with Elliott Wave Count with the current advance a fifth wave (terminal) movement.

This was then followed by two other updates, one on October 25th, 2007 simply titled “Stock Market- Update” and then the other on November 27th, 2007, entitled “Financial Upheaval.” In the update from late October I stated,

“To date, Asian stock markets have held up longer than we expected, but the roll over in RSI in recent days smacks of something more serious afoot. While some of the Hong Kong ‘H’ Shares still appear as though they could hold up and make token new highs over the next two to three weeks, overall, the vertical nature of the move appears to be very late in the cycle. In our view, a break in the Asian stock markets – perhaps in November or early December would be very serious and could accelerate the outcome to the downside for the US Equity and other International markets leaving us with a mindful approach to investment risk at this late date in the cycle.”

Above: the Shanghai Composite from our piece on October 25th 2007... this was the full Elliott count we updated only a few days after the market peaked on October 16th, 2007 at 6,124.04. Back then, we captioned this chart as follows: "Above: the Shanghai Composite with a very clear five wave pattern, the final high looks to be in place and with a few more percentage points on the downside, we can start to make a bear case for China.”

As the market rolled over and notched those additional few percentage points, the late November 2007 column stated,

“To that end, anyone notice the 2% decline in Shanghai last night? That market peaked on October 16th at 6,092.06 and closed last night at 4,861.11. That’s a decline of 20.20% in just 6 weeks with the index now below (a) the rising medium term to long term trendline, (b) below a declining 50 day average, and (c) below the now flattening 100 day moving average. We have been stating all year that the speculative bubble that is the Shanghai Stock Exchange was unlikely to survive 2007, and with the decline in Chinese share prices, which ramped up in a parabolic bubble, we would say that Shanghai is in the process of starting some serious downside fireworks. In addition, other cycle leading indices ranging from Mexico and Brazil, to Hong Kong and South Korea, to our own Base Metals Share Index, all look like an important down turn could be getting underway. This is not to say that over the very short term, with stock market indices oversold, these stock indices could not experience another trading rally. What we note is that on all of the charts, seen from a more medium term perspective, evidence of topping behavior is becoming clear. At present there are many who still believe that these markets will be immune, or less vulnerable to the downside of this credit cycle. In our view, this is very much unlikely to be the case as foreign markets have always been hammered in larger scale bear markets, and right now the bear is emerging first in the US and will spread to the rest of the world.”

Above: From the Financial Upheaval Article in late Nov 2007 captioned originally as follows:

Above: the Shanghai Stock Exchange Composite – breaking down from its bull market Structure.

Our goal today in writing this piece is to help investors find a measure of ‘pause’ and perhaps restraint to help seek middle ground. Remember, things always look really lousy at major market bottoms, and even at some important medium term bottoms. When we update the chart of the Shanghai Composite now, let’s see how things appear a bit over a year later. To begin with, the market has indeed crashed from above 6,000 to a recent close near 1664, for a total decline of 72.82% in just over 12 months. That is no small move to the downside, and is a move which has inflicted enormous pain on the mainland Chinese population, which only a year ago was wheeling and dealing in stocks with wreckless abandon. What’s more, using Elliott Wave theory, I see at least a reasonable argument to be made that China has now completed a major five wave decline, complete with a declining parallel trend channel and perhaps the early stages of an upside reversal per Monday’s announcement. In addition, the very medium to long term RSI gauge, along with a number of other technical indicators are pounded into oblivion. We are talking about a very, very depressed market when viewed on a primary trend basis. Simply put, our bias at this point would be for a bounce, a relief rally of at least 5 to 10 weeks duration, if not something even more important, that reveals the recent extremes as being just that -- extremes.

In looking ahead, it is absolutely clear that the secular baton of economic leadership is being passed off from the United States to China. Yet perhaps with a strengthening China, the entire global economy will be better able to find a “muttle through” scenario. While the strength of the present bust is likely to be enduring for some time, we at points along the way, may be at least open to the possibility of other potential outcomes, and right now the excess layer of thick gloom which now prevails has my stock market ‘basic instinct’ shifting its bias. For now, I am “seeking neutral ground”.

Above: the Shanghai Composite Index with a very complete Elliott Wave Count on the downside.

Above: the long term weekly view of Shanghai, with RSI down in deeply oversold territory. Is this a market people should sell? We don’t think so.

That’s all for now,

Frank Barbera

© 2008 Frank Barbera

Contact Information

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