Prediction: Nasdaq Will Not Crash for Awhile

(It will see 1,650)

by Martin Goldberg CMT. July 22, 2004

Last week I was listening to a radio broadcast and was marveling at how confident stock market prognosticators can be when predicting the long and intermediate term stock market. Many gurus are so confident they will actually predict both the precise numerical value and date that their estimates will occur. For most of us mortal souls though, trying to predict the stock market can be a very humbling experience. (It can also be quite rewarding.) However, unlike stock personality prognosticators, the most successful traders are those who can technically evaluate the market and stocks, select and wait for their appropriate entry point, and then stay with their position as long as the market agrees with their trade. It is with this disclaimer in mind, that I want to briefly present to you, my intermediate term Nasdaq prediction and its supporting basis.

The Nasdaq Has Topped – Now Looks to Complete Multiple Head and Shoulders Pattern

Below is a one-year daily chart of the Nasdaq index. I believe that the index has topped and formed a multiple head and shoulders (HAS) pattern. As I draft this on Wednesday evening, it appears that the neckline at about 1,875 has been "tickled" but not yet decisively broken to the downside.

The action over the last few months was one of lower highs and lower lows, a bearish sign. It is also notable that since the January top, each rally has come on decreasing volume, suggesting a progressive exhaustion of buying power. In addition, the downtrends have come on increasing volume compared to the uptrends, a sign of distribution. (Also see discussion of Money Flow, below.) With all the positive Greenspan talk, and good news out of Dell Computer, and Microsoft, the Nasdaq has yet to muster a sustained meaningful rally over the last week.

What would confirm that I was right about the multiple HAS pattern? If the neckline were broken downside by a close that was 3% or more below the neckline, that would confirm the validity and completion of the HAS pattern. Three consecutive daily closes below the neckline would also validate the pattern. However, it is also relevant to note that when a HAS pattern is whipsawed, it generally occurs with a sharp and tradable rally to the upside. This can happen, and although it would not invalidate the pattern; it would frustrate and annoy many Nasdaq bears. No one ever said that this was an easy game to play!

What would confirm that I was wrong and the multiple HAS was invalid? A close above 2,100 would invalidate the pattern in my view. Although admittedly, I do not have a documented technical basis to support this, I believe the trend for additional rallies to shake out the bearish and draw the public into the market is still very much intact and may continue further. This trend is evident by the two apparent sucker's rallies that have occurred since January, and I believe this is a trend that can continue until the HAS is validated as described above.

Multiple HAS – A "Lazy" Pattern

From the time that the Nasdaq showed its first technical weakness in November of 2003, I discussed the potential for a stock market crash. While for fundamental reasons, a crash is still possible, the potential for a near term crash has been reduced by the formation of the multiple HAS. Edwards and Magee provide an excellent description of the pattern in Technical Analysis of Stock Trends, 8^th Edition.

"There is something about Multiple Head-and-Shoulders patterns especially pleasing to technical chart followers. Because of their symmetrical tendencies, it is fascinating to watch them evolve to completion. Once completed, however they may try your patience (!!) by their seeming reluctance to 'get going' with a new trend. On that account, it becomes easy at times to jump to the conclusion that they have 'blown out', i.e., produced a false signal. Actually, except in the matter of extent of move (see below), which we have already discussed, they are fully as reliable as the plain Head-and-Shoulders. False moves are relatively rare with both. And in those extraordinary cases when a Complex Formation does go wrong, it still stands, like the plain Head-and-Shoulders, as a warning that the final Reversal is near."

Edwards and Magee describe the reduced "power" of a complex (many shoulders) versus simple (1 head, 2 shoulders) head-and-shoulder pattern (page 77):

Curiously enough, the "power" of a Multiple Head-and-Shoulders Pattern is more apt to be over- than underestimated. One might think, in view of the length of time and amount of trading entering into its construction, that it would signal a move (in reverse direction to the trend preceding it) of greater extent than the simple Head-and-Shoulders. Yet, in its immediate consequences, at least, the Complex shows consistently less power. Minimum measuring rules for the two types of formations are the same and are applied in the same manner. The difference between the patterns appears in the price action after the minimum has been reached. The first downswing out of a plain Head-and-Shoulders Top, not counting any early Pullback pattern will frequently carry out of the minimum measuring implications of that pattern quickly and run well beyond it. From a Multiple Top, the first downswing is often more leisurely, and very seldom does it exceed the bare minimum – a probability well worth remembering when you are dealing with an Intermediate rather than a Primary Top. Of course, if the Complex does develop at a turn of a Primary Trend, prices will eventually go much farther, but even then there is usually a strong recovery from the "minimum" rule.

So there you have it. Once the neckline is decisively broken to the downside, we should see the Nasdaq reach the "minimum" price objective, before correcting with a rally. The minimum price objective is equal to the "distance" between the neckline and the January top measured downward from the neckline. That is approximately 1,650, as indicated in the chart. It is also notable that the Nasdaq appears to have some minor support at 1,650, which is likely to hold for a while.

The principles described by Edwards and Magee suggest that a rally off of the 1,650 level is likely,

Of course, if the Complex does develop at a turn of a Primary Trend, prices will eventually go much farther, but even then there is usually a strong recovery from the "minimum" rule.

Golly, following the principles described by Edwards and Magee, a Nasdaq drop down to 1,650 followed by a rally "into the election" seems to "fit".

Could the resumption of the bear trend be considered the turn of a Primary Trend, as described by Edwards and Magee, even though many technical analysts (including me) consider the recent rally to be a secondary correction within a secular bear market? I think that for intermediate technical analysis, the end of the recent rally can be considered the turn of a Primary Trend, because the characteristics of the recent rally fit the definition of many a bull market. It lasted for over 15 months, and the Nasdaq gain was over 70%, sufficient to define as a bull market in both magnitude and duration. (One would have to consider that we are in unprecedented ground considering the extent and duration of the previous Nasdaq 5,000 bubble. Hence, in retrospect, there is every reason to believe that we can have a secondary correction that meets all of the definitions of a "bull market".)

Given that we have completed a secondary correction that meets all the definitions of a bull market, I believe that "prices will eventually go much further" after a recovery from 1,650. An "Inauguration Day Drop" fits, but I may be getting ahead of myself.

That is my humble prediction for the intermediate term Nasdaq.

Money Flow Suggests Intermediate Nasdaq Downtrend

In addition to price action itself, there are more secondary indicators such as Chaikin Money Flow, which suggest that the Nasdaq is technically weak. Quoting from John Murphy of Stockcharts.com,

"Developed by Marc Chaikin, the Chaikin Money Flow oscillator is calculated from the daily readings of the Accumulation/Distribution Line. The basic premise behind the Accumulation Distribution Line is that the degree of buying or selling pressure can be determined by the location of the close relative to the high and low for the corresponding period (Closing Location Value). There is buying pressure when a stock closes in the upper half of a period's range and there is selling pressure when a stock closes in the lower half of the period's trading range. The Closing Location Value multiplied by volume forms the Accumulation/Distribution Value for each period. The Chaikin Money Flow oscillator generates bearish signals by indicating that a security is experiencing selling pressure, or is perhaps under distribution. As with the bullish signals, there are three items used to determine whether or not a security is experiencing selling pressure and the degree of selling pressure.
The first and most obvious bearish signal is when Chaikin Money Flow is less than zero. A negative reading indicates that the security in question is under selling pressure or experiencing distribution.
The second potentially bearish signal is the length of time that Chaikin Money Flow has remained negative. The longer the oscillator remains negative, the greater the evidence of sustained selling pressure or distribution. Extended periods below zero indicate that sentiment towards the underlying security is bearish and there is likely to be downward pressure on the price as well. The length of time can be determined by measuring the percentage of time that the indicator remains below zero. If Chaikin Money Flow were negative to 3 out of 4 weeks, then it would be experiencing selling pressure 75% of the time.
The third potentially bearish signal is the degree of selling pressure or distribution. This can be determined by the oscillator's absolute level. Readings on either side of the zero line or within 10 percent of both sides (plus or minus .10) are usually not considered strong enough to warrant a bullish or bearish signal. Once the indicator moves below -.10, the degree selling pressure begins to warrant a bearish signal. (A move above .10 would be significant enough to warrant a bullish signal). Any further movement would increase the degree of selling pressure and the bearish or bullish inclination. Marc Chaikin considers a reading below -25 percent (-.25) to be indicative of strong selling pressure. Conversely, a reading above .25 is considered to be indicative of strong buying pressure. These levels are general guidelines and establishing important levels will depend on the characteristics of the individual security and past readings for Chaikin Money Flow."

Following is a one-year daily chart of the Nasdaq index with money flow and relative strength highlighted. As you can see we have the Chaikin money flow less than zero for the Nasdaq index. Since going negative after the Nasdaq topped in January, the money flow has been less than zero about 2/3 of the time.

Note also that the relative strength index of the Nasdaq broke into new low ground on Friday. This is another weak technical indicator.

Is There a Relationship Between Presidential Party Affiliation and Stock Market Crashes?

With stock market valuations historically high, it may be relevant to examine crashes of the past. The table below outlines stock market crashes that have occurred since 1960, where I defined a "crash" as a 20% or greater drop in the S&P 500 index.

Party	President	Year of Bottom	S&P 500 at Top	S&P 500 at Bottom	% Of Drop
Democrat	Kennedy	1962	72.04	52.68	27%
Democrat	Johnson	1966	93.18	73.20	21%
Republican	Nixon	1970	108.37	72.25	33%
Republican	Nixon	1974	119.87	62.34	48%
Republican	Reagan	1981	140.52	112.77	20%
Republican	Reagan	1987	335.89	223.91	33%
Democrat	Clinton	2000	1418.78	1128.43	20%
Republican	Bush Jr.	2001	1172.51	847.75	28%

Over the last 44 years, republican presidents have sat for 5 crashes totaling 162% of "crash" versus 3 totaling 68% for the democrats. Looking further back into the distant past, there were two major stock market crashes in the 1900s. The 1929 crash resulted in the Dow dropping 89% with a republican, Herbert Hoover, as president. The Dow was halved from 187 to 95 between 1936 and 1942, with Franklin Delano Roosevelt, a democrat, as the president. The supporting chart from stockcharts.com is below.

Today's Market

The Nasdaq, which is sitting on the crossroads of its multiple head-and-shoulders pattern, appeared to be in danger of a decisive downside break today. Following an extreme high volume sell off yesterday in the face of all of the cheese put out by Microsoft and Greenspan, it appeared that the downside break might have happened today. This seemed to be a stronger possibility following Ebay's earnings announcement that didn't meet expectations. As would be expected, the Nasdaq sold off in the morning. Yet, at about 1:30 in the afternoon, the Nasdaq 100 got a sudden "afternoon delight." I think it is notable that it was the Nasdaq 100 that accounted for practically the entire increase in the Nasdaq index which totaled 0.78%. Consider the following daily results:

Index	% Increase (Decrease)
Dow	0.04
S&P 500	0.27
S&P Mid Cap Index	0.27
Russell 2000	(0.37)
Nasdaq Composite	0.78
Nasdaq 100	1.58
Nasdaq Tracking Stock (QQQ)	1.37

While I haven't done the math, it appears obvious that the daily increases in today's indices were a direct result of the gains in the Nasdaq 100. Note that the entire Nasdaq composite was up only one-half the amount of the Nasdaq 100. This point may be moot though, as the Street appears to be unhappy with Microsoft and Amazon's after hours earnings reports. Short-term traders are saying that the Nasdaq is oversold, and therefore due for a bounce. Yet I wonder if we are at the beginning of a clear and decisive trend break. We may know by the close tomorrow. Can you stand the excitement?

Gold was down $2.70 ($394.60), silver up $0.02 ($6.43), the XAU up 0.99%, and the HUI up 0.44%. Below is a weekly chart of the 10-year note indicating no short-term trend breaks. In the short term, I don't believe that the Fed can afford any implosions in the bond market, and will talk the talk accordingly. The 10-year note was up slightly today and yields 4.46%. Homebuilders were up strongly today on excellent results reported by Ryland (RYL). This is likely to be a result of the "last train leaving the station" effect, where buyers are panicking as they are starting to see interest rates go up. In a similar line of thinking, how many people who have seen gasoline go well over $2.00 per gallon are still looking at Hummers having observed the potential for gas to increase at the pump over the last few months? At this point, many have sworn off purchasing more vehicle than they actually need whether the transitory reduction in gas to below $2.00 per gallon happens between now, and say, the election. (Philadelphia suburb prices.)

Please ponder this as you enjoy your relaxing summer evening.

Martin Goldberg

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