Familiar Patterns: Avoiding Drawdowns and Crashes

The worse the economic and earnings numbers get, the bigger the deficits, the faster energy supplies decline, and the worse off the fiscal and monetary conditions get, the better our financial markets respond. Contrary to popular opinion, earnings don't always drive financial markets. In the short run it is often driven more by public perception than the reality of facts. In 1994 earnings rose spectacularly, but markets performed dismally due to derivative problems and the Mexican peso crisis. The next year earnings came in less strongly, but the markets rose double digits, so markets can rise on the basis of perception even when that perception is unrealistic. Today, based on trailing earnings for the S&P 500 at $29, analysts expect earnings to rise to about $50, a gain of over 70 percent. Yet each day we hear more stories of new layoffs and companies missing lower estimates. Wall Street says it is because of the second half recovery and a new bull market in stocks. The only thing they have right is the bull *&%#! Many now question the unnatural tendency of the markets; while so many on Wall Street are busy explaining away that this is all natural. It reminds me of many of the �new era� myths and rationalizations used to justify the Internet and technology mania of the late 90's. Others suggest perhaps something else is at work here.

The Alchemists

There is a growing view globally that the unnatural phenomenon of today's crazy markets may be the work of government alchemists. Most readers are familiar with The Washington Post story written years ago about the Plunge Protection Team, a committee formed after the 1987 stock market crash made up of the President, the Secretary of the Treasury, the Chairman of the Fed, Comptroller of the currency and large Wall Street firms such as Goldman Sachs, and Merrill Lynch. Their purpose was to stabilize the markets in periods of uncertainty. Unstable markets pose a risk to a leveraged financial system. More recently after the Asian crisis of 1997, Russian debt default and LTCM in 1998, experts gathered again to discuss the vulnerability of U.S. financial markets. The purpose was to derive a response to head off the potential of a highly geared financial market from collapse, especially today with the advent of derivatives, which had the potential to bring down the whole financial system as LTCM nearly did in 1998. Experts studied markets and found four potential crisis accelerators:

1. Leverage
2. Forced selling
3. Momentum mood swings &
4. Loss of confidence

Any one of these factors, if unstopped, could trigger a nuclear detonation of our financial markets. The incredible amount of leverage in today's financial system through the use of derivatives could bring down the whole system by one hedge fund simply ending up on the wrong side of a trade. The system is even more leveraged today than it was in 1997 or in 1998 when similar events nearly caused our financial markets to collapse. The other problem is when markets are so highly leveraged or geared as they are today, falling markets and program trading mechanisms automatically trigger additional selling which then begins to snowball into a crisis. Once you reach the severe crisis stage, you then begin to lose confidence, which sets off a panic in the markets and you end up with a crash that could be so severe that the markets never recover, which leads ultimately to depression.

This is where we are today. Our markets hang by a narrow thread that threatens to implode. The economy and the financial markets are highly leveraged and can’tafford a crisis or the whole system collapses. That is why, in my opinion, you see markets rally on the basis of new rumors that seem to fit nicely as a cover for intervention in the financial markets. Intermarket relationships seem to be out of whack, and knowledgeable experts are scratching their heads in an effort to explain away the markets� actions. Bulls seem to have no problem; for them intervention or no intervention, there is always a reason to be buying stocks valuations or poor earnings aside.

When viewed from this perspective, the unnatural phenomenon of the markets make more sense. On days when economic reports such as the trade deficit, the unemployment report, housing starts, and retail sales come in poorly, the markets plunge only to rally at the end of the day. Poor economic reports are often accompanied by sales and earnings warnings and more job layoffs, which also trigger rallies. I believe what is happening here is the prevention of drawdowns, or the effort to prevent losses from spiraling out of control. Because of the very nature of leverage today, it wouldn't take more than a few leveraged hedge funds or major money center banks to be on the wrong side of a trade to collapse the whole financial system. Equally important is to avoid accelerated selling. Once accelerated selling begins, it takes on a life of its own and could then easily become unstoppable. As you review the charts below, you can see where the markets have been, and where they have been recently. After peaking in 2000, the markets have been falling down the mountain. I believe a decision was made last summer to cap the losses and keep the markets contained within a narrow trading range. Specifically, an imaginary Maginot Line has been drawn at the head and shoulders neckline of the S&P 500. The same holds true for the Dow and the NASDAQ.

Each time the markets have touched the July and October lows of last year, remarkable miracles occur in the financial markets. When it appears that the markets are ready to breach support levels, the markets suddenly spike up for inane reasons. The spin machine then comes in and tries to explain it away. Companies that lose money beat estimates, or economic reports that worsen are better than expected. The markets suddenly begin a new rally process that lasts for short periods of time until new reality sets in and the markets begin to plunge again.

This familiar pattern can be discerned in July, October, and last week. They usually begin by a surprise upward surge in a plunging market, a spike up at the opening bell, or a gap up at the open, or series of opening gaps. You can see this in the fourth graph in the areas circled. The shorter or intermediate rally has most of its move in 3-4 explosive sessions. The markets then hang there with occasional smaller moves that extend the rally until the next wave of bad news hits the markets with the next quarter's earnings warnings, the monthly economic reports, or a worsening geopolitical environment.

This pattern has been repeated consistently since last summer's July rally. It is part of my engineering a rally thesis. I have written about this in the past and it bears repeating to understand how this cycle works. The four-step process is as follows:

1. Intervene in the market (done by buying futures)
2. Higher stock prices through intervention forces short covering
3. Stock prices that lurch higher brings in momentum players
4. If the rally lasts long enough, John Q may move money into mutual funds. This happens just about the time the rally fades

The rallies usually begin with intervention that comes in to support and prop up the market at key technical support areas. The danger technically is that with so many eyeballs and computer screens watching, the same technical charts breaching key support areas would generate further selling pressure. Falling through key support areas generates more selling that takes indexes down to even lower levels until the next area of support is found on a chart. Therefore, intervention seems to come any time key support levels are in danger of being violated. You can see this pattern repeated consistently since last summer's nadir in the markets. The markets are driven up violently in sudden surges that take place on a few major days of trading. They then seem to consolidate until additional intervention is brought to bear on the markets. However, beyond the few days of intervention that generate the four-step rally process you can see momentum indicators begin to decline. What is clearly transparent is that there are no follow-through rallies that come from widespread public participation. John Q is slowly exiting the market. The exit traffic is small and building momentum. This is one reason you can see a clear trend in the major averages of declining volume that has been evident since last summer and continues on to this day.

In summary, we have now reached the point of no return. Intervention is needed at all levels of the markets, whether it is propping up the dollar, driving down oil prices, propping up the stock markets, inventing new statistics to keep attention away from the problem, or preventing the price of gold or gold shares from rising. The markets require constant tinkering by the alchemists. Not to intervene would bring about a stock market crash, higher interest rates, a plunging dollar, and a collapse of the economy and the much-feared depression that few thought possible. However, history is replete of numerous examples how emperors, kings, prime ministers or presidents have all failed to turn the tide of the markets. The best that can be done is to prevent the inevitable. It has now become a question as to when the inevitable will arrive. Suffice to say it will arrive on a day when it is least expected. It will be triggered by an event that the experts didn't foresee. It will become unstoppable. The power of the markets are just like the power of nature. It can’tbe altered or stopped by man. Once a storm front arrives, it would be best to prepare for it rather than to try and outrun it. I suggest you find a safe harbor and batten down the hatches.

Today's Market

Today's markets were no different than previous periods. There was, of course, the bad news coming in last night from Applied Materials and Gateway Computer. Then there was today's bad report on housing starts falling 11 percent. There were earnings warnings and the pending war with Iraq. Saddam isn't leaving. The markets headed down and then miraculously recovered. The major averages rose for the fifth straight day in a row. It has been the biggest winning streak in almost two years on the worst possible news. Indexes bounced around between gains and losses all day until the final hour when the miracle occurred that took stock prices into positive territory. Bubblehead anchors explained the gains were due to investors suddenly turning bullish that the war will be short and painless and that nothing but good things will come as a result of it. The miracle occurred in the futures pits and was followed by the cash markets. The markets rose despite a fog emerging from the latest FOMC meeting. The Fed left the doors open for an intra-meeting rate cut if things deteriorate even more in the economy. Big board volume fell to 1.5 billion and Nasdaq volume came in at 1.6 billion. Market breadth was positive by 17-14 on the NYSE and the NASDAQ. The VIX fell .56 to 35.78 and the VXN headed higher by 1.36 to 48.02.

Overseas Markets

European stocks rose amid speculation slumping oil prices will cut energy and raw material costs at companies such as British Airways Plc. Bayer AG soared after being cleared of legal responsibility for the illness of a man that took one of its drugs. The Dow Jones Stoxx 50 Index added 4.15, 0.2 percent, to 2207.02. The Stoxx 600 added climbed 0.65, or 0.4 percent, to 184.94, with chemical stocks leading percentage gains.

Asian stocks advanced, with Samsung Electronics Co., Canon Inc., and other exporters rising on optimism a war in Iraq will be short. The Kospi rose 4.3 percent, while the TWSE jumped 4.2 percent. Both benchmarks had their biggest gains since Feb. 17. Japan's Nikkei 225 Stock Average rose for the second day in three.

Charts courtesy of www.stockcharts.com

James Puplava

© 2003 James Puplava

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James J. Puplava CFP
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