The Lull Before the Storm: A Fundamental & Technical Review
By James J Puplava CFP with Frank Barbera CMT, February 7, 2005
A Fundamental Review by Jim Puplava
In their benign state they are referred to as tropical cyclones. These minor tropical depressions may turn out to be nothing more than a brief burst of wind that develops as a result of unstable atmospheric conditions. Their genesis is the result of significant temperature differences in various parts of the atmosphere as you go aloft. When they become menacing, the weather bureau gives them a name. They become hurricanes and typhoons. These storms get their own name when their wind speed exceeds 64 knots. A mature hurricane or typhoon is a formidable force of nature that can pack winds reaching as high as 150-200 knots. They represent one of the greatest natural hazards known to man.
Major debates persist among storm forecasters regarding the ingredients necessary to turn a tropical cyclone or an arctic high pressure system into a major storm. Most weather forecasters will tell you that climatological models have a poor track record of predicting nor' easters, hurricanes or typhoons. Nor' easters occur in the eastern United States between October and April when moisture and cold air are plentiful. They are known for dumping large amounts of rain and snow and are capable of producing hurricane force winds. Hurricanes form in tropical regions between June and November where there is warm water, moist air and converging equatorial winds.
What we do know about storms is where and when they are likely to occur. We even know what causes them. The only difficulty is forecasting them. Tropical depressions don't always turn into a hurricane nor do artic high pressure systems form into nor' easters. It is only when unstable atmospheric conditions persist long enough that they form the genesis of a storm.
Forecasting The Perfect Financial Storm
Like the weather the financial markets and the economy are periodically ravaged by storm fronts. They are known as recessions, depressions and bear markets. Benign financial storms are similar to tropical depressions. They may be nothing more than a correction in the markets or a minor recession. The hurricane and nor' easter types turn into bear markets and depressions. Like climatological models financial models have a poor track record of forecasting financial storms. The majority of economists can’ttell you we're in a recession until well after it has begun. Wall Street analysts suffer from a similar myopia. Most analysts see nothing but sunshine and fair weather in the financial markets. Seldom is a storm cloud ever discovered until well after the downpour.
Bear-o-Metric Pressure Dropping
It should come as no surprise that even as the financial barometer is dropping with each Fed rate hike, economists and analysts are once again forecasting clear and sunny skies. Record trade deficits, rising government deficits, leveraged financial markets, ravaged consumer balance sheets, corporate malfeasance and a climate of speculation concern no one. Our financial forecasters are once again predicting perfect financial weather rather than the perfect financial storm.
Instability in the International Monetary System
Meanwhile the financial jet stream otherwise known as the international monetary system is becoming increasingly unstable. Barometric pressure is dropping steadily in the world's credit markets as central banks pump hundreds of billions of dollars into the world's monetary system. Instead of targeting credit, central banks are targeting interest rates. The result is that money is plentiful whether for economic need or for speculation.
Washington and Peking Storm Fronts
On the horizon two simultaneous storm fronts are developing; one in Washington and one in Peking. Central bankers in the U.S. and central planners in China are attempting to slow down their respective economies. Both economies are awash with money and credit the financial atmospherics that produce storms. In the U.S., credit is being used to finance consumption and asset bubbles. In China, credit is being used to finance an industrial boom. The U.S. is in the process of hollowing out its manufacturing base, while China is in the process of transforming itself into a manufacturing powerhouse. One country is in denial, while the other is in ascendancy. We are witnessing the greatest wealth transfer in history� one that may eventually lead to war as an inflationary hurricane in the U.S. confronts a deflationary typhoon out of China.
Inflationary Warning Signs and More of the Same
Financial forecasters are keen to point out the deflationary dangers emerging out of China, but ignore the inflationary warnings at home. Here in the U.S. the CPI has risen by 3.3% over the last year and that number is understated by hedonics. Asset bubbles continue to inflate in the stock and bond markets, mortgage markets and real estate. Consumers continue to borrow and consume. Investors are high on speculation chasing IPOs, bidding up shares of high beta stocks, standing in line or camping overnight to bid on a new home or condo. Corporations are back playing the merger game instead of building new plants or buying equipment. Wall Street is pitching IPOs in a feverish pitch and bubblehead financial anchors urge the crowds to play on.
Interest Rate Hikes Seeding Storm Clouds
Financial atmospherics meanwhile are turning combustible. Rather than targeting the money supply the only way to keep a bubble from inflating and prevent inflation; the Fed is seeding the storm clouds with interest rate hikes. By not controlling money and credit, the Fed is providing the heat and energy that will turn a financial cyclone into a full fledged storm. If the Fed persists in raising interest rates, it could unleash another perfect financial storm. This next financial storm could end up producing violent winds, incredible waves, torrential rains and floods that devastate the financial markets and cripple the economy.
The Fed has never been good at forecasting, especially storms of its own making. I have a vision of Mr. Greenspan as Captain Edward John Smith at the helm of the Titanic. Knowing he is surrounded by icebergs, he steams ahead without caution believing his ship to be invincible.
There is a double message here one that the financial markets and the Fed are ignoring. The Fed seems oblivious to the myriad asset bubbles it has created. In fact it admits it has no way of telling when the financial markets are in a bubble until well after it has deflated. Perhaps that is why the Fed's moves are measured?
The "Carry Trade" Continues
The Fed remains oblivious to asset bubbles and the financial markets are more than happy to keep perpetuating them. Greenspan's warning in Germany and recent Fed minutes from the December FOMC meeting indicate that the Fed is getting serious. It faces rising inflation rates here at home, global financial imbalances, especially in the U.S., and excessive signs of risk taking and speculation in the financial markets. The Fed's frustration stems from the fact that no one is taking the Fed seriously. The excessive risk-taking the Fed cites in its December minutes (such as the increase in IPO activity, the increasing number of mergers, and narrow credit spreads) persists. Despite rising short-term interest rates, the "carry trade" as yet to unwind.
The "carry trade" has become far too profitable to the financial economy. Despite ample warnings from the Fed, hedge funds, regional banks, industrial corporations and speculators continue to borrow short and invest and lend long. Many financial institutions are digging in and refusing to unwind. An example is U.S. Bancorp, which sits on a large portfolio of mortgage bonds. It realizes 19% of its earnings from its mortgage bonds, while its lending margins have narrowed to 4.2%. Rising interest rates are cutting into the returns on its bond portfolio. So far the bank is holding, on hoping that profits from corporate lending will offset the losses it realizes on its bonds. That is getting harder to do has the fed funds rate keeps climbing.
As the Fed continues to raise short-term interest rates, the yield curve will eventually flatten. This removes the profit margin for financial institutions and narrows the spread for making money at hedge funds. It isn't just banks and hedge funds that are affected by rising interest rates. Industrial corporations are dependent on the "carry trade" to finance trade and shore up profits margins. Company profit margins are shrinking as a result of rising energy, healthcare and raw material costs. To compensate for shrinking profit margins, companies are relying on yield spreads to maintain profitability.
This loss in profitability has broader implications for the stock market. Financial services make up 23% of the S&P 500 and more than 30% of its profits. Financial companies aren't the only ones that are affected by rising interest rates. Major manufacturing firms are increasingly relying on their financial units for profits. In some cases, the financial unit is the company's main source of profits as is the case with Ford, GM, and GE.
Percent of net income these companies earned from their financing units in the third quarter.
income 2Fourth quarter ended Oct. 31, 2004
3Income before interest and taxes
|Source: "Fool's Paradise," Forbes, February 14, 2005.|
The "carry trade" permeates the manufacturing sector from GE to GM and from Caterpillar to Pitney Bowes. Playing the "carry trade" is crucial to maintaining manufacturing profitability.
The problem is that cheap money has become an addiction. Companies and speculators are finding it difficult to give up the habit, so they continue to play the game. Last year 53% of all corporate bonds issued were floating rate. In order to unwind these positions many large financial institutions would have to take losses on their portfolios. If everybody unwinds at the same time, long-term interest rates would rise and bond prices would plunge. For leveraged players, such as hedge funds, that presents a problem. They are too highly geared to absorb the losses from a major bond market convulsion.
Bond Tsunami Looms Ahead
If the spec community unwinds long-term rates rise, it would impact all asset classes of bonds from junk bonds and emerging market debt to mortgage back securities. Hedge funds have emerged as major players in the junk bond markets. They make up 82% of the trading volume in distressed U.S. debt and 30% of the volume in below-investment grade bonds and credit derivatives. That is giving poorer quality companies an extended lease on life, a lease that lasts only as long as the bond market holds up. Currently bonds rated Caa or lower make up 20% of the outstanding supply of speculative bonds. That is twice the level reached in 1998 when the Asian financial crisis and Russian debt default ended the reign of LTCM. According to Moody's, the percentage of risky debt is unprecedented. Moody's believes that default rates are set to rise again as low-quality bonds age.
Meanwhile spreads have narrowed considerably, but not enough to endanger the costs of rising rates, defaults, or falling prices. With increasing amounts of leverage you can still arbitrage and make a nickel. In effect, the Fed has engineered the largest one-way bet in history. Everyone assumes that long-term rates will remain low for eternity. Hedge funds crave yield spreads and have very little fear of risk. Like tourists on the beaches of Puket, they are oblivious to the bond tsunami that is on its way.
Real Estate Bubble Continues
Even worse is the deterioration of underwriting standards in the mortgage markets. According to one underwriter "when money chases deals underwriting standards suffer." Last year interest only loans skyrocketed to make up more than 39% of all loans. That is up from 10% in 2002. Interest only loans are fine as long as real estate prices continue to rise or stay firm. Problems begin to surface in the way of defaults once home prices head south.
Meanwhile homeowners remain distracted and unaware of risk mesmerized by the returns made on real estate. Last year in San Diego housing prices rose 21.1%, the ninth consecutive year of gains. That figure is just an average. In the suburbs, price appreciation has been much higher. It has been 48% on the coast and as high as 39% in the tony parts of town. The median price San Diego home is now $500,000. San Diego is leading the state in lending trends. Buyers of homes are resorting to adjustable rate mortgages and interest only loans. In San Diego County in 2004 adjustable-rate mortgages represented 80% of all new purchases last year.
With housing inflation making most homes unaffordable, buyers here are relying on creative financing. Adjustable-rate mortgages, interest rate only, and negative amortization loans have become the new trend. It's the only way buyers can qualify and make ends meet. Homebuyers are using savings and drawing down investments in order to buy. Salaries and wages just don't cut it anymore when median price homes in the suburbs start at $700,000-$750,000. The new California definition of a millionaire is a homeowner. You have to be one to live here anymore.
California isn't the only city to be taken over by the gold rush mentality sweeping over the real estate markets. From Miami to New York and from Orlando to San Diego, buyers are lining up, camping out overnight in front of sales offices to be the next in line to buy a new condo. With homes becoming unaffordable, buyers are rushing in to buy condos. Some are first-time buyers, some are looking for a second home, while others are just speculating hoping to make a quick buck by flipping the property. Buyers are oblivious to risk and believe that home prices can only go up. The Center for Economic Policy Research believes that a one percent rise in borrowing rates could start driving home prices lower. The fact that housing prices could decline may come as a shock to homeowners. Especially if they own an adjustable-rate, negative amortization, or interest only loan.
Even worse is the shock that falling real estate prices could have on consumption. Last year U.S. consumers spent a record $4 trillion taking advantage of cut rate prices for cars and discounts from retailers. Total sales for 2004 were up 8% from 2003 to $4.06 trillion. The consumer is back at the mall buying everything from new cars to furniture and home entertainment systems. Funding this spending orgy is home equity extraction, which is now averaging close to $300 billion a year. What happens to consumption when consumers ATM machines their homes stops appreciating? Add this to rising interest rate costs and ballooning property taxes and it isn't hard to see that a home budget squeeze is in the making.
At the moment consumers, hedge funds, banks, and industrial companies can breathe a sigh of relief; the long end of the bond market is holding up and hasn't collapsed. But the spreads between what it costs to borrow and what a lender or investor can earn on his money is getting razor thin with each new Fed rate hike. By the looks of things the Fed has no intention of stopping. What lies in wait for investors sometime this year is a nasty popping of the bond bubble. Why? Because credit spreads are too narrow, yields are too low, and bond prices are too high and inflation rates are rising.
At the moment the endgame is causing investors and speculators to rush into bonds fearing an economic decline. Talk of deflation is everywhere, so the first reaction is to buy bonds. You can see the results of this in Frank's charts of the bond market and the dollar further below.
The deflation scare will provide the cover for the next leg of the "Great Inflation." As a result of economic weakness and a stagnating asset market, the Fed will begin another round of liquidity injection. The next credit boom will go increasingly into speculation and will do very little to reignite the economy. Stagflation is what lies directly in front of us.
Corporate America Braces for High Winds
Another trend along with rising interest rates that will slow down the economy is corporate mergers. As the pace of mergers quickens, corporate layoffs will shortly follow. The first piece of news accompanying the SBC and AT&T takeover was another round of job cuts. SBC will eliminate 13,000 jobs after its planned purchase of AT&T. These are all high paying jobs; 5,100 from sales and business operations, 2,600 from administrative, and another 5,100 from engineering. More layoffs are planned for 2009. The new layoffs follow over 20,000 jobs eliminated at AT&T over the last two years. U.S. telecomm companies have fired 300,000 workers since March of 2001, a 22% reduction in the telecomm labor force. People talk about good times, but they ignore the fact the manufacturing sector is in the midst of a depression. Over 3 million jobs have been lost in this sector since 2000.
What is lost here from a macroeconomic perspective is that cost cutting and mergers contribute to economic contraction. If only one firm cuts its costs, greater profits are realized. However when whole industries downsize, they end up cutting each other's revenues. When firms cut expenses by slashing payrolls, they end up cutting the purchasing power of their customers. A fired worker loses his ability to consume. As the pace of mergers accelerate with companies using their cash hoard to buy out the competition, job growth should decelerate.
History has a way of repeating itself perhaps never in the same pattern but following similar paths. It has been five years since the Dow Industrials reached their peak. Investors have incurred horrendous losses in the markets between 2000 and 2002. A Nasdaq decline of 76 %, a loss of over 40% on the S&P 500 and close to 28% losses on the Dow have failed to dissuade investors from speculating. Speculation is back and is evident everywhere from IPOs to high beta momentum stocks and everybody's new favorite real estate. Real estate speculation has replaced the dot-com bubble. According to recent public opinion investor polls, investors ranked real estate as their best investment. It has become the latest can’t lose investment.
What it shows is that investors have short-term memories. Apparently they have learned nothing from the bursting of the stock market bubble. Like sheep surrounded by wolves, they are about to get sheered again. The day traders are back. They have unquestionable faith in their black boxes. John Q. has traded in his dot-com for a condo and granny is invested in junk bonds. This is the moral hazard at its finest display. Confidence has returned once again to the markets. Volatility readings haven't been this low since December of 1993 a short time before the bond bear market of 1994 was to begin. What we have now is the lull before the approaching storm. It is time to put on the foul weather gear. For a look at how this end game possibly unfolds, read below.
 Fool's Paradise, by Bernard Condon, Forbes, February 4th, 2005
Stock indexes suffered minor losses on Monday as speculators take profits. We've had a nice two week run that still leaves the averages in negative territory this year. Market analysts remain optimistic believing 2005 will be another positive year for stocks. The momentum players are back, so stock prices could head higher.
The Dow Industrials slipped 0.37 points closing down to 10,715.76. The S&P 500 edged lower by 1.31 points to 1,201.72 and the Nasdaq fell 4.63 points to close out the day at 2,082.03.
Oil prices gave back $1.20 to finish out the session at $45.28 a barrel. Gold lost $0.50 an ounce to close at $415.40 and silver slipped $0.08 to $6.55.
Yields continue to fall with the 10-year note ending the day at a yield of 4.05%, down from 4.09% on Friday.
The Lull Before The Storm
A technical review by Frank Barbera
After a sharp sell off in January, equities have reclaimed a better footing amid a strong rally in bond prices and signs of a slower paced economic environment. On Friday, the Labor Department reported Non-Farm Payrolls up 146,000 which was well below the consensus forecast of a gain of 190,000. In response, Bond prices surged as lower employment and stagnant wage growth augurs poorly for consumer spending in the months ahead. For equities, recall that the sharp sell off in January was sparked by the early January release of Fed Beige Book Minutes, in which, Fed members openly hinted at an elongated series of interest rate hikes. Never a fan of tightening monetary policy, the equities market retreated in January with the S&P dipping nearly 5%. However, with Friday's release of weaker than expected employment, stocks rebounded quickly as a slower growth environment could move the Fed toward a "wait and see" posture where further rate hikes are concerned. As a result, stock prices moved in tandem with Bonds, as stocks posted their best day since December 1st, over 2 months ago.
So what's next from here in the stock market ?
Looking ahead, it appears that the market has now embarked on a renewed Intermediate Term advance which likely will be strong enough to lift a number of major averages to new and higher highs. This advance will likely be medium term in nature, lasting 8 to 12 weeks and could readily see the S&P make moderately higher price highs in the 1240 to 1270 area. However, there is also a very high probability - which has escalated considerably in recent days, that the next advance to higher highs could cap off this cyclical bull market. One reason to become suspicious of the markets upcoming rally would be the simple idea of "Old Age". Yes, Bull Markets can and do, die of old age.
Historically, market technicians, starting with Robert Rhea in the 1920s and 1930s, and more recently Arthur Merrill, Richard Russell, and Victor Sporandeo have noted that under Dow Theory, bull market cycles typically last between 28 to 33 months. On page 66 of his classic book, "Filtered Waves" (first published in 1984) and then re-released in 1999, noted market technician Arthur Merrill points out that between 1897 and 2000, 28 Months was the average duration of most cyclical bull market moves seen in the 20th Century. That means that dating the start of this bull market to the major market lows of October 2002, it has now been 27 months since the major bottom thru 1/31/2005. Using 10% Swing Reversals from the low of October 2002, a bull market would have been confirmed when the S&P recorded a second bullish swing of greater than 10% off the March 2003 low yielding a set of higher highs and higher lows. However, others technicians might argue that while the exact price low for the S&P 500 occurred in October of 2002, with the real bull market advance not beginning until the major lows seen in March 2003. Under this circumstance, the current Cyclical Bull Market would not be quite as grey, weighing in at 22 months old. Under this point of view, a more important top in the market might not be seen until summer with July 2005 representing a full count of 28 months off the March 2003 low.
In addition, looking back at the behavior of the stock market throughout 2003 and 2004, there is ample evidence that going into year end 2004, the stock market still possessed high levels of internal strength. Normally, in the months preceding a major and final market top, stock market "breadth" and volume gauges tend to weaken signaling in advance, that the underlying trend of the market is deteriorating. In the case of market breadth gauges, the most common and often one of the best measurements is the Cumulative Daily Advance-Decline Line. While not infallible, the daily Advance-Decline Line has a strong tendency to begin declining well ahead of a final price peak in the major averages.
To illustrate this point, the accompanying charts show two of the more prominent market peaks in the last 30 years with the S&P 100 and its own Advance-Decline Line. On the top clip, we see that major peak of 2000 wherein the A/D Line actually peaked in July of 1999 and had been falling for more than six months as prices reached a final high in January 2000.
Similarly, back in 1987, it can be pointed out that a similar bearish divergence foreshadowed the major top which formed immediately before the great stock market crash of October 19th. Updating these charts to the present climate, it must be pointed out that going into year end 2004, as the S&P price indices moved to higher highs, that advance was fully confirmed by the action of the Daily Advance-Decline Line which actually led the move higher. Technically, this was very strong behavior and suggested that any decline in stock prices would be merely a correction and not a major trend reversal.
As can be seen, the subsequent pull back which developed in January saw both the S&P and it’s A/D Line hold above the rising 200 day moving average with both the S&P and A/D Line recovering strongly in recent days. The resulting lack of bearish divergence suggests the market still has more room open on the upside despite the fact that by some measures, time is starting to work against an aging Bull.
Other examples of medium term "breadth gauges" also paint a similar picture of an aging Bull Market, but one with more time left on the clock. The chart above shows an even more medium term breadth measurement using the Weekly Advance-Decline Line for Optionable Stocks. Note again, that this gauge has been moving steadily higher over the past two years retracing a good chunk of the prior bear market decline. Note that the 39 week (200 day equivalent) moving average for the Weekly Options A/D Line is moving steadily higher and that in late December, this gauge made new highs right along with prices. Normally, a more important market peak (possibly a final peak) would have been accompanied by a much weaker pattern in this medium term gauge, with indices making new highs and the Weekly A/D Line deteriorating into a downtrend. However, while the primary trend of the stock market is still clearly "UP", the recent correction did expose some major changes taking place within the stock market that underscore the potential for a market top in coming months. For one thing, there has been a major leadership shift within the stock market from technology related stocks toward more defensive issues.
"Creatures of Confidence" Important to Watch
Often an obvious sign of longer term topping action, the past few weeks have seen sector rotation unfold at a torrid pace. During the course of the most recent decline, money has flowed out of overvalued technology shares - moving away from high beta and sought out better values in high-cap defensive names such as Foods, Staples, Utilities and Energy. Back in the 1970s, the great market technician, Edson Gould once referred to the speculative leaders of a market as the "Creatures of Confidence". In Gould's view, these were always the high-beta, speculative stocks which led a bull market higher and which invariably sported absurd fundamental valuations. While for most "value" investors these stocks held little appeal, the "Creatures of Confidence" retained a very important meaning to Gould as they defined the pulse of speculative sentiment. Once these speculative leaders stopped moving up, in Gould's work, it was invariably a sure sign that the final phases of a bull cycle were developing and that a more important market top might not be too far away. In today's market, a list of the Creatures of Confidence might include some of the names in the table below. Within this list P/E's are often over 30 and often there is little in the way of earnings relative to market cap.
| High Beta Index
(Creatures of Confidence)
|Defensive High Cap Index|
|1. Sirius Satellite (SIRI)||1. Archer Daniels (ADM)|
|2. Monster.com (MNST)||2. Church and Dwight (CWD)|
|3. AskJeeves (ASKJ)||3. Conagra (CAG)|
|4. I-Vallage (IVIL)||4. Constellation Brands (STZ)|
|5. StemCell (STEM)||5. General Mills (GIS)|
|6. Google (GOOG)||6. Pepsico (PEP)|
|7. EBAY (EBAY)||7. Wrigley (WWY)|
|8. Yahoo! (YHOO)||8. Hershey (HSY)|
|9. Taser Int'l (TASR)||9. Uniliver (UN)|
|10. XM Satellite Radio (XMSR)||10. Procter & Gamble (PG)|
|11. UTStar.com (UTSI)||11. Colgate Palmolive (CL)|
|12. J-2 Communictions (JCOM)||12. Budweiser (BUD)|
|13. Travel Zoo (TZOO)||13. Kimberly Clark (KMB)|
|14. Websense (WBSN)||14. Abbott Labs (ABT)|
|15. Research in Motion (RIMM)||15. Johnson & Johnson (JNJ)|
|16. Infospace (INSP)||16. Baxter Labs (BAX)|
|17. Overstock.com (OSTK)||17. Chevron-Texaco (CVX)|
|18. JupiterMedia (JUPM)||18. Exxon-Mobil (XOM)|
|19. Aladdin Knowledge (ALDN)||19. British Petroleum (BP)|
|20. Amazon.com (AMZN)||20. Philip Morris (MO)|
|21. NetFlix (NFLX)||21. Wyeth Aherst (WYE)|
|22. Net-Ease (NTES)||22. Heinz (HNZ)|
|23. SINA (SINA)||23. United Technologies (UTX)|
|24. Zebra Tech (ZBRA)||24. General Electric (GE)|
|25. Imclone (IMCL)||25. Clorox (CLX)|
From January 2, 2003 thru June 30, 2004, the index of the 25 Creatures of Confidence (left) soared 339%, -- that's right, 339% in 18 months from a low of 87.16 to a high of 383.33! Amazingly, these 25 stocks now sport a total market cap. of $227.77 Billion Dollars with EBITDA of only $3.5 Billion for a MarketCap to EBITDA Ratio of 64.85 to 1. Compare this to just one Oil Stock, British Petroleum, which has a market cap of 219.30 Billion Dollars and total EBITDA of $33.15 Billion (6.61 to 1) or Exxon Mobil, with a market cap of $334 Billion and EBITDA of $47.61 (7.01 to 1). Something is definitely missing in the "E" for earnings department in this list of high-fliers.
However, what is most interesting about this list is the "roll-over" taking place on the chart over the last few weeks. After putting in a major peak in late June 2004, this index experienced a sharp decline into August and then a "failing" rally where it was unable to make new highs with the major averages in December 2004. Since the December 30th peak of 346.09 to the recent low of 284.40, the index had fallen 17.82%, --- a sharp break in less than 4 weeks leaving the index at one point down nearly 26% from its June 30th high. Note that the 200 day moving average is now declining and the index is very close to "breaking down" and has lagged the recovery in the overall market. While a bounce may indeed unfold in this speculative list of stocks, odds are high that after a bounce, the downside movement will accelerate and the index will break down.
|Stock||Trailing P/E||Forward P/E||MarketCap||EBITDA|
For the overall market, the demise of the speculative leadership is a warning sign that we are likely advancing into the late innings of the Bull Market, wherein a more important top could be seen in the weeks and months ahead. To highlight and contrast the switch over in market leadership, a second index of 25 leading "bluechips" (right side) with low P/E's and other defensive qualities was constructed. Believe it or not, that index was actually up throughout the January decline sporting a NET GAIN of 1.00% at the very time the S&P was near its January low with a loss of 3% and with NASDAQ down nearly 6%.
Yet another signature of an approaching market high comes from another one of the market's great masters, George Lindsay, who worked on Wall Street his entire life. One of Lindsay's classic topping patterns for the Stock Market was known as "The Three Peaks and Domed House Formation" and appears to be developing in the market over the last 12 months. While some might scoff at Lindsay�s work, as a technician he had a terrific track record at calling some of the most important tops and bottoms of the last 40 years, including the major lows of October 1974 and August 1982, the major highs of 1965, 1969 and 1973. Yet using his Three Peaks Pattern, there are a number of rules that need to fit. In the current case, so far, they all do. Within the pattern, primary momentum gauges normally peak at extra-ordinary levels around point 3, and this is a high which culminates an "elongated multi-month advance". Within the Lindsay pattern, following Point 3, the market traces out a broad range referred to as "The Three Peaks" which often possess a symmetry that is apparent.
The next key element is what Lindsay referred to a "the Separating Decline" using his words as follows,
"after the third peak, Point 7, a rather severe downtrend begins. This is called the separating decline because it separates the three peaks from the formation that follows. The Separating Decline usually comprises at least two selling waves from Point 7 to 8 and from 9 to 10. Point 10 is always at a lower level than either Point 4 or 6 and it is often lower than both. Unless one of the two prior lows is broken, it doesn't qualify as a Separating Decline."
Continuing with Lindsay's commentary,
"after the Separating Decline, a new formation begins. It begins with a base shown between Points 10 and 14. To be a satisfactory base, there should be a rebound from the low at Point 10 and then two secondary dips to Points 12 and 14. One test of the low doesn't suffice, there must be two. After Point 14, the average then shoots up in a fast, short-lived advance ending at Point 15. At this point, we then see a pattern of "Five Reversals". You may recall that a triangle on a chart usually has five reversals. After Point 20, the last of the five reversals, the main uptrend is resumed. This culminates in Point 21 at which point, the average hesitates (corrects) before spurting again to a higher high at Point 23. From Point 23, (the Final High), the average quickly falls retracing the entire previous gain from Point 21."
Point 23 tends to peak approximately 7 Months and 8 to 10 days AFTER the low at reversal point 14, the last retest of the base of the Domed House. In the current instance, Point 14 in this pattern was seen on October 25th, 2004 at 1090.19 on the S&P 500. Looking back at Lindsay's past examples of this pattern, which were seen in 1906, 1916, 1919, 1922, 1929, 1946, 1952, 1956, 1960, 1968, 1987, and more recently, 1989 - it is not uncommon to see the five reversal element of the pattern unfold in a somewhat distorted fashion, and in fact, quite often, a sell off from Point 19 to Point 20 is a rather prominent medium term correction. While the pattern is somewhat subjective, using some Lindsay's own past patterns as a guide, the January 2005 decline fits well with the decline in the pattern representing the low at Point 20.
In the chart below, the labeling for the Lindsay "Three Peaks and Domed House Pattern" for this cycle is applied along with the 200 day Bands for the S&P and a Medium Term Momentum Gauge known as "MACD". Notice that at Point 3, MACD was on a huge excursion above zero reaching +22.16% on 1/6/04. At that point, the classic 8 month correction embodied by the Three Peaks unfolded throughout 2004 bottoming on August 13th, at 1062. As a "Separating Decline", the 2004 June to August decline was perfect with Point 10 undercutting both Point 4 and Point 6. This was then followed by a rally and then two higher retest lows at Points 12 and 14. Over the eight month period between January 2004 and August 2004, the MACD went negative, drawing down the first major impulse of upward momentum. As can be seen, the second upward impulse of momentum was seen late last year, as the market formed what Lindsay called "the walls" of the Domed House. This advance was also quite powerful, lifting MACD up to a peak of nearly +17% in late December 2004.
That reading of +17% represented a still "high" level for medium term momentum, implying that between late 2003, and late 2004, there wasn't a whole lot of technical deterioration in the cyclical bull market. Yet Point B, the Dec. 2004 high, did unfold at a lower momentum high, setting up what could become the first in a string of lower momentum peaks (or excursions on MACD above zero) going forward into 2005. Ultimately, the exhaustion of upside momentum may very well correlate to a final price peak later this year as forecast by the Lindsay pattern.
Under present circumstances, Lindsay's Model gives us an estimated final top due in June 2005, potentially between June 3rd and June 7. While it is doubtful that any one particular model for the stock market can be expected to predict a major high to the precise date, it is fascinating how many gauges are highlighting the potential for a more important market top to develop in the coming months. Perhaps among the key ingredients to watch for in coming weeks, would be the beginning of a deterioration in market breadth which would be the signature of a stock market moving higher, but with fewer and fewer stocks participating in the rally. To date, that process has not yet been evident and is normally a key component to a final peak.
US Bonds on Halting Uptrend
While Stocks appear likely to maintain an upward trajectory for at least a little while longer, it seems that coming into 2005, virtually everyone was bearish on the U.S. Bond market. As it turns out, the very one sided nature of sentiment toward Bonds, is probably the Bond markets greatest savior at the current time, helped along perhaps by a string of stalled out economic data. As recently as January 10th, an institutional poll of Bond managers showed only 11% looking for higher Bond prices, while 45% expected prices to decline. Those same polls have been one sided for a long time with regard to Bonds suggesting that odds were building for a sharp rally to squeeze out the Bond bears. That rally took off on Friday with yields on the 10 year Treasury plummeting to 4.08%. In looking at a medium term chart of the 10 Year Treasury (inverted) the current bond rally appears to have reasonable upside potential toward the 200 day upper band, which would carry yields down to the 3.65% to 3.70% area and back to the vicinity of the mid-March 2004 lows.
As a result, Bond prices also appear to be locking on to an uptrend, albeit a halting uptrend for the first half of 2005. Stepping back for the near term view of Bonds, the longer term view strongly suggests that the major lows in yield seen back in June 2003 at 3.10% in the 10 Year Bond finished off a 5 Wave Bull Market in Bonds. The larger pattern emerging Bonds is distinctly bearish suggesting that all the behavior seen since September 2002 has been one big price distribution pattern, put another way, a major top in Bond prices. At the moment, the current rally in Bonds looks likely to yield a major secondary top in mid-2005 with a distinct possibility that the second of half of the year could see long term yields rising at a time when few expect the much anticipated reversal. Ultimately, it would take a swing reversal back above 4.75% on the 10 Year yield to confirm the beginning of a major Bond Bear, however, when that signal is given it may be shocking to see how rapidly long term interest rates will rise.
US Dollar Downtrend
One catalyst for a second-half downside reversal could well be a bout of renewed weakness in the U.S. Dollar. For the time being, the Dollar Index has found stability between 81 and 85 garnering some upward movement off a deep oversold condition seen in late December 2004. However, what has to be very disturbing to the Dollar Bulls is the fact that so far, with a relatively meager bounce, from 81 to 84, the index has already rapidly unwound much of the oversold condition and could in fact soon become overbought.
Given the strength of the Dollar downtrend, which in the past has shown a remarkable ability to trend in one direction for exorbitant periods of time, the odds are very high that the best case scenario for the Greenback would be a sideways "holding action" over the first few months of 2005. From there, the Dollar could easily become overbought and begin a renewed Primary Trend decline. That decline which would likely start in the second half of 2005 could readily see the Dollar break below major long term support (the dark horizontal line - top clip) between 78 and 81 en route to a string of new lows against virtually all foreign currencies. In this outcome, a weakening dollar could force the Federal Reserve to continue hiking rates at an "unwanted" pace, pressuring both Bonds and Stocks to the downside.
Slow Start - Big Finish for Metals
Finally, one of the more prominent beneficiaries of a renewed downturn in the Dollar would be the currency of last resort, Gold. Historically, Gold and the Dollar have had a strong inverse relationship which has moved Gold from the mid-200's to the mid-400's over the last few years as the Dollar as declined by almost 33%. In that vein, it appear likely that the major Gold Stocks are probably close to putting in an important long term low as the Gold Index has been moving down for the last 8 weeks. Over that period of time, leading Gold Stocks have become technically oversold and are moving down to the lower 1/3 of their two year range. At the same tome, the longest standing rising trendline is intact for the XAU as key gauges of sentiment such as the Rydex Precious Metals "Flow of Funds" Model works its way down to a major oversold reading. Thus, while it may well be that Gold and Gold Stocks suffer a little while longer in the opening months of 2005, a host of technical gauges are already suggesting that Gold and Gold Stocks could finish 2005 as the strongest market sector, ending the year with robust gains.
Stepping back from the short term to view the larger picture, 2005 is shaping up as a "turning point" year for the stock market. While it is possible the market could manage to "hold up" and make some additional progress to the upside, odds are highest that the first half of 2005 will be strong, while the second half of 2005 could be surprisingly weak.
© 2005 James Puplava