by Richard T. Williams, CFA, CMT
Director, ICAP Equity Research
September 15, 2006
|Closing Prices||Support||Resistance||Yield %|
|2228.30||2025||2250||S&P 500 EPS yield||6.39%|
|1316.83||1240||1316||30 Yr. Bond yield||4.89|
Dow Jones Indus
cheap by 31%
The topping process is a complex one that often contains numerous fits and starts which seem to be ideally designed to frustrate the maximum number of participants and all of the prognosticators. This time is no exception to the rule. The S&P500 is moving towards a resolution with glacial speed and manifold head fakes. The interesting part from our perspective is that despite the market�s tendency to close each day at a technically ambiguous level that at least marginally satisfies both bulls and bears, several indicators are showing marked deterioration of market internals.
While the actual progression of the next bear leg lower may have only just begun, there are increasing signs of its imminent ascendance over gradually eroding forces of bullish players. We count our selves as optimists in general but have been swayed by the mounting evidence that a sea change appears to be in its final stages of evolution. Taken over a long timeframe the chart of the market shows a huge run up from the �90/91 recession, ending in �00 and correcting in a big bear leg down, ending arguably in late �02 or early �03. A study of major corrections shows that most taxonomies fit an ABC form where an initial decline is followed by a partial recovery only to then fall once again to lower lows. Our market clearly meets the first two conditions but unless it is something other than a major correction must soon succumb to the final downdraft.
Like most students of Elliott Wave Theory (EWT), we have internally debated the various counts and structures of the declines since Y2k as well as the rally since �02 lows. The outcome is not set in stone for us, yet there is a reasonably clear resolution that calls for a second down leg to carry US and many markets globally down to retest �02 lows, if not set new lows, over arguably 2-4 years duration. We cite the EWT rule of proportionality where corrective waves need to conform to patterns that are proportionate to their peers. For example this rule would make a case that the initial decline took 2.5 years and covered 50.5% in the SPX, 38.7% in the Dow and 78.4% in the Nasdaq; the bounce to the May highs took roughly 3.5 yrs. According to the rule the third leg (down) should take between 1.25 (50% of 2.5 yrs) to conceivably 5.8 yrs (1.618x 3.5 yrs), but more likely leaning towards the shorter end of the spectrum. Our projections put the conclusion of the next bear leg at either SPX 820 or 575 around December �07.
The alternate interpretation calls for a correction that does not exceed SPX 980 but could be as little as to 1190 or so before rallying to perhaps 1470 to 1750 over then next 3-5 yrs. The basis for this scenario derives from the assumption that the Y2k decline was a full ABC correction in and of itself rather than our operating assumption that it represented only the A (down). Accordingly the rally from �02 lows would then count as a 5 wave movement that would call for an ABC correction before running considerably higher once again. This is where we have the most difficulty with EWT; determining where you are in the cycle becomes all important and explains the seeming �off the deep end� forecasts that miss entire bull markets. Hence the need for alternative methods employed to triangulate results and thereby provide confirmation. Macro themes also can be helpful to identify cyclical phases of the economy and the market. In �94 when many technicians called for a major bear market the emergence of the Internet spawned a huge bull run. In absence of any such powerful catalysts we remain skeptical regarding the new highs scenario and interpret the market to be entering the C (down) of a major bear which is itself most likely a 4th wave correction to an even larger bull market structure covering decades.
Bull markets climb a wall of worry it is true, but differentiating between walls and tidal waves is important too. The current economic climate not only lacks a major catalyst for the next bull run, but moreover is so beset with problems as to argue for a deeper than normal recession or depression in order to wash away massive imbalances born of Y2k and beyond. The case for another bear market leg begins with economic patterns. America has shifted from being a net creditor to being a debtor of unprecedented magnitude. Huge outflows of capital have occurred for the worst of reasons: to sustain consumption at levels unjustified by US economic value creation. Jobs paint a meaningful picture of the problems with the post 9/11 recovery, underperforming by many millions compared to virtually every other recovery phase on record. Further the paper gains of rolling over a stock market bubble into the real estate market created unprecedented paper gains in wealth and financed a large part of economic expansion since the �01 recession. Enormous deficits and war costs paid the balance. In our view much of this recovery is illusory and will likely be revised to show that the recession of �01 lasted into mid �03, a result that is not surprising considering other B wave recoveries that also proved to be unsustainable.
Inflation and interest rates have played significant roles in almost every major correction in the markets. At the time that then Fed Chairman Greenspan engineered the shift from stock market bubble into real estate, he also changed important aspects of time-honored inflation measures like CPI. By altering the focus to the PCE index, Greenspan may well have set the stage for the next bear market and recession. When we recalculated CPI using BLS data to put housing costs back into inflationary gauges along with eliminating several of the more egregious changes introduced by Greenspan over the years, the result was that inflation ran 2%-2.5% above reported levels. Accordingly if the Fed has fooled itself into believing that inflation is something like 2% rather than what traditional measures of CPI would call something closer to 4%-5%, then current monetary policy will only exacerbate the next recession.
Normal checks and balances put in place after WW-II may prove to be ineffectual. Social Security, monetary policy and Fed-monitored price stability were established to protect Americans from significant economic disruptions. Unfortunately, deficits racked up during the expansion when surpluses usually are booked will only further impede flexibility, limiting government�s role in mitigating recessions or depressions. Greenspan's tenure accomplished a great deal, but we wonder at what cost to future prosperity. Social Security has less than $50b of actual cash according to gov�t filings, while the balance of its huge assets are now Presidential IOU�s that are not marketable and must be redeemed from the already over-taxed national budget. The profligate deficit spending in recent times leaves the Fed a huge problem to deal with but the tools available to combat the mess Greenspan perhaps more than any other created have been rendered sharply less effective due to decisions made with only short term benefits in mind. The use of Social Security funds to hide larger annual deficits than have been publicly acknowledged creates potentially ruinous debts that could easily take a generation to repay, another Greenspan innovation. Now when the housing market is in serious trouble along with consumers wracked by sharply rising debt service costs, lower interest rates may not be tenable due to earlier deficits and inflation. Bond market vigilantes function to drive the long bond yields higher when the Fed has fallen behind the curve in fighting inflation. Thus the Fed was pointedly reminded that its true reason for being is to control inflation and create jobs, not to finance aggressive gov�t spending. It is in terms of both of these core goals that the Greenspan Fed will likely come to be recognized for what amounts to enormous failures. The results will be deeper, more painful recessions in the months or years ahead.
Fed-heads have been increasingly talking about how the current stance to pause in its string of 17 consecutive rate hikes was not nearly as unanimous as currently thought by the marketplace. With each commentary pointing out that further rate hikes may be needed to stamp out inflationary expectations, the sentiment of investors and traders may soon turn less optimistic. At a time when Street consensus is overwhelmingly in agreement that rate hikes are done for the rest of �06, the Minutes of the last FOMC meeting pointed to more dissention than previously acknowledged, suggesting that further rate hikes by the Fed may be more probable than widely realized. Inflation hawks have come out of the shadows and have demonstrated a willingness to force the issue by raising long rates to combat the risk of purchase power erosion should the Fed fail to convince the marketplace that it has pricing stability as its primary focus. We would argue that FOMC thinking has only recently shifted after a prolonged period of market facilitation at the expense of inflationary behavior. As long as the Fed sticks to its inflation fighting charter, then we believe further hikes are likely to come based on rising or persistent Prices Paid, wage pressure and inflationary expectations. Such a focus likely would compress P/Es and depress prices.
Housing prices may have considerably further to run before completing their bear market. With rates likely to run significantly higher and with what we believe will be a replay of the 1929 margin death spiral only this time in housing thanks to mortgage hybrids, the downward selling pressures are immense and far from over. The number of consumers with IO�s or non-amortizing loans appears to be better than 50%-60% of the enormous refinancing booms in �03, �04 and to a lesser extend in �05. The numbers of hybrids could well be north of half of the $3 trillion of mtg debt underwritten in the last 3 years. The resets for hybrid teaser rates are hitting consumers last month and into this month, shocking households into taking desperate measures like selling their homes, handing keys back to the banks or sharply cutting spending. Pawn shops and IRA loans will be interesting proximity gauges of the looming troubles in the housing market. As banks are forced to liquidate repossessed properties, the natural bid to the housing market will be wiped out, driving prices lower and lower as distressed sellers have to sell to cover their mounting debts.
In this scenario the most liquid assets will be sold first: stocks and bonds! Then contracts will be cancelled, something that is occurring in a flood right now according to housing stocks. Retailers will hit a wall as distressed consumers� spending grinds to a halt due to higher mtg payments for people that cannot qualify for a refinancing, These people likely number in the millions based on mtgs issued over the last 3 years. Dramatically lower home equity statistics could set off a spiral of forced sales or mtg defaults. One media report showed that 50% of recent mtg holders had less than 20% of equity in their homes and that was before the latest home price declines. Finally the households under extreme duress will walk away from debts. Recently changed bankruptcy laws severely stiffen penalties for filers, forcing them to pay out a great deal more of previously retained assets, spreading the impact of large numbers of filers. Should the hybrid mtg boom lead to a downward spiral of forced liquidations, whether from distressed homeowners or from banks unexpectedly owning collateral from defaulted borrowers, it will lead to skyrocketing incidents of crime leading into Xmas spending season. The worst part of this scenario that we fear is all to likely to occur is that once started, it is almost impossible to stop until the tidal wave of sellers are finally out of the market. Recovery from such a crisis would require extended periods of time for the huge reservoir of debts to be paid down. So enjoy high P/Es while they still exist.
The market pattern argues for the resumption of selling pressures as well as compression of valuation multiples for equity and fixed income markets. Commodities also show signs of further declines over the coming weeks or months. The measures pointing to a completion of the recovery bounce are only one set of metrics that argue for lower prices ahead. So too do time and proportions imply further downside. The momentum indicators like Wells Wilder�s RSI show negative divergences in many senior averages around the world. The fact that so many global indices are closely mirroring the same behaviors suggests that a meaningful decline in prices is coming; in prior major declines virtually all equity markets correlated to one as buyers backed away from what they �should� do based on what they feared would be the result of such actions. The price/volume action shows a decided deterioration over time, with declining volume far outstripping upside activity, another bearish sign. Our Supply/Demand models have illustrated a continuing divergence of momentum compared to volume-adjusted price in weekly and daily time frames. The Hourly models show a dramatic shift from the sideways action typical of most of the summer to a sudden change this week. The fact that pre-announcement season begins in a few days bears on the technicals of the market as knowledgeable players act upon their convictions in ways that technicians can observe and follow. In short manifold signs of a bear can be found.
The New High/Low data had been giving a confusing series of signals of late. So too did the A/D line, with big divergences between momentum and price level that normally does not show up. The New lows surged in early August only to reverse and drop sharply back to near single-digit levels, a common sign of rallies about to unfold. New Highs usually spike into short-term rallies especially near completion, but in August this did not occur for a surprisingly long period of time. Finally these indicators have migrated back into more predictable actions, suggesting that new sell signals are becoming operative.
The confusing aspect of the emerging picture of the market is that the dollar and the price of gold typically would rise into a big stock correction as players run to safer havens to protect their capital. But in a climate of such huge deficits, particularly ones employed to extend consumption beyond sustainable levels, the dollar cannot be expected to hold its value for long without a major source of demand. Once inflation threatens the dollar will decline, as it has so markedly in the past 3-5 years, as foreign investors liquidate to protect their capital from price erosion. In this scenario all dollar assets may be subject to international selling pressures which would result in downward price movements across the board rather than the normal behavior in prior eras. The willingness of investors abroad, even Central banks motivated by political considerations, to hold rapidly eroding dollar based assets cannot long persist, turning the tide of liquidity inflows so necessary to float US deficits. The results will be to exacerbate the very conditions that precipitated market weakness such as rising interest rates, inflationary expectations and profit growth deceleration. Thus the 3Q earnings season may add to the bad news that has only just begun to wake sanguine bulls out of their complacency; it will eventually provoke the fear and panic that will mark the conclusion of the rout.
Thus we expect the declines of the last two or three months to continue and accelerate punctuated by short, sharp rallies that will correct the sustained downward slide of stock and bond prices. The patterns suggest that this process will take over a year to complete and will include a recession that likely will run deeper than any in recent memory, aggravated by the deficits and consumer spending patterns that have run far beyond what equilibrium can sustain. The key tests will be the speed of the downside and the depth of retracement bounces. Rates may rise up to 6% or higher, oil may slide towards $50, the dollar may erode below 80 on the dollar index, stocks may retest �02 lows or worse, and jobs will likely fall significantly into the red into the trough of the coming recession/depression.
The ST picture is characterized by a corrective ABC bounce that is done or very nearly done. The action from 8/4 to the present can be measured as a wedge top with all requisites met, but with the potential for one last blowoff to finish the throwover phase with a flourish. Otherwise the SPX appears ready to begin a downward run over the next hours to days which should display accelerating speed, volume and momentum. Anything else would be a sign that something else is at work. While we have cited the bull case based on the charts, at present it seems likely the market works lower. As bad as this news may be, for us it is better to be forewarned and prepared than surprised out of a state of denial �
|SPX Hourly Price Chart|
|Source: Bloomberg Charts|
A small H&S pattern may have confirmed in major indices today
|Daily SPX Price Chart|
|Source: Bloomberg Charts|
SPX rebound since June lows measures A to C at 100% suggesting a completed corrective bounce
|Weekly SPX Price Chart|
|Source: Bloomberg Charts and ICAP Technical Research|
Wave �C� down could follow the Y2k wave �A� bear market down in duration and in magnitude
|Weekly Chain Store Sales Chart|
|Source: Bronson Capital Markets Research|
Should consumers pull in their horns, retailers could face a sharp drop in sales
|Money Supply Growth Rate Chart|
|Source: ICAP Technical Research|
Money Supply remains range bound so the dollar will be a better indicator while this is the case
|Dollar Index Daily Chart|
|Source: ICAP Technical Research|
The dollar is trying to rally above trendline resistance
|Hourly SPX Supply/Demand Chart|
Source: ICAP Research
The Hourly is signaling a new Sell signal
|1-hour Volume-adjusted Price Chart for S&P500|
|Source: ICAP Research|
Momentum is so much weaker than VAP � looks like a trend change lower is likely
|Unit Labor Costs Indicator Chart|
Wage costs are threatening to become critical � we hear of regional wage pressures getting fierce
|1-year Supply/Demand Chart for SPX|
|Source: ICAP Research|
Daily S/D is coming off a corrective bounce
|1-year Volume-adjusted Price Chart for S&P500|
|Source: ICAP Research|
VAP is testing its highs - Momentum didn't rise enough for more than a ST corrective bounce
|30-yr Treasury Bond Price Chart|
Bonds are retesting the LT support � now resistance
|30-yr Treasury Bond Yield Chart|
Long rates may have survived a test of the spring breakout higher � if so then the target becomes 6%+
|Copper Price Chart|
Copper momentum is deteriorating � suggests global economy is slowing faster than thought
|Mid-Cap Index Price Chart|
Smaller caps are poised to turn down again
|5-year Supply/Demand Chart for SPX|
|Source: ICAP Research|
Weekly is shifting from a ST buy signal
|5-year Volume-adjusted Price Chart for S&P500|
|Source: ICAP Research|
Momentum is so far below VAP compared to prior rallies that a return to the LT sell signal is likely soon
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© 2006 Richard T.
Williams, CFA, CMT
Richard T. Williams, CFA, CMT
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Jersey City, NJ