EARLY CONFIRMATIONS?
by Richard T. Williams, CFA, CMT
Director, ICAP Equity
Research
November 6, 2006
| Closing Prices | Support | Resistance | Yield % | ||
| NASDAQ | 2330.79 | 2240 | 2380 | S&P 500 EPS yield | 6.17% |
| S&P 500 | 1364.30 | 1348 | 1390 | 30 Yr. Bond yield | 4.82% |
| Dow Jones Indus | 11933.60 | 11750 | 12000 | Greenspan
index cheap by 28% |
127.9% |
| Crude Oil | 58.96 | 58.00 | 63.00 | ST yield | 4.97% |
| Gold (spot) | 627.10 | 600 | 691 | Yen/dollar | 85.91 |
The economic data coming out is providing a stark look into the health of the recovery. The conclusion is not cheery. The recent surveys of C-level executives turning negative on the business environment looking forward have been corroborated by the IT executives with similar outlook. The last four Fed regional surveys starting with Philly Fed and most recently with Chicago PMI show a consistent deepening of the slowdown in economic activity, but more disturbingly yet that inventories and prices paid components remain stubbornly high. In fact the Chicago inventory report showed the highest reading in 30 years, second only to the �73/74 recession onset. The significance of these data points is subject to interpretation as is the latest sentiment data, which alternately is indicating surprisingly low bullishness at new highs on the Dow or a relative high with growing negative divergences. Any longer term reader can readily guess which way we would interpret the data!
The oil market started the day on key support after apparently breaking out of a wedge-like bottoming pattern only to then fall further to hit our intermediate term pattern target at $57. Oil then staged a powerful rally, helping to build confidence that a bottom has now been set in place. The upside objectives could reach the prior highs at $81 last May or even go so far as to reach $100. The message appears to be that with a weaker than expected economy oil consumption will now rise. As perverse as this may sound, it probably has more to do with inflation and weather than with economic activity levels. Oil is priced in dollars and our growing inflation problem erodes foreign buyers� purchasing power through no fault of their own. Accordingly we expect to see initiatives to price oil in euros or yen rather than the buck over the next few years. Gold may also follow oil's lead off its lows.
Interest rates on the long end of the curve have broken down from normal retracement limits, which is curious given its bullish run off key support for a larger breakout pattern. Now TYX is showing a potential bottom and reversal on the combination of weaker economic data and falling productivity. This view comes after a surprising period where rates fell hard even in the face of inflation data that at least to us looked like it confirmed the problem if not threatening worse situations developing. If the Fed has overshot as we have opined in the past (due to CPI changes that hid inflation and ironically later misguided the Fed itself) then bonds would logically benefit, but in the situation where Productivity may be turning negative this relationship is reversed. For whatever reason the bond market took the news favorably, there will be increasing pressure to sell bonds and rally yields in the coming weeks in our opinion. Should the TYX indeed turn higher, our pattern target of 5.31% seems probable or perhaps even our LT target of 6%+. But until a turn can be confirmed more time needs to pass before the next set of observations and forecasts can be made.
We have also noticed an interesting phenomenon in the equity markets that may lead to wide scale estimate revisions that could impact the stock market and pressure valuation multiples for a variety of high-flying stocks. With the news of substantially lower economic growth than expected following on data showing that inflation remains a serious concern to the Fed, a standard practice among equity analysts on Wall Street could play an important role in pegging valuation multiples going forward. In the past it became clear to us that much of the Street arrives at so called �out-year� estimates in a simplistic manner, one that is markedly different than the process of determining current year numbers. The technique is to apply a LT growth rate to the current year (2006) estimates to generate �07 forecasts. Then as the current year winds to a close, the Street revisits the out-year numbers and adjusts them as necessary to match current conditions and expectations for actual results. Forecasting two years forward is a difficult task for an industry that has a hard time pegging next qtr results! So for example a stock that usually grows at 10%/yr, the out year consensus number will end up being roughly 10% more than consensus �06E but will be subject to revisions in the final qtr before the out year becomes the current year, adjusting expectations closer to realistic outcomes.
Accordingly the current crop of estimates for enterprise software stocks as well as for the market in general may be too optimistic by a fairly wide margin due to the situation last year when growth rates were applied to �05E numbers. The economy was growing robustly and IT spending was improving for the 3rd year running. Now the data points indicate a significantly slower economic environment and negatively trending IT spending plans going into the annual budgeting season; quite a change from last year. The current environment will therefore be highly likely to motivate analysts to pull in their collective horns on �07E estimates. Yet the current consensus still calls for top and bottom line growth in �07 over �06 of 8.9% and 15.6%, respectively. We see similar glaring disconnects between top-down and consensus bottoms-up estimates for other groups besides software indicating that our premise that �07E is too high on the Street and will have to come down soon is broadly applicable.
Signs of a significant turn in the market�s direction are mounting but not yet conclusive. Initially we saw big sell signals on our hourly Supply/Demand models that soon corresponded with early breaks in wedge patterns forming a larger top. Then oil made its impressive bottom out of a wedge throwover and reversal only to running higher in the near term. The same action was visible in gold and other metals suggesting that inflation is indeed a potent force that investors need to be aware of or face increasingly negative consequences. The notion that inflation is adequately contained seems ever more unlikely and off the mark as Prices Paid, wages, emerging strikes and now rapidly falling productivity measures show that it is a primary risk going forward along with recession in the US. The dollar may eventually breakdown if indeed inflation is an operative force and the Fed is seen as being late or off-point in their emphasis. Foreign investors could be forced to quickly exit dollar-based holdings or experience both price erosion and selling pressures. Once the Fed is confronted with a falling dollar, it could have little choice but to raise rates despite recession risks in order to protect the stability and augment the confidence in the US financial system. It all comes down to confidence in the system; lacking that the market can do quite dramatic things as it seeks to discount the emerging view of reality, one that may focus on retrenchment and bankruptcies rather than growth.
The SPX is building what we interpret to be a bear structure that spans an ominously large scale of completion suggesting a bigger, deeper period of retrenchment and downside trading than has been seen in many a year. We hope in fact that our view is wrong because it would mean a deep recession and painful bear market that could last years. With such complex patterns that extended the topping process far, far longer than we had anticipated, the implications are for a broader bear than corrects bullish formations that could conceivably span back to the �92 lows or even the �82 or �74 bottoms. Originally our LT forecast called for a deep correction after Y2k to then be followed by a big rally to new highs. After the completion of this future bull run, the market would then enter into a period of time similar to the �73-�82 era with prolonged recessions that wipe away whole eras of excess. Now the many greater degrees that appear to have finished in Sept/October timeframe could be telling us that in stead of new highs in the big 5-wave rally we anticipated, it may have already come and gone in the �03 bull rally that would then have truncated to complete at SPX 1385 or .786% retracement of the Y2k bear. While this is surprising the structure of the run fits rather better than the corrective 3-wave patterns required to make the �03 bull an intervening recovery before the 2nd and final corrective bear market lower. If so then the truncated 5th scenario would accelerate the prolonged recession/bear market forecast from perhaps 2010-12 back to the present. We hope very much that the reality turns out to be something different than this extremely negative scenario.
So far the Supply/Demand models have only notched significant Sell signals in hourly and now daily models but have yet to show up in weekly charts. This is to be expected given the longer time frame of the data series and will become critical in the next week or so should the market continue to trade lower on relatively higher volume and momentum. The New High/Low models are just indicating Sell preliminary signals as the internals of the rally begin to break down. RSI readings have been negative for quite some time now, but the unanimity amongst different time frames suggests something is about to happen rather than the previous delays upon delays. The extremely low volatility readings for the SPX and Nasdaq are in the process of turning up, which could well coincide with a turn for the market from bull to bear. It has happened in the past this way. But the business statistics that reflect on the health of the economy are the ones that give us the most pause. With every recession we have ever read about or experienced, inventories have surged to highs just before the onset and then plummeted shortly thereafter. The Chicago PMI inventories as well as several other Fed surveys now show the kind of upward momentum that very closely corresponds with prior recessionary onsets. While our own thesis on enterprise software developments suggested that inventories should fall to recessionary lows and stay there more or less, the evidence both of Web Channel adoption and of sudden, dramatic inventory surpluses mounting up seems clear. Because of Just-In-Time (JIT) techniques and heightened efficiencies made possible by Web Channel evolution into an e-business solution, virtually every business around the world will require adoption in the near future in order to remain competitive in business. Hence an inventory correction of historic proportions may be an even more potent signal to investors that something very serious might be happening to business activity.
The case for such a high order of completion in market patterns follows a number of indicators. The first is pattern measurements that build a case for an unusually high degree of order in a normally disordered marketplace. In the past when pattern structures display multiple degrees of synchronicity using Fibonacci ratios, at least intermediate magnitude turns have shortly followed. For the SPX the measure of wave-1 between 10/02-12/02 measures to 1.382 of wave-5 starting April �05 and ending with the recent highs. The sub-wave 1 also measures a significant .618 of wave-1 from �02. Similarly sub-wave 1 matches exactly the sub-wave 5. As the final sub-waves of the bull-run unfolded, manifold wedges appeared and subsequently broke down. SPX has encountered what may be key resistance at the .786-retracement level residing at about 1382. The high hit on 10/26/06 at 1389.45, about .5% above the retracement target. Other indicators of importance include the internals mentioned above as well as the key reversals in oil, gold and interest rates. With a breakdown in the dollar it would be a clean sweep and sharply increase the odds of a recession looming ahead if it has not already begun. Since inflation measures have been debased it is extremely difficult for us to spot the actual event; with the rebasing of labor data once again a crucial indicator will become largely useless by bad luck or by design just when it matters the most.
If this market is indeed turning into a bear, the period leading up to the top will likely be known as the era of self-delusion. In retrospect legions will marvel that clear-eyed market participants could have missed or ignored huge warning signs or worse that they allowed the systematic debasement of the very indicators needed to see the deterioration of the economy. What better implementation of propaganda than to make the public believe what the architects want them to think by taking away any benchmark with which to evaluate current conditions. If you can't see it coming no one can cry wolf and the entire system could easily be deluded into self-destructive behavior. For us the more egregious examples would be the separation of debt service costs when measuring the growth of the economy by using GDP instead of GNP back in 1991. The belief that �deficits don't matter� has to be one of the great delusions of history. The changes in inflation gauges from measuring standard purchasing power to comparing households� ability to avoid inflation through substitutes and timing techniques in an effort to �more accurately model how people live� according to the BLS, the very professionals charged with calculating inflation, actively inhibits the ability of investors to tell when inflation surges. Likewise substitution of traditional inflation gauges with others that are tailored to understate price spirals also result in the same distorted view of reality.
Since economic growth has been made to look substantially better than in fact is the case and inflation which directly detracts from economic growth is systematically understating price spirals, the impact is to push out the recognition of recessions until well after they actually begin. This effect also vastly complicates the ability of traditional tools to manage the economy effectively and will likely result in exacerbating the business cycle rather than ameliorating it, the same problem that occurred in the Great Depression. How ironic that we might be doomed to repeating one of the most obvious lessons of history, but for strikingly different reasons. The very structure developed to lock in US hegemony in global economies, the Bretton-Woods monetary system, has created conditions from which its demise along with the world leadership of America, by allowing massive money supply growth without commensurate inflationary impact: up to a point. After that point, the breakdown of the system could accelerate rapidly yet with distorted indicators, application of previous effective tools to smooth economic peaks and valleys becomes virtually impossible to deploy resulting in potentially magnified highs and lows that the tools were intended to reduce. The net outcome of these policies may be to shake the confidence of the investing public in the financial system or even the political system. All major changes in democracies originate as reactions to crises. This one could be a doozy!
RTW
| SPX Hourly Price Chart |
 |
| Source: Bloomberg Charts |
Multiple Wedge patterns are all coming to a major resolution very soon
| Daily SPX Price Chart |
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| Source: Bloomberg Charts |
Our ABC corrective rally count shows a potentially complete structure
| Weekly SPX Price Chart |
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| Source: Bloomberg Charts and ICAP Technical Research |
The entire bull run measures at A = C at .618% - a logical end point and close to a .764 retracement as well�
| Missing Data from GDP Chart |
|
|
| Source: Shadowstats.com |
GNP was changed to GDP in �91 � shows only part of the equation of economic health � leaves out debt service pmts !!
| Chicago PMI Inventories Chart |
 |
| Source: Bloomberg.com and ICAP Research |
Inventories have always signaled the onset of recessions but lately software has trimmed them dramatically so
a sharp run up like this chart shows is doubly important � it shows that inv�s may be out of control!
| Economic Growth Chart |
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| Source: Shadowstats.com |
Reversing Gspan�s changes to inflation measures � GDP is dangerously close to recession if not in it already!
| Hourly SPX Supply/Demand Chart |
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|
Source: ICAP Research |
The Hourly Sell signal is at the extremes so a bounce could happen
| 1-hour Volume-adjusted Price Chart for S&P500 |
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| Source: ICAP Research |
VAP is trying to bounce � RSI is a bit better but still weak � Momentum will be key here
| CPI Before and After Changes Chart |
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| Source: Shadowstats.com |
CPI runs 2%-3% higher when we calculate inflation the traditional way vs. Gspan�s changes
| 1-year Supply/Demand Chart for SPX |
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| Source: ICAP Research |
Daily S/D is starting to turn negative but must accelerate to confirm
| 1-year Volume-adjusted Price Chart for S&P500 |
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| Source: ICAP Research |
RSI has fallen sharply while VAP falls too � this is a remarkable signal! � caution is indicated�
| 30-yr Treasury Bond Price Chart |
  |
| Source: Bloomberg.com |
A decisive failure at key resistance � inflation is scaring the bond market !
| 30-yr Treasury Yield (TYX) Chart |
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| Source: Bloomberg.com |
Rates are on key support � a bounce here targets the highs, pressuring consumers and slowing business activity�
| Dollar Yen Index Chart |
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| Source: Bloomberg.com |
The dollar hit important support and now bounced off � higher rates the reason?
| Building Permits Chart |
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| Source: Bloomberg.com |
Permits are a truer measure of construction � this cannot be good for consumers as hundreds of billions vanish!
| 5-year Supply/Demand Chart for SPX |
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| Source: ICAP Research |
Weekly S/D lurks at 4-yr extremes � could be turning soon
| 5-year Volume-adjusted Price Chart for S&P500 |
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| Source: ICAP Research |
For a new high on VAP, RSI is still weak and now turning down, but was stronger than expected
| Money Supply Growth Rate Chart |
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| Source: ICAP Technical Research |
Money Supply recently jumped higher Gspan would have poured on the liquidity injections months ago - Bernanke just did!
Certifications and Disclosures
© 2006 Richard T.
Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
ICAP Enterprise Software
Jersey City, NJ
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