McHugh On The Markets

The Dow Jones Industrial Average fell 104.47 this week, in line with our expectations as the Short-term TII came in at negative (28.75) last Friday. Most of the decline came on Monday. Tuesday corrected very little and Wednesday had the scent of a crash until a late day out-of-nowhere key reversal stopped the 160 point, momentum-gaining dive. The Plunge Protection Team? This created a bullish candlestick pattern, a "hammer" and signaled the market would rise on Thursday and Friday. The market should have risen substantially the past two days - but failed. Volume on Thursday and Friday was low as the DJIA could only muster a sideways move. The sideways move not only failed to start a significant uptrend, but served the Bearish function of working off quite a bit of the extreme oversold condition of the market. As a consequence, we start next week with only mildly oversold readings in the Relative Strength Indicator and the McClellan Oscillator. This means the stage is set for another significant downside move, probably to at least 9750 in the Dow Industrials, and perhaps even lower.

New lows have settled down to non-crash levels, but still outpaced new highs by more than 100 each day, Tuesday through Thursday, and by 94 to 16 on Friday. This is Bear Market action. We remain under a Dow Theory "sell signal" although it is soon time for the Transports to confirm the new low in the Dow Industrials. To confirm the Bearish case, the Trannies need to decline below 2,750. We believe they will eventually do so.

This week the Short-term Technical Indicator Index comes in at negative (25.75). This indicator is a useful predictor of equity market moves over the next two weeks, both as to direction and to a lesser extent strength of move. For example, readings near zero indicate narrow sideways moves are probable. Readings closer to +/-100 indicate with a higher degree of confidence that an impulsive move up or down is likely over the short run. Market conditions can change on a dime, so it may be unwise to trade off this weekly measured indicator. Massive increases in M-3 have reduced the severity of this indicator. It appears the Intermediate reading is dominating the Short-term at this time - highly unusual.

The Intermediate-term Technical Indicator Index is useful for monitoring what's over the horizon - over the next twelve weeks. It serves as an early warning system for unforeseen trend changes of considerable magnitude. This week the Intermediate-term TII comes in at negative (66.45), warning that the Bear is about to break into the tent.

Bearish Topping Patterns are all over the place. Not much has changed there and we await the forecasted deep declines these pictures portend. I wouldn't be surprised if bottoms come in stair-step fashion over a period of many months - a bunch of slow-motion crashes. A Double Top shows up in the Morgan Stanley Consumer Index ($CMR), Quadruple Tops in the Russell 2000 ($IUX) and the Wilshire 5000 ($TMW). Head & Shoulders Bearish Tops are evident in the NASDAQ Composite ($COMPX) and NASDAQ 100 ($NDX) indices, and the Philadelphia Semiconductor Index ($SOX) which looks to be breaking down fast. Rounded Tops are some of the more statistically reliable Bearish patterns and they are showing up in the Dow Industrials ($INDU), the Dow Transports ($TRAN), the S&P 500 ($SPX), the Dow Financial Sector Index i shares (IYF), and the Amex Gold Bugs ($HUI).

The Federal Reserve has announced that they expect a stock market crash any day now. You missed that, you say? Didn't hear that report on any of the usual media outlets? Think news that huge should have been the headline on every newspaper this week? Well, it wasn't reported. So I'm reporting it here.

Oh, they didn't "speak" the words, no sage quote from a Fed governor or the venerable Chairman, but their actions did the talking. If you go the Fed's website, you'll see that they reported M-3 is up an astounding $104.8 billion in just the past two weeks! That computes to 30% annualized growth in the money supply! That's not a typo. Thirty percent per year, a $2.72 trillion increase to our current 9.1 trillion M-3 supply. The Fed was chartered to "maintain a stable currency." Yet here we see them inflating the value of our currency by 30 percent. Why? Have they gone loony? What is going on? The answer can only be one thing: The Federal Reserve has come to the conclusion that equities are at grave threat to deflate at crash proportions - and soon. The Fed is convicted that deflation in assets is so probable, that it is worth the risk to manufacture money at a thirty percent annualized clip. Hyperinflation by the US Central Bank, right before our very eyes.

How does the Fed manufacture money? It buys bonds, Treasuries, with printed (actually electronic) currency that is paid to investment banking houses who deposit the money in commercial banks where these deposits are included in the count of M-3. This also has the effect of artificially keeping interest rates low. Question is, are they buying short-term or long-term Treasuries? My guess is both.

The Fed is hosing M-3 across burning financial markets because they believe there is a direct correlation between M-3 and the stock market. The first chart we show you this week indicates they are right. There is a high degree of direct correlation between M-3 and equities. It goes like this:

When M-3 plateaus or falls, equities decline - in fact often crash. When M-3 rises, equities rise. Simple. There appears to be about a 3 to 6 months lag between M-3 and equity prices. Let's look at the cause and effect since the Bear Market began in 2000.

Plateau # 1 in M-3 growth occurred from September to November 2000 and led to the 17 trading day equity market 13.5% crash that began four months later on 3/8/01.

Plateau # 2 in M-3 growth occurred from June 2001 to August 2001 and was followed by the 15 trading day equity market 20.9% crash that began on 8/24/01.

Plateau # 3 in M-3 growth occurred from February 2001 to April 2002 and was followed by the 48 trading day equity market 25.2% crash that began on 5/14/02.

Plateau # 4 in M-3 growth occurred from May 2002 to July 2002 and was followed by the 12 trading day equity market 15.3% crash that began 3 months later on 9/10/02.

Plateau # 5 in M-3 growth occurred from Nov 2002 to January 2003 and led to the 38 trading day equity market 14.9% crash that started on 1/14/03.

Plateau # 6 in M-3 growth was actually a decline from June 2003 through December 2003. Note that M-3 fell for 6 months. The subsequent crash is due at any time. Because this sixth pause in M-3 growth lasted longer than the other five, and actually was a decline in M-3, the next crash could be deeper and more protracted than the others - which explains the Fed's Banana Republic behavior.

The flip side of these periods of M-3 stagnation/contraction are those periods where M-3 grew. Denoted with green upward sloping lines along the magenta M-3 line connected with green arrows to green upward sloping lines on the DJIA plotted price line, it is clear that when the Fed pumps M-3 higher, equities also rise within 3 to 6 months.

Since the Fed is opening up then M-3 spigots at record setting pace, once the next crash has completed, look for a significant market rise - but don't be fooled, it will be merely another correction inside the long-term Bear Market.

Enough on M-3. Next, I want to explore the incidences of rally days inside market crashes.

Have past crashes entertained rally days? Significant rally days? Or do the presence of rally days by their very nature cancel out the crash threat?

The next chart is a summary of the crashes since the Bear began on January 14, 2000.

During Crash # 1, which started on 3/8/01 and lasted 10 trading days, there were 3 days the market rallied (30% of the time) and 7 the market declined. Rallies were day three (82 points), day five (58 points) and day seven (136 points). The other seven days lost a total of 1,745 points.

Crash # 2 started on 8/24/01 and lasted 15 trading days. Inside that crash period, there were 3 days the market rallied, days five, six, and seven. Over these 3 days, the market rallied 114 points. Over the twelve declining days, the market fell 2,302 points.

Crash # 4 began on 9/10/02, lasting 21 trading days and had six (28%) rally days. One of them, day # 15, rose a whopping 347 points. Three rose over 100 points.

Crash # 5 began on January 14, 2003 and lasted 38 trading days. Inside this crash were 13 rally days.

The point here is that markets get oversold - even in crashes - and rally days are necessary to work off oversold conditions to sustain the downside momentum. If we are currently in a crash (a decline of over 15% - about 1500 points) then the sideways price movement this past week has served the purpose of working off extreme oversold conditions, facilitating the crash event. If we are in a Major Equity Market crash, I would label the DJIA's start on April 27th, putting us about a third of the way toward the minimum crash price target. If we are in a crash, most likely prices will decline into the 9500 to 9750 area, bounce back up toward 10,000 one more time, then fall hard to at least 9000. That's basically following one of several possible Elliott Wave counts. June 15th is a major Fibonacci turn date, the phi mate of October 9, 2002's Bear Market low. Could be a high or a low. But, if a high, this market is heading lower than anyone even wants to begin to think about.

The above chart shows a classic Rounded Top pattern in the Dow Transportation average. This pattern represents broad-based participation in the beginning stages of a decline and forms a solid basis for accelerated decline. The reason this type of pattern occurs is because of the "distribution" concept we mention from time to time. The smart money (the pros - institutions) are getting out slowly, gradually over time so as not to drive prices too low too fast before they can get rid of all their shares. They want out, and bad, but they control so much volume that they must distribute it a little at a time to eager amateurs and commission-focused money managers for the innocent public.

At about the time the right side of the arc circles toward due east (picture a globe), selling momentum picks up as most of the pros are out and the amateurs and public money managers realize something bad is happening and it may be time to dump shares. This fear psychology creates panic selling and eventual capitulation where selling becomes exhausted (at the south pole of our imaginary globe) and a new rally can begin, led of course by the pros. We are close to the point where panic selling occurs. A break below the March 24th close of 2750 would confirm the Dow Theory "sell signal" establishing a new lower low in the Transports, keeping this average in sync with the price action of the Dow Industrials which have already reached a new lower low for this down move that began in February 2004.

The Elliott Wave pattern is telling us that new lower lows will be achieved in the Trannies as we are only about halfway down minor degree wave 1 of major degree (3) down, perhaps concluding on the June 15th Fibonacci turn date. We'll see.

The headlines on the economic news this week were dour for the most part as the fundamentals are catching up to the technicals (This is normal. The technicals pick up the language of the markets about the future while the economic statistics and news dutifully follows the technicals expectations).

The Commerce Department reported that Retail Sales fell a large 0.5 percent in April. The decline was led by auto and clothing sales. No surprise here. The Morgan Stanley Consumer Index ($CMR) has been showing a Bearish Double Top for a while now. People are feeling the effects of unemployment, underemployment, ridiculous gasoline prices ($2.17 a gallon in Philadelphia), out-ofcontrol health care (insurance) and tuition prices, and are predictably cutting back on spending.

We received news out of the Treasury Department this week that the Budget Deficit is $80 billion worse this fiscal year-to-date than last year's record setting pace. The White House has projected a $521 billion budget shortfall for fiscal 2004. But with the Iraq mess, you can bet it will be more. An economic slowdown would do even more damage.

The Bureau of Labor Statistics reported an April Consumer Price Index number that left many people scratching their heads. CPI up only 0.2 percent in April? Are the good folks at Labor kidding? Well, it turns out that much of those Trade Deficit, employment-stealing imports are coming in at even lower prices and carry enough weight in the CPI formula to keep the official figure low. This allows the Fed to justify ignoring the so called "robust" economic recovery and keep short-term interest rates at 46 year lows. M-3 is growing at a 30% annualized pace. Think all that money will eventually affect the CPI figures? Probably not - nice, low CPI figures keep entitlement payments low. Part of the Master Plan?

The Producer Price Index followed suit, the wholesale price index coming in this month up 0.7 percent (blame it on oil), but a mere 0.2 percent in core (excludes food and energy).

Jobless Claims were reported to be up this past week, at 331,000. Continued claims rose 53,000, and sit near the 3.0 million figure. What's the problem? Didn't the Labor Department just tell us everyone went back to work? In spite of the Labor Department's rosy employment report the past two months, the University of Michigan Consumer Confidence Index did not increase in May, rather remained the same as April. People know the truth. That's why it's called "truth."

M-3 growth is astronomical. We've already covered that. Unless a stock market crash occurs, unless bond prices tank, unless real estate plummets, unless debt defaults rise, unless deflation kicks in, this sort of money creation must cause the Dollar to dive and push Gold higher like lava being tossed from an exploding volcano. It must. Supply and Demand. Period.

However, deflation has to be perilously close for the Fed to allow this hyperinflationary monetary creation. We approach the abyss.

US Dollar Index ($USD) chart above (courtesy of www.stockcharts.com) shows a clear-cut long-term downward trend-channel that is at a major crossroad. The Dollar broke above the upper trend-line of the down channel this week, but not yet decisively. A decisive break to the upside, above 93, would portend a new trend for the Dollar - at least over the intermediate term. How could the US$ break out above this channel? Deflation. Declining prices in major financial and real estate assets that would leak into everything else controlled by a free market. Deflation is catastrophic to the US at this particular time in our history because of the Debt bubble. Debts that are collateralized by bubble-valuation assets. Debts that depend on the liquidation of underlying assets to ultimately payback debt. Should the value of the underlying asset fall below the debt itself (debt is about the only thing that does not fall in value should deflation occur - the contractual debt amount remains the same, it does not reduce or go away), the difference must be made up by finding dollars somewhere.

Example: A person owes $250,000 on their $250,000 house (1st mortgage and a home equity line). If real estate deflates and the house drops to $175,000, the home owner needs to come up with cash - dollars - if they want to sell the house and move, probably to downsize. So they are forced to sell other assets, perhaps stocks to raise the dollars to make up the difference to the debt holders. Perhaps they cash in savings to cover the difference. If bank deposits are withdrawn, M-3 shrinks since there is less money available to be loaned out by the banks. A slowdown in lending makes it harder to find (borrow) dollars. The point is, there is a mad scramble for dollars on a cumulative mass scale. That's why the dollar is rising right now. It projects to become more in demand. Fear of deflation.

The Fed is preparing for this by making sure banks are flush with M-3. They see deflation coming. Should the massive infusions of M-3 be successful in warding off the immediate deflation threat, look for the US $ to fall back into its downward trend and head for the bottom of its long-term trend-channel, into the 70s.

The above chart of the US Treasury Bond shows that the massive, ominous Head & Shoulders pattern continues to complete. A decline below 100 will confirm this pattern and indicate a high probability decline in bond prices to the low 80s, probably over the next six months. The flip side of this is a huge increase in long rates, with a perilous consequence on real estate values, consumer spending, and financial stock performance at a very minimum.

The Fed's decision to hyperinflate the money supply will ironically fulfill the predictions of this ominous Bond Head & Shoulders pattern. By pumping M-3 at a 30% annual clip, the Fed has prioritized saving the stock market before the bond market. Given that horrible choice, you'd think they'd prefer to protect bonds given the enormous debts of individuals, corporations, and government entities. Actually, a stock market crash would serve the useful function of rallying bonds sharply and staving off the current threat of rising rates. But with the M-3 avalanche, the doomsday scenario has stocks crashing anyway, but bonds unable to rally because the Fed pumped too much M-3 into the economy. Both markets crash at the same time? That's the risk with the Fed's go-for-broke, caution-to-the-wind M-3 strategy.

Interesting times. We have two massive tidal waves heading for a smashup: Asset Deflation (market crashes) versus M-3 hyperinflation. Which will win? Will we get the financial crash and be rescued by M-3? The technical charts say M-3 can only delay the inevitable declines. Tough market to trade. Could go either way. The Fed's war begins. Defensive strategies are warranted.

" My son, eat honey, for it is good,
Yes, the honey from the comb is sweet to your taste;
Know that wisdom is thus for your soul;
If you find it, then there will be a future,
And your hope will not be cut off."
Proverbs 24: 13,14

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Note: Crude sets a RECORD HIGH, M-3 UPPP Into the Stratosphere!

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Robert McHugh Ph.D. is President and CEO of Main Line Investors, Inc., a registered investment advisor in the Commonwealth of Pennsylvania, and can be reached at www.technicalindicatorindex.com. The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. Editor shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.