This week the Dow Jones Industrial Average hit a new closing low for 2005, down for the third week in a row, down 165 points after rising 70 points on Tuesday. This is about as we expected as our Short-term TII indicator was positive 29.00 last Friday, but with the caveat that "a weak up move is probable." That we got. And brief too. The rally from Thursday January 13th's low capped an a-up, b-down, c-up minor rally on the first of our four possible Fibonacci turn dates identified for this week. Tuesday's top came on the 1,259th trading day from January 14th, 2000's all-time high in the DJIA. Thus January 18th, 2005 becomes the phi mate of December 14th, 2001's minor low (which came the 482nd trading day from January 14th, 2000). The ratio of 482/1,259 = .382. Once again another Fibonacci phi mate date marks a turn in the DJIA. Since 1/14/2000, there have been no exceptions. The DJIA plummeted 236 points from this latest phi turn date, closing below its December 2004 low, which is Bearish. Today's close in the DJIA wipes out all the gains of 2004, thus validating our perpetually negative Intermediateterm TII readings over the past year. Technical Analysis works.
This week the Short-term Technical Indicator Index comes in at negative (25.50), indicating a sideways to declining move is probable. 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, or the Plunge Protection Team can come in and temporarily stop market slides, so it may be unwise to trade off this weekly measured indicator.
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 (21.83).
Analogs are snapshots that compare current price patterns with those times of the past that we suspect are being replicated. Of particular concern to equity investors at this time are those secular (major) Bear markets of the past that we may be mirroring now. Our suspicions are high because we entered the winter period of the Kondratieff Wave back in September 2000, which is expected to last at least through 2010. It is the longest of cyclical waves. Winter is the bad season for equities. Previous winters occurred from 1835 to 1844, 1875 to 1896, 1929 to 1949, and 2000 through likely 2010.
So, we want to measure investor psychology today with that of past major Bear markets that fostered crashes in order to determine when the risk is highest of another crash. We in effect use the past as a blueprint of the future because the past patterns continue to repeat themselves. This week we highlight five different analogs of the past. 1) The DJIA from 1972 to1973 with 2004 to 2005 2) The average of the DJIA in 1929-1936 and 1968 to1975 Bear markets with the DJIA in 2000 through 2005, 3) Japan's Nikkei from 1985 to 1998 with the DJIA from 1996 to 2005, 4) The S&P 500 from May 1998 to October 2002 with the S&P 500 from October 2002 through January 2005, and 5) the DJIA from 1928 to1929 with the S&P 500 from 2004 to 2005.
In every single instance, each analog of past investor psychology is suggesting that a major stock market crash is upon us, that it has already started the slow, gradual decline phase, and that it is expected to pick up vertical speed by late February and plummet into March 2005.
This is not coincidence. This is the price pattern of the common investor psyche during Bear markets. A crash is in all probability beginning right now.
Let's explore why all these analogs are warning of an impending surprise equity slide. If you recall, back in our discussion of Dow Theory, we mentioned that one of the tools used to alert the Dow Theorist is stock valuation. We indicated that when price/earnings multiples reached historically high levels, market tops were in place and therefore equities were set to decline. For equities not to decline, the "E" portion of the equation, earnings, must grow at least as fast as the "P," Price. Well, corporate profits were actually down 27.6 billion in the third quarter of 2004 according to the Bureau of Economic Analysis, a government agency (no, you didn't hear that number in the mainstream financial press). So we cannot count on earnings to fuel further equity price growth. That leaves us with the reality of current Price/Earnings ratios in their historical context. A hard look at "P."
The following is some interesting analysis reproduced courtesy of Chris Ciovacco, Registered Investment Advisor, Ciovacco Capital Management, LLC (www.ciovaccocapital.com - visit their site for an outstanding slide show far superior to the bits and pieces I've chosen to present below), based upon historical data courtesy of Charlie Minter, Comstock Partners (www.comstockfunds.com).
Looking at 75 years of market history, the average Price/Earnings ratio for the S&P 500 for the last nine major market tops (excluding 2000's) was 18.55. The average PE ratio for the S&P 500 for the last nine major market bottoms (excluding 2002's) was 9.39. That gives us a mean PE of 13.97. PE's above the mean indicate markets are at risk of decline. PE's below the mean indicate equities are poised to rally. What do you think the PE ratio was at the so-called Bear market bottom in October 2002? Answer, a historically ridiculous 28. Does that sound like a Bear market bottom to you? Earnings grew substantially since October 2002, however the PE ratio as of December 29th, 2004 was still an outlier 20.15. How does this PE compare to other major tops in equities?
Just before the stock market crash of 1929, the market topped at a PE of 21. In 1946 it topped at 22. Just before the stock market crash of 1987 it peaked at 23. In 2000, just before the two-year, fifty percent crash, the S&P sold at a PE of 32. None of the other six major equity market tops over the past 75 years had a higher PE than now. Today's 20.15 PE in the S&P 500 certainly supports a stock market crash at this time. It ties in with the Dow Theory non-confirmation and Primary Sell Signal in force. It ties in with the analogs. Chris points out that should the S&P 500 decline to a level where its PE reaches the historical average, it would have to crash 30 percent from current levels. Should the S&P decline to its average trough PE seen at market bottoms, it would have to crash 53 percent from here. For the DJIA to fall to its historical average PE seen at market bottoms, it would have to crash 48 percent from here.
The NASDAQ sat with an obscene PE of 53.54 on December 29th, 2004. The DJIA sat at a PE of 18.11. Should anybody really listen to the perma-bulls and buy stocks for the long haul now? Yikes.
Here's the raw data:
The above analysis compares the number of Dow Jones Industrial Average Stocks that are sitting above their 10 Day Moving Average with the future price action of the Dow Industrials. The correlation is terrific. Whenever the percentage rises above 80 percent, the Dow Industrials are overbought and a short-term trend reversal to the downside is probable. Whenever the percentage above their 10 DMA falls below 15 percent, the Dow Industrials are oversold and a short-term upside reversal is probable, though not necessarily imminent. Friday, January 21st's reading was 10.00 percent, indicating at least a short-term bottom is near.
The top chart on the next page is a contrary sentiment indicator, the 10 Day Moving Average CBOE Call/Put Option ratio. No buy signal yet. Significant bottoms occur when this ratio falls to 1.00, then turns decisively up. We currently sit at a 1.15 reading, meaning the sell signal generated December 2nd, 2004 remains in force.
The chart below shows a measure of Bullish/Bearish sentiment, the SPX to VIX ratio. It is a contrary indicator under the theory that once the pendulum swings from over-pessimism to over-optimism, the pendulum is about to swing back again the other way. This has implications for stocks. Whenever this ratio rose above 68, the S&P 500 not just fell, but crashed. Whenever this ratio fell below 35, nice rallies started. Two exceptions. Back in 1998/1999 we saw a long-term pattern that led to an extreme peak. Because it took so long to develop, the subsequent crash was the start of a massive Bear market. Same pattern has showed up again from 2003 into 2004, meaning another major Bear is about to start, or may in fact be starting. Note the similar upside down "V" patterns evidencing the pinnacles. Friday's reading sits at a Crash-warning level of 81.33.
Here's how things are shaking out. The Dow Jones Industrial Average shown above (courtesy www.stockcharts.com) has confirmed that a Head & Shoulders Top is in place - meaning the probability of it reaching its minimum downside target is high - with the decisive break below the neckline Thursday and Friday of this week. Momentum is down hard as Minuette degree wave iii unfolds. The minimum downside target is 10,100 per the H&S pattern, which could very possibly be the bottom for Minuette iii. By then this market should be oversold at which time we'll get a small bounce, Minuette degree iv up. Then one final panic selling drop for the bottom of Minor degree wave 1. If the analogs are correct, and this is a multi-month crash unfolding, then once the oversold condition gets worked off with a Minor degree 2 retrace rally, that should set the stage for one very nasty decline from late February into March, Minor degree wave 3 down. By then, the Fed should be dropping money from cargo planes all across America. By then, Bulls should know something is very wrong, that this is different than they expected for 2005, and Bearish sentiment should rise fast. The VIX will likely be headed toward 30 by the middle of March 2005.
Unannounced, the DJIA blew through its 50 day moving average support this week and is making a beeline for its 200 day MA. The DJIA was the lone major average that had not broken below its December 2004 low - until Friday. It took a while to break under strong support at 10,500, but once it did, buyers ran. New lows are rising. Once both new lows and new highs exceed 90, it will be a crash signal. Watch for this sign carefully.
The S&P 500 is in big trouble. There is no other way to put it. The Elliott Wave count shows that prices are now declining in a Micro degree wave 3 down of a larger degree Minuette degree iii down. This should have the power to push prices down to the minimum downside target of a now confirmed Head & Shoulders top pattern, confirmed because prices fell decisively below the neckline this week.
The pattern that clued us into the current decline is the Rising Bearish Wedge shown in blue converging lines above. The bad news for the SPX is that this pattern indicates prices should return to the base of the pattern, in this case to 1,090ish.
Momentum is down, but approaching oversold levels. The RSI is also at oversold levels. However, during crashes, prices can dwell in oversold territory for a while. A clear sign of an imminent retracing correction would be if we saw panic selling where breadth is just simply horrible. That would temporarily exhaust the selling and allow some bottom fishing buying. However, the Analogs and longer-term Elliott Wave count warn that this Bearish environment is going to be around for a while.
Money Supply, the Dollar, & Gold
M-3 fell 8.7 billion for the latest week, but it isn't the third week yet. The Fed likes to raise M-3 by huge $50 billion chunks in stealth fashion about every three weeks when it tries to support equity markets during high crash-risk periods like now. That's what it did back in April/May 2004, successfully staving off a crash. Look for M-3 to jump next week. Still, M-3 is up $63.9 billion over the past month, an annualized rate of growth of 8.8 percent. That's not the sort of growth rate in money supply a Federal Reserve worried about inflation tolerates. It is a unique approach to Money Supply management. Raise short-term interest rates, jawbone your concerns about inflation, promise you'll be vigilant to fight inflation and then print as much money as you can. Leak to the mainstream financial press that, hey, you really don't control money supply (which of course is pure and utter hogwash). The goal, I suppose, is to fake out the Bond market, hoping to keep long-term rates tame while supporting equities. Sooner or later the truth always comes out and markets respond accordingly. If M-3 is truly going up 8.8 percent, then look for the Dollar to continue its descent and for Gold to climb.
We tweaked the Elliott Wave count on the Trade-Weighted U.S. Dollar to reflect a cleaner Minor degree wave 4 up that may have finished this week. Friday's intraday high was a Fibonacci 38.2 percent retrace of Minor degree wave 3 down, and so could very well represent the top of Minor degree 4. While Minuette c up this week looks small in relation to wave a up, that's okay as it is essentially a Fibonacci 61.8 percent of Minuette a, further supporting a short-term top. The Dollar fell impulsively Friday from its 84.00 intraday high, further adding to the evidence that Minor degree wave 5 down has started. Our belief is that the Dollar has one more leg down to go, Minor degree wave 5, that should take prices back down to the lower boundary of its downward trend-channel, into the high 70's. This count looks the most proportional to us at this time, an important component of accurate EW labeling. An alternate count is that the U.S. Dollar bottomed Friday December 31st, and that the rally to today's high is wave 1 up of Intermediate degree A of Primary (2) up. While we fully expect a strong rally in the Dollar sometime in 2005, an A-B-C primary degree (2) up move to correct the two year decline, we believe the start of that rally is a few weeks, or at most, a few months away. The RSI turned down Friday, as did the MACD. Momentum may be turning down.
Gold finished its Bearish Flag pattern shown two weeks ago, at the bottom boundary of the Ascending Bullish Triangle pattern, completing Minor degree corrective wave 4 down. Next should be a decent rally that has the potential to reach 500 over the next three to six months, a fifth of a fifth wave to complete primary degree (1) up in this Bull market in Gold. This target is calculated by taking the widest distance of the Ascending Triangle and adding that to the point of the upside breakout. Both the RSI and the MACD have reversed up from oversold levels. If the Fed is going to pump M-3 like we think they will, Gold will benefit.
It looks as if the Gold Bugs Index ($HUI) is going to get caught in the downdraft of the general equity market slide now underway. There is a difference between Gold stocks and Gold the metal. The metal is above ground, supply certain and limited, and is a monetary store of value. The Gold stocks are managed companies subject to risks of any company - legal, regulatory, operational, managerial, production, research and development, resource availability and cost, etc… The bulk of its Gold inventory is underground, quantity and extraction uncertain. This puts the $HUI in the unique category of a hybrid, subject to occasional general equity market influence. Now is one of those times.
The first leg down inside the C wave down of an an A-down, B-up, C-down corrective Intermediate degree wave 2 looks complete, with Minuette degree ii up underway. Given the negative technical big picture for stocks, we don't believe this countertrend rally will carry much force, possibly lifting prices to the 218 area, a 38.2 percent retrace of the decline since November 5th's 248.18 high, which has essentially been a 19.3 percent crash. A rally from here is not starting anywhere near the previous lows for the MACD, nor RSI, a clue that once the corrective Minuette degree wave ii is complete, more strong downside action is likely.
Based upon the Elliott Wave count, a 38.2 percent retrace of Intermediate degree wave 1's rally from 35.31 on November 16th, 2000 to 250.59 on January 6th, 2004 suggests a bottom from the current Intermediate degree wave 2 decline of 168.35. A 50 percent retrace takes prices to 142.95. A 61.8 percent retrace drives prices to 117.55 before the next major intermediate Bull run gets started. We favor the 38.2 percent or 50 percent retrace scenarios because in addition to the EW count, a Bearish Head & Shoulders pattern also suggests more significant downside is probable, that once prices break decisively below 200, a minimum downside target could drive prices to as low as 152ish. Interestingly, should Minor degree C end up equal to Minor degree A, that would suggest a bottom of 154, very near the H&S target. After the carnage, we should be at the bottom of Minor degree C of 2, to be followed by a powerful rally for several months or even years, Intermediate degree wave 3.
Silver (chart courtesy of www.stockcharts.com) has formed an unconfirmed Bullish Head & Shoulders bottom. A decisive rise above 7.00 portends at least 7.50 short-term. It looks as if the Bearish Flag pattern pointed out a few weeks ago accurately forecast further decline, but failed to hit its targeted minimum low. Such failures with Flag patterns are rare.
Bottom Line: If you consider all the evidence, it is at best a time for the sidelines. There are so many ominous technical signs right now. Caution remains warranted.
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2005 Promises to be volatile, with many surprises and opportunities along the way. If this market is crashing, you won't want to be caught without our cut-to the-chase reporting and unique analysis. We hope you will join us for this exciting adventure!
22 January 2005
Robert D. McHugh, Jr. Ph.D.
MAINRDMCH@aol.com
Main Line Investors, Inc.
www.technicalindicatorindex.com
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.