Momentum remains with market but
the tape tells a story of distribution
The broad U.S. stock market, while breaking its recent downtrend this week, continues to show evidence of topping. Our reading of the tape shows that distribution has been underway at least since April and that a much larger correction looms ahead.
Looking at the charts of the two most widely followed indices—the Dow Jones Industrials and the NASDAQ Composite—presents a picture of weakness with most of the recent upmoves occurring on low volume and much of the volume flowing to the downside, both of which are bearish signals. Indeed, a bearish complex "head and shoulders" pattern can be seen taking shape in both the Dow and the NASDAQ and this portends at least a big decline is in the cards in the next couple of months, though it is too early to gauge the extent of such a move. However, market momentum and seasonal cycles are in the market's favor right now so it is possible prices will continue to trend higher over the next few days-to-weeks. But the larger pattern is still bearish.
Last week the "neckline" of the head and shoulders patterns in the Dow and NASDAQ were both violated as prices broke above two key resistance areas, thereby temporarily nullifying the bearish trend. Nevertheless, the implications of this pattern stands. As we discuss in our book, Technical Analysis of the Internet Stocks, and as the bible of technical analysis—Edwards and Magee's Technical Analysis of Stock Trends—tell us, the implications of a developing complex head and shoulders topping pattern (which means that the chart is developing multiple "head" and "shoulder" patterns) are undeniable even if the pattern has seemingly been annulled. Penetration of a "neckline" (in the Dow's case at 10,400 and at 2300 in the NASDAQ) does not automatically cancel the pattern out. The H&S is a distribution pattern and it nearly always fulfills its bearish objectives. The minimum downside objective for each index based on the pattern in each index is for a Dow of 9600 and a NASDAQ of 2000.
Momentum indicators are less bearish and indicate a short-term uptrend is underway that could propel the averages higher in the days ahead. The 10-day NYSE Momentum Indicator (see page 3, lower left corner) has bounced from recent lows and is heading higher which should accompany the Dow to higher levels as well. Seasonal factors are also in the market's favor until mid-summer. Because the Dow and NASDAQ have both broken above their 10- and 30-day moving averages (while the averages themselves are starting to turn up) we can expect higher prices over the very near term.
Volume considerations present another story. Volume on both the Dow and the NASDAQ has been bearish with most of the volume flowing to the downside in recent weeks, evidence of distribution. Note the NYSE Advancing Volume indicator and moving average on page 3. The intermediate term upward trend was recently broken and since then advancing volume has been on the wane, a bearish sign. Interestingly, volume over the past two weeks has been rather light, even on the down days. Ordinarily this would be seen as a sign that selling pressure is drying up and that the buyers are still in control of the market. But because even recent impressive one-day gains of 100 points or more in the Dow have occurred on light volume this interpretation must be viewed as suspect. The safest course is to avoid adopting either a bullish or bearish posture and instead to let the market dictate our position. We still need to see more action before we can decide with 100% certainty whether this market will continue higher in the near term or whether a bear market beckons. However, our best guess is that we will get a replay of 1997 and 1998 where prices top out in late July and bottom in the fall.
The Internet sector continues to deflate, though there still remains some upside potential in select Internet issues. Our Leading Indicators Internet Index, a composite of the top five Internet stocks, is now in a critical position, having evinced a Fibonacci 62% retracement from its theoretical starting point of zero to its all-time high. However, as of this writing the index has broken below the third "fan line" of its fan support chart. This entails that a much more serious correction lies ahead. Selling pressure remains on the Internet sector and our index is trading below its 10-day moving average, another bearish sign. In order to reverse higher, the index must now begin rising on increasing volume to change the trend. Further declines in this index will indicate that the expected major decline is underway. We'll know more by next week.
Other technical and sentiment measures confirmed the bearish overall market outlook. Both the NYSE and NASDAQ Short Interest Ratios are at very low levels, which is a bearish sign. A low level of short interest means that a market decline may easily develop into panic proportions because there are few short orders supporting the market on the way down. This in part may account for the fact that the market in recent days has declined so easily on such light volume. The OEX Five-Day Put/Call Ratio—another measure of market sentiment—is currently in a neutral position. This may explain why some sectors of the market are in a bullish or potentially bullish position (such as the Internets) while other sectors are bearish. Advisory sentiment ratios are still too high—a bearish indicator. Most investors and investment advisors are bullish on the market, and when these levels reach extremes it typically sends a contrarian signal that the market is at a peak and a decline is on the horizon. Mutual fund cash levels, another market indicator, are at extremely low levels. This means that should a serious decline get underway mutual fund managers would be unable to meet obligations or take advantage of bargain prices; hence, it is bearish. Member and specialist short position ratios are still bearish but not quite as bearish as they were in our last report.
The main focus and concern of traders and investors recently has been the potential for an interest rate hike. Indeed, interest rates are heading higher as the Federal Reserve will almost certainly follow the precedent set by the benchmark 30-year Treasury Bond. The yield on the long bond is nearing six percent. Our reading of both the long bond's chart and tape shows undeniable proof that this trend has got a ways to go before reaching exhaustion. Interest rates are heading higher in the months ahead. Typically, an uptrend in the 30-year T-bond yield precedes a top in the stock market by anywhere from two to ten months. From here on out, market conditions should be rough and successful navigation will require careful planning.
Perhaps the most striking aspect of this bull market, particularly over the past few years, is the extent to which it has been based on nothing more substantial than credit (i.e., debt). Indeed, the better part of this decade has witnessed one of—if not the most—rapid and profound credit inflation in stock market history. Unfortunately for the masses of investors every great credit inflation must eventually be deflated, and the extent and magnitude of the ensuing deflation (or worse, implosion) is always in inverse proportion to the previous inflation. Translation: this market is in a very precarious position.
According to Alan Newman, editor of Crosscurrents, NYSE margin debt has exploded to a new record high of $181.94 billion (as of April). "Margin debt is now more than 2% of total gross domestic product," writes Newman. "Adjusted for inflation, the numbers are nearly three times as high as they were at the top in 1987." As Newman correctly asserts, "the indexes can only be held up by a further expansion in borrowed money. Unfortunately, a further expansion in margin debt will only increase overall systemic risk to intolerable levels." True enough, but it is highly doubtful at this point that margin debt can be any further expanded.
For instance, consider the amount of outstanding credit card debt among U.S. consumers. According to the latest Federal Reserve reports, consumer credit outstanding expanded a seasonally adjusted $1.334 billion in April, from a revised $1.330 billion in March, a tidy sum to be sure. The chart showing U.S. consumer credit outstanding is almost a straight line extending from the beginning of the decade into the present. However, a slight but noticeable decurvation is beginning to appear in the chart which indicates the rate of change in consumer credit outstanding is slowing. This is confirmed by recent reports that, while Americans are heavily bogged down with debt, they are nonetheless trying to extinguish it and are making some headway (however slight). Along these same lines even the chart showing the explosive and almost perfectly linear growth in M3 money supply by the Fed has been slowing as well. In other words, early deflation is already setting in. And, as Bob Prechter of the Elliott Wave Theorist recently said, "contracting margin debt is the kiss of death to any bull market."
16 June 1999
Clif Droke is editor of the weekly Leading Indicators newsletter covering U.S. and global equities markets and general socio-economic affairs from a technical perspective. For a free sample copy of Leading Indicators, or to subscribe, write to: 816 Easely St., #411, Silver Spring, MD 20910; e-mail: firstname.lastname@example.org
Also by Clif Droke
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