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Primary Bear Market - 2nd Down Leg

October 19, 2004

John Mauldin just emailed a brilliant article entitled "Quarterly Review and Outlook, Third Quarter 2004", By Van R. Hoisington and Lacy H. Hunt, Ph.D. (Thank you John - [email protected])

John is looking for a Muddle Through economy in the USA in the foreseeable future but, in the past few weeks, I have become more bearish than that.

The essential difference between our views flows from our differing perceptions regarding valuation of Household Assets.

In the body of the article, it is specifically acknowledged that the outcome (whether or not we have a sideways movement or a downward movement in the USA economy) will be largely dependent on the "assets" element of the "debt:assets" equation.

Quote #1

"The above factors, however, should slow spending to the 0% to 2% growth pace in 2005. While most of the post war recessions were associated with declines in consumer spending, nearly half of those recessions have been associated with spending in the 1% to 2% range. If, perchance, a reduction in wealth were to be derived from lower housing or equity values, a recession would ensue given the already low level of expected spending and the minimal level of saving."

Quote # 2

"Despite the addition of nearly 1.6 million private jobs in the past twelve months, since the recession of 2001, only 391,000 private jobs net/net have been created, compared with 5.3 million private jobs at the same point in the previous five business recoveries. This lack of job growth has caused individuals to drop out of the job force in droves, so that only 65.9% of the potential labor force is participating, down from the 67.3% peak in 2000. The number of unemployed stands at eight million individuals, and if discouraged and underemployed individuals are counted, the total would rise to 13 million, or 8.9% of the labor force. Incidentally, this is down from the peak of over 16 million, or 10.9% of the labor force"

BB Note: In addition to the above, the number of hours actually being worked in a week in the USA has been falling.

Quote # 3

"Further, the work week has averaged about 33.7 hours over the past twelve months, marking the lowest annual hourly level since the Department of Labor began measuring this statistic in 1965".

So the $64,000 question is: What will happen to the US Equity Markets? Will they trend upwards, sideways or downwards?

Up until a few weeks ago, I was anticipating a sideways movement. Now, it appears to me that the move is likely to be "down" (following some technical "noise" leading up to the elections)

A key factor to watch will be whether or not the "long term" oscillators go into negative territory (below zero)

In the chart below I have highlighted both the Momentum oscillator and the Moving Average Cumulative Differential (MACD) oscillator. Chart courtesy

  • Note how the perpendicular histogram bar of the Momentum is just peeking down into negative territory - for the second time in a decade (the first time was in 2000 following the market's peak)
  • Note how the blue line of the MACD is approaching a cross over through the brown line, which - if it happens - will represent the third time in a decade that this will have happened
  • Note how the histogram of the MACD has also just tentatively entered negative territory.Finally, note how the Dow Jones Index rose in price from March 2003 on volume that was decreasing

To me, it has been the decreasing volume that has been most worrying. Rising prices on decreasing volume is indicative of an absence of selling pressure as opposed to a presence of buying pressure. The "smart" money people have been the most likely sellers during this phase because they passively "feed" demand as opposed to actively sell into the market. What happens during this phase is that investment moves from strong hands into weak hands; and weak hands have a high propensity to panic when the going get tough.

The Fed has been able to hold it together leading up to the elections, but their incentive to continue doing this is waning.

If I'm right, investors have only a couple of weeks to get out before the markets head south in earnest.

What has caused me to become concerned that sideways expectations are "optimistic" and downwards expectations are "realistic" has been two indicators published by

  • The first measures the percentage of Price Momentum Oscillators that are pointing up. Focussing on the DJIA only, 47% of PMO oscillators are pointing up as at today's date - which implies that 53% are pointing down. (In the interests of objectivity, it needs to be emphasised that this same indicator is far less bearish for the Nasdaq and the $SPX, but I am particularly focussing on Dow Theory here)
  • The second measures the number of PMO oscillators that are below the zero line (currently around 50% in the DJIA, but - again to be objectively fair - less than 50% for the broader market)

Focussing specifically on the Dow Jones, however, if the latter number grows significantly above 50%, then it follows that the overall Dow Jones Industrial Index oscillators will also enter negative territory.

If this happens, it will represent only the second time in thirty years that this will have occurred in the MACD oscillator (

And it will be the third time it will have happened in 22 years in the PMO

Why am I focussing only on the Dow Jones?

Because this is where the big money is invested. The little guys and the hustlers (including the hedge funds) are dickering around in the smaller counters and the more speculative counters, but the heavyweights have to be in the DJIA if they are going to be in the market at all. Thus, if/when the Dow Jones starts heading south it is/will be indicative that the heavyweights are getting out. In this sense, the Dow Jones is a "leading indicator"

An implication of the long term (monthly) Oscillators entering negative territory is that the equity markets as a whole will likely enter the SECOND (of three) down legs in a Primary Bear Market (The first occurred between 2000 and 2002)

The second down leg in a Primary Bear Market is typically associated with fear, as "Denial" (evidenced by decreasing volume in the "first upward pointing reaction leg" that occurred in 2003 ) turns into "Recognition and Acknowledgement", which is typically associated with rising selling pressure, as the weak investors start rushing to the exits.

Bottom line:

For those who have not yet done so, it's probably time to get out of equities and into precious metals as an insurance policy (around 5% - 10% of net worth). Note however, that gold is technically overbought from a trader's perspective, and has a higher likelihood of consolidating in the short term than of rising. But, from my (non trader's) perspective, waiting to get in at exactly the right time will be analogous to losing a multi million dollar deal because we were too intent on screwing the last dollar out of the seller. It will be exceptionally difficult to get the timing right on this one.

Post Script Regarding Dow Theory

The Dow Jones Transportation Index has been rising and there has been a lot of confusion as to why. Let's apply common sense here: The distance from Los Angeles to New York is four hours by plane. Distances in the USA are vast. As an example, to transport lettuce from the farms to the market place is a complicated logistical exercise (remember the James Dean movie where the lettuce went off in the train carriage?). Profitability in the Transport sector is high because the cost of rising oil price has been passed onto the consumer who cannot say no. Consumers will have to accept the higher transport cost or stop receiving their deliveries of lettuce.

In Australia, Qantas is now talking about a THIRD increase in their "oil levy". But what are they doing in reality? They are attempting to preserve their PERCENTAGE ratio of profitability to revenue. It follows that the absolute dollar profitability of the "freight delivery and essential travel" elements of the Transports Industry are booming - but that this does not auger well for the economy as a whole. THAT is why the divergence between the Transports and the Industrial Indices is bearish as opposed to bullish.

A medical study in France during the early twentieth century suggests that gold is an effective treatment for rheumatoid arthritis.
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