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Primary Bear Market - II

February 16, 2004

Technical Analysis is all about listening to what the market is telling you - and the messages are often very unclear because of a phenomenon called "biofeedback". It's like the words of the old song: "The girls watch the boys watch the girls watch the boys watch the girls go by" (Who's behaviour is influencing whom?)

The most reliable method of forming an accurate view is to watch from a great distance - to observe BOTH the girls and the boys watching each other.

In essence, the reason why predictive (of human behaviour) computer models inevitably turn out to be unreliable is that biofeedback occurs ex post facto. The very introduction of the computer model causes a new biofeedback loop to come into existence which the model - by definition - did not have factored into it. i.e. Immediately after the model has been developed, the landscape changes, which renders the model increasingly unreliable. Multiply that by a factor of "x = the number of models and systems out there", and you start to develop an understanding of the complexities.

In essence, the existence of biofeedback is the primary reason why technical analysis is an "art" as opposed to a "science". Technical analysts attempt to filter out the biofeedback phenomenon by looking for "confirmations" and "non-confirmations" but, in the end analysis, the talented artist just "feels" which variables are more important than others at any point in time.

Anyone who has managed to convince himself that it is possible to mechanise investment decisions would be best advised to pack up and go home whilst he still has the shirt on his back. In short - if you have convinced yourself that Mr Elliot or Mr Dow or Mr Gann or Mr Granville has developed THE answer - you are probably going to lose your shirt.

Last week I spoke about a possible "Double Top". Within two days the market rose dramatically (but, significantly, it did not penetrate the previous historical top). Have I changed my view regarding the possible peak in the market? The short answer is "no, I have not changed my view" - because my view was formed from 100,000 feet above "see" level.

Let's be absolute clear about one thing: I'm not in this for "ego". I'm trying to listen to what the market is saying. If I turn out to be wrong, I'll be the first to admit it. But between last week and this week, essentially none of the variables - which seem to me to be important - has changed.

Of course, it might well turn out that I'm wrong, but here's the logic - from 100,000 feet. Judge for yourself.

  1. The P/E ratio of the S&P 500 Index was 29.62 X as at February 6th 2004. (Source: ) What does this mean? It means that, if the average of 500 companies' after tax earnings remains at current levels, it will take 29.62 years for Investors in the Standard and Poor 500 Index to get their capital back.

    Two factors need to be examined. a) It is possible that "the market" is telling us that after tax earnings are about to rise dramatically b) So what if the P/E ratio is 29.62X? Even though the historical average P/E ratio over the past 100 years has been around (or less than) HALF of this level, it has demonstrated a capacity to remain at elevated levels for many years. Why should 29.62X suddenly be unacceptable today when it was acceptable yesterday?

    No one can say with any certainty whether or not earnings are about to (say) double. Conceivably it is possible given that the Fed has been pumping money into the system. The Money Supply has been inflating and, if this translates into Price Inflation then earnings could well explode upwards in "nominal" terms - even as they deteriorate or remain stagnant in "real" terms (This is called "Stagflation"). However, the balance of probabilities does not point to such an outcome because the USA does not exist in a vacuum. It is part of an overall world economy, the globalization of which is not yet complete. For example, OPEC recently announced a reduction of production quotas. Forget about "price" implications for a minute and focus on "volume" implications. If there is insufficient volume of energy available to "drive" the world's economies, they will slow down. But OPEC did not say it was going to raise its price. It said it was going to reduce its volume. Bidding up prices to compensate is not going to bring more volume onto the market. Supply of oil is relatively inelastic.

    So let's assume that the price of oil does rise (and volume availability does not). Price levels within the US economy will rise whilst activity slows down or stagnates. Demand will slow, and VELOCITY of money will slow. What will the Chinese do under these circumstances?

    We can speculate about the details until we are blue in the face and we will not come to a "bullet proof" answer . However, from 100,000 feet one factor is clear: There are excessive levels of production capacity, world-wide and (apart from the Space Program that is not yet in place) there is no sign of any robust "driver" of the USA economy. Jobs in "legacy" industries and services are migrating overseas, and the rate of job creation within the USA is not consistent with "normal" recoveries. In short, there is nothing (other than a wave of cash) that is driving the "growth" of wealth creation activity within the USA. Further, the propensity of individuals to spend this wave of cash is (at best) marking time and (at worst) waning - because personal debt levels have reached a point where the "best" the USA consumer can hope for is to "tread water".

    So, the bottom line is that it seems highly unlikely that after tax earnings of the S&P (whether nominal or real) are going to "explode" upwards, and it therefore follows that the P/E multiple of 29.62X is being held up by nothing more than a "sense" of confidence in the system.

     2.  Confidence levels are at historical highs

The "artist" in me is telling me that the following chart is THE most critical clue we currently have available to us. (Source:

The reader's attention is drawn specifically to the bottom half of the chart which shows the percentage of NYSE stocks that are trading above their 200 day Moving Average.

In my judgment the following factors are critically important:

  1. On February 13th 2004, 93% of all NYSE stocks were trading above their 200 day MAs. This was the highest level in 17 years, reflecting a degree of investor optimism that was unprecedented over that time - even at the peak of the Bull Market in 2000.
  2. In 1987 and in 1997 the ratio "almost" reached 90%, and on both of those occasions the ratio fell to around 10% or less within a year - reflecting the FACT that intoxication typically gives way to sobriety in a relatively short period.
  3. On NOT ONE of the six previous occasions between 1987 and 1998 when peaks above 80% were reached, did the level stay above 80% for more than a couple of months.
  4. This most recent occasion is only the second time in 17 years that a new high was reached within months of a previous peak having been reached (the first being in 1997 - when the ratio fell from around 90% to around 70% virtually immediately thereafter)

So where does this leave us?

Right now, the party is being hosted by the US Federal Reserve and the self serving Politicians, and the partying REALLY began in around September 2003.

But from the following chart, it can be clearly seen that whilst the "noise" of the party has been rising, the "number of people" actually partying has been falling. Ie - It is only the drunken razzlers who have stayed on 'till dawn. (Chart courtesy

Note how the perpendicular bars - which reflect volume - have been rising to lower and lower peaks since March 2003; even as the price of the Dow Jones has risen from around 7,500 to around 10,700 during that time.

Note also how the most recent volume bar is lower than the previous one (and this is the second week in a row where the weekly price has risen whilst volume has contracted) - indicating that notwithstanding Mr Greenspan's upbeat message in this past week (and the resulting jump in overnight stock prices) the partygoers are STILL leaving the party.

Dear Reader, this is typical of Bear Market action!! (See note below)

Note on volume: The following is a direct quote from the book Technical Analysis of Stock Trends" by Robert Edwards and John Magee. This book is one of the "Bibles" of technical analysis. Its first edition was published in 1948:

(at page 16 of the 1977 edition)

"Primary down trends are also usually (but again not invariably) characterised by three phases. The first is the distribution period (which really starts in the later stages of the preceding Bull Market). During this phase, far sighted investors sense the fact that business earnings have reached an abnormal height and unload their holdings at an increasing pace. Trading volume is still high though tending to diminish on rallies and the "public" is still active but beginning to show signs of frustration as hoped-for profits fade away. The second phase is the panic phase. Buyers begin to thin out and sellers become more urgent; the downward trend of prices suddenly accelerates into an almost vertical drop while volume mounts to climactic proportions. After the panic phase (which usually runs too far relative to then existing business conditions) there may be a fairly long Secondary recovery, or a sideways movement, and then the third phase begins. This is characterised by discouraged selling on the part of those investors who held on through the panic or, perhaps, bought during it because stocks looked cheap in comparison with prices which had ruled a few months earlier. The business news now begins to deteriorate. As the third phase proceeds the downward movement is less rapid but is maintained by more and more distress selling from those who have to raise cash for other needs. The "cats and dogs" may lose practically all their previous Bull advance in the first two phases. Better grade stocks decline more gradually, because their owners cling to them to the last, and the final stage of the Bear Market in consequence is frequently concentrated in such issues. The Bear Market ends when everything in the way of possible bad news, the worst to be expected, has been discounted, and it is usually over before all the bad news is 'out'"

Where are we in the Primary Bear Market?

My view is that we have completed the first down-leg, and are about to enter the second "panic" down-leg.

The primary rationale that underlies his view is that - to date - we have had no sign of panic (Note the following Advance Decline line which shows that even as the first leg of the Primary Bear Market took hold and the NYSE Composite Index feel from 7,000 to 4,500, optimism was rife:)

Note that the NUMBER of shares that rose outpaced the number that fell - even as prices were falling on the NYSE Composite Index. This is consistent with the "first leg" of a Primary down move.

The declining volume that can be seen in the bars depicted in the preceding chart - even as prices rose - is consistent with an upward reaction in a Primary Bear Market

Having confirmed that we are in fact in a Primary Bear Market, this writer's contention is - for reasons relating to excessive optimism that precedes a hangover (as shown in the % of shares above their 200 day MA) - that we are very close to entering the second and "Panic" leg of the Primary Bear Market.


The Market is sending clear messages that "Confidence" is at a peak but that the increasing noise level has been masking a reducing attendance level.

When the last party goers go home, those who wake up with a hangover the next morning - and who still have their wits about them - will finally start to focus on the P/E ratio of 29.62X. At that point, selling pressure will start to emerge once again.

Technical Analysts should now be watching for signs of increased selling pressure. The problem is: By the time selling pressure becomes recognisable, it's typically too late to do anything about it. That's why you need to have the courage of your convictions and move BEFORE the crowd starts to stampede.

Important: The above is not a recommendation. It reflects the opinion of one individual who is selecting a couple of variables from an ocean of variables based more on instinct than anything else.

Gold was first discovered in U.S. at the Reed farm in North Carolina in 1799, a 17-pound nugget.
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