US Markets Coming Under Pressure

June 17, 1999

A recent analysis on the status of Wall Street concluded on the basis of volume behaviour that there is a good probability that the Dow Jones has already peaked.

It is beginning to look very much as if recent price volatility is merely some footsie wootsie for old times' sake between market players who have been programmed to buy on the dips and who do not as yet realise that doing so in a bear trend is a quick way of writing your own financial death warrant and other, more experienced investors who have sat it out to the bitter end and now accept that rising yields on the bond market are sounding the death knell for the equity bull market.

Ever lower turnover on Wall Street over the last few weeks shows that eager buyers who were present in great numbers during April and May have bought their fill and are now waiting to realise their hoped for profit. New buyers are less eager to buy at ruling prices and are also fewer in number – experienced investors are withdrawing from the market as they become aware that yields on US bonds are making new highs and that this trend has, in the past, been a warning that equities too are due for a major correction.

It would be shortsighted to consider only the US investor in relation to Wall Street and the US bond market. Ever since the systemic collapse of SE Asian economies in second half 1997, funds from that region has flowed to the US to find a safe haven, firstly in its bond market and later to search out good returns on Wall Street. By all accounts, these flows were augmented during 1998, when events in South America and later in Russia resulted in even greater nervousness among non-US investors.

Fear for the future of the euro probably added even further to foreign investment in the US during late 1998 and the first part of 1999 as investors in Euroland sought protection for what many expected to be and then actually turned out to be a shaky start to the common currency – which by default also dragged down the more established national currencies.

In this analysis we review Wall Street at the hand of the S&P500 index and the US bond market, the latter in terms of the yield on the US 30-year Treasury bond. A foreign perspective of these two markets are presented at the hand of the S&P500 index expressed in terms of Yen and the Yen price index of the 30-year bond.

The Standard & Poor 500 Index. Daily close (Last = 1293.6)

The most impressive feature of the daily chart of the Standard & Poor 500 index, similar to the chart of the Dow Jones shown in a previous report, is a large megaphone, A-M, where line A is the steeper derivative of line M.

(Readers who are not familiar Chart Symmetry and the terminology used here, will find a description of Chart Symmetry in the G-E archives at:
http://www.gold-eagle.com/south_africa/regional_analysts/joubert020699.html)

Megaphones are strong formations that contain sustained and volatile price movements. A second major chart formation is the rising wedge, A-F, where line F is the second steeper derivative of line M. This means its gradient, too, is fully determined by the gradient of line M.

A rising wedge formation has long been associated with the approaching trend reversal at the end of an extended bull market.

Two major bull trends are evident subsequent to the mainly sideways trend of the middle portion of 1997.

After the spike downward late in October 1997, reaching just short of support at line B, the S&P500 gained 35% to peak in July 1998. A 20% decline in the index followed, with a low at the end of August, as investors were frightened off by the bank crisis in Russia.

There are some reports of a massive effort at this time, combining widespread PR and reflationary activity among other measures, to get buyers back onto Wall Street. The success of these measures is evident in the second steep bull market that carried the S&P500 higher by 42% to reach a final top in mid May this year.

In fact, October 1998 – the time of the start of this new bull market – was also the beginning of the bear market in US bonds as can be seen on the chart below. It is as if investors in bonds had thought that at a yield of about 4.8% the 30-year bond had limited scope for further gains, while the equity market could still run for years. They started to sell off their investment in bonds and re-invested the proceeds in equities. This was also the time that day traders started to be mentioned as a market force, although they were primarily active on Nasdaq during this early period.

The effect of the asset re-allocation from bonds to equities, with probably some contribution from the day traders, can be seen in changes in turnover on Wall Street.

During the first half of 1997, average daily turnover was about 500 million shares. From October 1997 (the start of the Asian Flu) through to July 1998 (the intermediate high before Russia imploded) turnover was about and often well above 600 million shares per day, for an increase in about 20% in average turnover over what it was a year earlier. By late October, almost 2 months after the 20% fall and when the campaign to entice buyers back onto the Street was in full swing, the monthly average turnover mostly exceeded 800 million shares, for another 33% increase in turnover over the first half of 1998.

During November 1998 turnover fell to below 700 million shares on average, while prices on Wall Street rose very steeply – a typical result of sellers withdrawing from the market and waiting for better prices, while buyers eager to get hold of the reduced number of shares on offer were bidding prices steeply higher. Then turnover suddenly picked up dramatically, to peak at above 1 billion shares on average during early to mid May this year – a typical sell-off as nervous holders of stocks escape from the market by selling into what can only be termed a feeding frenzy among hopeful buyers.

It is this pattern of behaviour that over time develops the rising wedge that now signals a top to the market as share prices begin to fall on sharply reduced turnover – now well back below 800 million shares on average again and an indication that keen buyers have all but disappeared. Yet the bargain hunters in the dips are still present.

This evolution in trading patterns further supports the view, presented by the rising wedge, that the S&P500 has already peaked to complete the 17 year bull market and that a major correction is now mostly a matter of time.

Yield on the US 30-year Treasury Bond. Last (6.158%)

The weekly chart of the yield on the US 30-year bond was discussed previously, at a time when the rising yield found market support along line B and hesitated there for some weeks from February to April. The break higher, when it finally happened, was followed by a steep rise in the yield that easily broke through the psychologically important 6.0% level to close at the next major level of market support at line A (6.16%).

Note that the yield bottomed in October 1998 and was soon followed by a steep increase – circumstantial evidence that, combined with an equally steep rise in prices on Wall Street, supports the contention that investors were switching into equities from a heavily overbought bond market with limited scope for further gains.

It is interesting that the three main bull trends that can be seen on the chart, seem to have a gradient that is much shallower than major parts of the two bear trends that occurred in late 1993 and in 1996. It is as if bear trends start with a bang and then either slow down or consolidate for some period of time before the steep bear trend is resumed, if at all.

This observation raises the possibility that the yield may now consolidate below market support at line A for some length of time before the yield resumes the move higher to the top of the bull channel – which appears the logical conclusion of the break from the steep bull channel, Y-X. Such a move to reach market support at line M would carry the yield on the 30-year bond to above 7%.

The question of course is whether the anticipated break above line A will really take place and for what reason.

An obvious answer lies in the US inflation rate. If a rising oil price, or an increasing labour cost or any other factor, causes the US CPI to rise from its recent low levels, the Fed is almost certain to raise interest rates. They would have to do so, despite what this step would do to the bond and equity markets, and directly and indirectly to the economy as a whole.

Some expectation for such an increase is already factored into the bond market. If a small increase in the rate is announced, the market could even recover, on the often experienced rule of thumb that states, "buy the rumor, sell the fact" – which in this case of a rate increase would be, "sell the rumor, buy the event".

If inflation should keep on increasing, despite a moderate increase in rates, a further increase in interest rates would become necessary and that would not be received too kindly by the markets. If that does happen, it could be the trigger to send the yield rising through market support at line A on its way to the top of the bear channel.

A larger than expected jump in rates quite soon would have a similar bearish effect on the 30-year and other bond yields – and thus on prospects for Wall Street as well.

Standard & Poor 500 index in Yen. Daily close.

It was mentioned above that investors from SE Asia moved large amounts of funds into the US in the wake of the troubles experienced in that region during late 1997 and 1998. As a consequence, the US dollar gained much value against the Yen and other SE currencies – over and above any depreciation in some of these currencies on account of internal weakness.

Initially at least, most of these funds were probably invested in US bonds, these being viewed as the safest haven in times of crisis.

However, subsequent to the low in the yields in October 1997, and more so as the yield on the 30-year broke back above 5% and then remained there, foreign investors may well have led the asset re-allocation from bonds into equities.

By the time foreign investors from South America and elsewhere – including Russia and later Europe – moved their funds to the US to escape greater risks at home, the bear market in bonds was in full swing and at least a portion of these funds must also have found their way onto Wall Street.

If foreign investors begin to play a significant role on a market, one would tend to see some correlation between the market index and the value of their currency. In the chart below the S&P 500 index is multiplied by the dollar-yen rate to obtain an index of the top stocks on Wall Street in terms of the Japanese currency.

It is clear from the trends on the chart of the S&P 500 index in Yen that some correlation beween market and currency does exist.

There are two well-defined bull channels, one lasting from mid-1997 through to the market high in July 1998, and the second from the start of the more recent bull trend in November 1998 through to may 1999.

Observe that the sharp fall that started in August 1998 through to September 1998 is much exaggerated here, compared to the normal S&P chart discussed above. The reason for this exaggeration is the strong performance of the Yen through August/September 1998 – an event that caught those hedge funds that were deep into the Yen carry on the wrong foot and triggered a panic reaction among them to sell out their US investments in order to repatriate the borrowed Yen before they suffered an exchange rate loss. This reaction by the hedge funds at least partly contributed to the steep fall on Wall Street over this period, while the firmer Yen made the loss of value for their equity investments on Wall Street more severe from the Japanese perspective.

It can be seen that the S&P500 in Yen terms has just broken lower out of the more recent bull channel. While the break is as yet still quite marginal, it is a warning that the S&P500 in yen could plummet steeply lower – as happened previously when the first bull channel was penetrated to the down side. Such a fall would also confirm the near double top, shown by line T, which serves as a major reversal pattern for the chart.

While a steep decline in the chart could in principle result from a very strong Yen, it is unlikely that the Yen would firm appreciably against the dollar without triggering at least some sell-off on Wall Street. Events in August/September last year showed what could happen as a consequence of the Yen carry when foreign investments on Wall Street – which include purchases made by non-Japanese hedge funds through the Yen carry – were sold in order to avoid currency losses. Similar developments are very likely if the yen should continue to firm against the dollar.

Note that the break from channel B-C is confirmation of anticipated weakness on Wall Street as a consequence of the break from the rising wedge on the daily chart of the S&P500.

US 30-year T-bond in Yen. Weekly close

While the S&P charts are daily charts, both the dollar chart of the US 30-year bond and this analysis of the 30-year bond in Yen terms make use of weekly charts.

The weekly chart of the US 30-year bond in Yen includes the time from 1988 to 1995 during which the Yen firmed against the US dollar, which meant that Japanese investments in the US were suffering currency losses, from the Japanese perspective. On the other hand, the US bond market was then in the latter phase of its long term bull market, which offset the currency loss to some degree.

This period during which a firmer Yen was largely off-set by a strong US bond market, is seen in the mostly sideways move in the Yen price of the 30-year bond above line P on the chart. Prior to this sideways period, the Yen price of the 30-year bond showed a steep increase, rising from line M to line I. This was when the yen weakened by 33% from ¥120 to ¥160 over less than 18 months. The bond market was quite bullish during this period, adding value to the Japanese investments.

Then the yield on the US 30-year bond bottomed in October 1993 and reversed upwards. Shortly thereafter in 1994 the Yen started a steep bull trend that gave the Yen price of the 30-year bond a double whammy, and sent the pirce back down to line M.

Master line M is defined as the support line of the first half of the chart. Line P, parallel to M, shows the consistency of this gradient. Line I is the inverse of M, so that I-M is a large symmetrical megaphone. Line S is the support line of the initial steep bull trend in the Yen price of the 30-year bond during 1995/96.

From the time of the trade accord between Japan and the US in mid 1995, where a cooperative effort to strengthen the dollar was one of the terms, the Yen had lost almost half its value by August 1998, going from ¥80 to ¥147 against the US dollar.

This weakness in the Yen, in combination with a US bond market that experienced the last part of its long term bull market between November 1994 and October 1998, meant that the Yen price of the 30-year bond skyrocketed out of the megaphone for a gain of 150% by the time the price reached its peak. Not at all bad going for investors in a country where a 1-year deposit earned interest at less than 2%!!

The sharp increase above line I was of temporary duration and the Yen price of the bond soon reversed direction and returned to rest on line I – almost at the cross-over of I and the steep support line of the early part of the bull trend.

The trend reversal was of course the result of, firstly, weakness in the US bond market after the yield reached its low point in October 1998, and later also a firmer Yen.

The break lower below I took place at the cross-over with line S. A brief recovery carried the price back to line S for a goodbye kiss, which was then followed by a steep fall in the Yen price as both the dollar and the bond market weakened simultaneously.

This break back into the megaphone is very bearish for the Yen price. The chart shows that a further 27% decline in the yen price is possible if the chart should decline all the way to support at line P – not an impossible development in terms of the chart dynamics. Such a move is likely to be the result of a weaker US dollar and a weaker bond market, and not to one of these components in isolation.

If the chart retreats all the way to the bottom of the megaphone at line M, the fall in the Yen price of the 30-year bond will be almost 50%. Line M has a value of 10.04 at the moment, say 10 in round numbers – which is the result of dividing the Yen/dollar rate by the yield on the 30-year bond.

As a possible target, this represents some combination of the Yen /dollar rate and the yield on the 30-year bond – say, for example, ¥80 and 8% on the yield; or perhaps ¥100 and 10% on the yield. Another combination could be ¥70 to the dollar in combination with a 7% yield on the 30-year. Perhaps something in the range between the first and second combinations would seem the more reasonable to expect if the Yen price does in fact decline all the way to line M.

Conclusions

A significant break from a steeply rising wedge is a signal from within the technical tradition that the S&P500 index has ended its bull market and is now really waiting for an opportunity to begin a bear trend. An ingrained belief that it is profitable to buy on the dips, in combination with a large reservoir of liquid funds from (remaining?) day traders, are viewed as reasons for the recent high degree of intra-day and intra-week volatility, yet with no clear direction on Wall Street.

Turnover is well below levels experienced during the latter stages of the bull market and this shows that the market has been thinned out substantially. Nevertheless, a sustained rally in the Dow Jones and S&P500 on much increased turnover (>850 million shares per day on average) from a new low should be seen as early evidence that the bull market is attempting another leg. This is however not expected on current charting evidence and given the likelihood that yields on the US bond market will at best consolidate in a range near current levels.

While the yield on the US 30-year bond closed at good market support on Friday (11 June), the Yen price of the bond has broken below prominent and old market support. The first event might initiate a period of consolidation in the bond market. The second is an indication that foreign investors in the US bond, through the Yen, will be strongly tempted to sell out and repatriate the funds to reduce capital and currency losses.

While a rally in the 30-year bond off market support at 6.16% is perhaps to be expected, renewed – or perhaps continued? – foreign selling of US bonds could place upwards pressure on bond yields. In that case, we could well see a break for the 30-year yield through firm market support at 6.16% that would open up a move higher to above 7% - and this would hold severe negative implications for Wall Street.

The world’s gold supply increases by 2,600 tons per year versus the U.S. steel production of 11,000 tons per hour.

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