The Wall Street Crash has Begun

October 12, 1998

U.S. equities markets entered the initial stages of what we consider to be a crash last week. While not reflected in the Dow Jones Industrials, other stock market indices showed tremendous weakness and experienced profound losses, while several important technical indicators were at levels seen only in times of severe sell-offs.

In a week that saw panic selling in the bond market and dollar index, all the major U.S. stock indices, with the exception of the Dow Jones Industrials, were off significantly from last week, including the NASDAQ, the S&P 500, the Russell 2000, the Value Line composite, and the Wilshire 5000.

Even more interesting was some of the internal action on the Dow Jones Industrial Average last week in what appeared to be a clear case of intervention on the part of "investment pools." Action on the Dow as measured by its Oct. 7 intraday chart showed what appeared clearly to be a classic case of investment "pool buying," where a cadre of high-powered investors attempt to influence or provide an artificial support to the market. This was evident from the smooth and powerful impulsive waves whenever the market tried to climb. But whenever the Dow tried to fall it was met with immediate and constant resistance as reflected by the extremely rippled look and shallow slope of its corrective (descending) waves. Meanwhile, the NASDAQ was slowly and steadily eroding over the course of the week along with, but to a lesser degree, the S&P 500. This highly unusual divergence of market indexes occurs only before significant downward moves in the broad market. Based on this occurrence alone we would be justified in expecting a market crash sometime this month.

Undoubtedly, there are those on Wall Street who, in their unbounded arrogance believe they can actually control and manipulate the market through such maneuvers as buying up index futures, or through large stock buy-backs on the part of major companies. Though such tactics do often have a temporary ameliorating effect (though "white wash" would be a more appropriate description), in the end they can do nothing to halt the ineluctable forces of the free market. In fact, any attempts at controlling the free market can only be made within the confines of the free market itself and under the principles which govern it (i.e., even if attempts are made at controlling the market they can ONLY be made by playing under the rules of the market—thus, the free market actually controls those who to try to control it). A beautiful pictorial example of this occurred last week under the circumstances mentioned above. Obvious attempts on the part of large, powerful investment pools were being made at halting the Dow's short-term decline. But all the while, a triangle pattern was being formed on the Dow's five-day chart. While the conspirators were trying to prevent an outright collapse of the Dow, they were actually guaranteeing its eventual demise and even exacerbating it by creating a massive price congestion of pent up "energy" waiting to escape (e.g., the triangle formation). So in the end, the market always has the last laugh over those who would control it.

More of the same type of action that characterized Wednesday was witness on the Thursday, Oct. 8 trading session. Every measure of internal strength showed a market in retreat and most of the stock indexes were down significantly. The Dow fell 274 points before staging a dramatic turnaround and finally close down only 10 points. Many traders were fooled by this action, especially as it was accompanied by some of the heaviest trading volume in Wall Street history. Ordinarily this would have been a buy signal and perhaps a sign the bottom was in place, but for those who closely follow the market it clearly wasn't anything of the sort; rather, it proved to be a confirmation of the major bear trend underway. This was ascertained by noting that the massive increase in volume began in only the first few hours of trade when the Dow was falling and before the Dow began its comeback; thus, it could not properly be considered a buy signal.

The Dow Jones Transportation index also served to confirm the major bear trend underway, falling more than 200 points over a two-day period last week, and finishing the week down a total of 176 points from last week (a considerable percentage for the Transports). This provided a Dow Theory divergence and pointed to yet lower numbers ahead for the Dow Industrials.

The Dow Jones Industrials chart has formed a rather large and uneven contracting, or symmetrical, triangle pattern with prices fast approaching the apex of the triangle. More often that not, symmetrical triangles are continuation patterns in which prices continue in the direction they were heading before the triangle formed (in this case, downward). But occasionally they may be considered reversal patterns. The question is, which type of pattern is this particular triangle—a continuation or a reversal formation?

The answer to this can be found in the pages of Technical Analysis and Stock Market Profits, a master work by the grandfather of classical technical analysis, Richard Schabacker. Writes Schabacker: "In the main, the most helpful indications [for determining the direction prices will head after breaking out of a symmetrical triangle] are generally those dealing with fundamentals, or at least with aspects not immediately present in the technical formation itself. How are earnings? What are the future prospects? What surprise news is possible in the stock [or stock index]? What is the future for general business? Is the technical position of other stocks, and of the general market itself, strong or weak? Such pertinent questions, while not all fundamental by any means, often give the correct answer to our technical problem as to whether a Symmetrical Triangle in process of formation is going to turn out to be a real reversal of technical trend, or merely a continuation formation (a temporary halt or congestion leading to a strong resumption of the previous trend)." The answer to each of these questions makes abundantly clear the general outlook for the stock market and the business sector. The outlook is nothing short of dreadful, and most stocks are still tremendously overvalued and must return to more realistic levels before the "correction" can be considered over. That could take a while.

Schabacker goes on to address the phenomenon known as the "braking effect" that often occurs in the early stages of a market reversal from bullish to bearish, especially when the preceding bull market has been a particularly strong one. This effect ties directly into the chart pattern we are witness on the Dow, where, after a period of hard falling from its previous highs, the Dow has of late proceeded only in fits and starts and has traced out several congestion patterns (such as the wedge or triangle formations we have noted) without making much progress in its new direction (down). Schabacker attributes this to the residual strength of the former bull (the mindset of which is still very much alive within most investors) and to the relative strength of other leading stocks in the overall market. Generally, several months must pass before the new bear trend can really begin in high gear, and that seems to be the scenario we face today. However, the bear trend is clearly becoming more entrenched with each passing day, and it shouldn't take too much longer before the market re-commences falling.

Also, from a technical perspective, the contracting triangle in the Dow mentioned here has nearly fulfilled the requirements of the venerable "Rule of Five," a rule of technical analysis which states that a price line on a chart will generally touch the lower and upper boundaries (support and resistance) of the triangle five times before breaking out of the triangle into its new direction. If this rule has any reliability this time, we should see falling prices on the Dow by early next week.

Other indicators continued to confirm the ongoing bear market. The ARMS index finished the week at a reading of .52—extremely overbought and bearish. The ratio of price premiums in Puts versus Calls on the CBOE was 0.42 at week's end—also bearish. The IBD Mutual Fund Index continues to trend well below its 200 day moving average and can properly be said to be crashing at this point. This index represents mutual funds from all major investment sectors; thus, the mutual fund industry (which has become the collective savings account of the American people) is in collapse. The U.S. economy will not be too far behind.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.  The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment.  He is also the author of numerous books, including “2014: America’s Date With Destiny.” You can view all of Clif's books here. For more information visit www.clifdroke.com.

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