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December 30, 2006

The Elliott Wave Pattern in Bonds Warns of a Recession in 2007
by Robert McHugh

We believe the risks for Bondholders leans toward a rise in prices, and substantially declining long-term interest rates. This is frightening, as it means we are about to enter another recession, one that could be deeper than we have seen in a long time. Why do we see this as an increasing risk? Primarily what has changed is the development of a Symmetrical or hybrid Ascending Bullish triangle from 2002, shown below. Triangles are usually wave fours, so that means we have a wave five up coming after this pattern completes. Whether this pattern is a Symmetrical Triangle or is an Ascending Triangle, both are Bullish for prices. In the case of a Symmetrical, the trend leading into the triangle is the trend that will continue after it completes -- in this case up. In the case of Ascending, they are almost always Bullish.

The first chart shows the long-term Elliott Wave labeling from 1982 when bonds bottomed, ending a century long decline in prices, perhaps of Supercycle degree. Perhaps the labeling is one degree too low, that the Intermediate labels should be primary degree, that the minor degree labels should be intermediate degree. It matters little, for the point is, once this triangle finishes, a major rally in Bonds should unfold, higher than we saw in 2000, which means long-term interest rates could approach 1 or 2 percent, which suggests a major recession or even depression could be coming. I hope I'm wrong.

Timing? It looks to us like wave d up has topped. Bonds are now declining into the final wave e down through the beginning to middle of 2007. Then we should see wave 5 up, and the recession as well. At this time, we also have an inverted yield curve, which often predicts recessions, so it all fits.

How could Bonds rise to these levels, given the possibility of a contemporaneous Dollar devaluation -- perhaps in half? Both scenarios suggest a response to a single problem -- a housing market disaster. With over a trillion dollars of adjustable rate mortgage debt about to reset for the first time in 2007, as teaser rates come home to roost, with little interest to buy real estate at current price levels, it isn't hard to see the looming disaster. If housing prices fall due to supply exceeding demand, Banks and mortgage-backed security holders are at risk. Homeowners are at risk. If you were the Working Group, a.k.a Plunge Protection Team, what would you do? Answer is, devalue the dollar so that the real value of debt is diminished, and buy Bonds so long-term interest rates are low enough to act as an incentive for another round of payment-reducing mortgage debt, which of course would stimulate housing demand and support prices (from the creditor's perspective, collateral values). These charts suggest it all is likely to happen.

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Robert D. McHugh, Jr. Ph.D.
Main Line Investors, Inc.

Robert McHugh Ph.D. is President and CEO of Main Line Investors, Inc., a registered investment advisor in the Commonwealth of Pennsylvania, and can be reached at www.technicalindicatorindex.com. The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. Editor shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.

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