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The Dow: Bottoming or Crashing

"The search for static security -- in the law and elsewhere -- is misguided. The fact is security can only be achieved through constant change, adapting old ideas that have outlived their usefulness to current facts." ~ William O. Douglas 1898-1980, American Supreme Court Justice

The Dow is extremely oversold on all time frames, very short, short, intermediate and long term time frames. If the Dow were to test its lows or trade below them within the next 3 days, it would most likely generate at least two new buy signals, in addition to at least 3 large positive divergence signals. If this scenario were to come true, the signals generated should be strong enough to generate at least a 700-1200 point rally. Market update Feb 17, 2009

The breach of the Dow's Nov 2008 lows was a major negative development; it firstly signifies that the chances of the Dow trading past 10,500 this year are now slim, and it has created a new downside target of 6500. Market Update Feb 24, 2009.

As always price action is going to determine everything. For the Dow to neutralise its Downtrend, it would need to trade above 7200 for 3 days in a row; until it does this the threat of it trading to and testing the 6500 ranges will remain valid.

The Baltic Dry index continues to trade at or close to 3 months highs; again it must be sensing some up tick in the economy for it is a leading economic indicator and if the future looked dim, it should be trading at 52 week lows and not at 3 month highs. Copper is a strong predictor of market action; it usually tops and bottoms well in advance of the stock market; it has already put in a bottom formation and is currently attempting to break out of a tight channel formation. A break out to the 180 ranges would be the first sign that the markets are stabilising and that a turn around is in the works; copper is currently trading in the 165-167 ranges. Market update March 4th, 2009.

After closing below its Nov 2008 lows, the Dow generated two very large positive divergence signals; time will tell us if these signals were valid or not.

The Dow trading below its Nov lows is certainly a negative development and cause for much concern. It would be a very normal reaction now to come to the conclusion that the next stage is for the markets to crash and burn and that things are going to look bleak for a long time to come. Thus if one dug deeper one should find that the core of this market is completely rotten and that from an internal, external and psychological perspective everything is shot to pieces. Thus working on this premise, we decided to re examine all the bullish factors we had listed in the past few weeks. Essentially we were looking for information to support the fact that the Dow's violation of its November lows was an extremely negative development and signalled that things could only get worse.

So we started to dig with the premise that we would find info to support the fact that the Dow's penetration of its Nov lows was indeed a very negative development; logically, one would expect the situation to have deteriorated significantly. To our surprise we discovered several potential positive developments.

Throughout this correction, the distribution between bears and bulls was rather too uniform; in other words, the two groups appeared to be equally divided and to make things even worse, there were simply too many contrarians in the contrarian camp. Furthermore, too many experts were marking the Nov lows as a do or die line. Thus from a psychological perspective, the Nov lows could have been taken out, to purposely drive a large number of contrarians into the bearish camp and in doing so bring the number of contrarians close to the 20% mark. Last weeks sentiment readings conducted by the AAII (American Association of individual's investors) illustrated that 70.3% of respondents are now in the bearish camp; this is the highest reading in the history of the survey. We would call this a major psychological development and an indication that the Dow might have put in an intermediate to long term bottom on 9th of March.

Several factors lead us to believe that the Dow taking out its Nov lows was psychological ploy to trigger the majority out of the contrarian camp and into the bearish camp.

  • The Baltic dry index continues to trade higher, and currently it has just put in a new 6 month high. The Baltic dry index is a leading economic indicator.

  • Copper tends to usually bottom and top well in advance of the economy; it put in a low of 128 towards the end of Dec 2008 and has not traded within this range since.

  • Several stocks that broke down when the Dow set new lows last Nov did not break down this time. Most of them were trading significantly of their lows; examples are ADM, SGR, CHK, PCU, BHP, IBM, etc.

  • Though VIX levels are still high, they did not even come close to testing their old panic induced highs between Oct and November of last year. In October of 2008, VIX levels shot well past 90 for several days. If we had entered into a new panic mode, VIX should have shot up additional 20-25 points.

  • The bond market did not put in new highs; another divergence, which suggests that money was not flying out of equities into the bond sector

  • Gold actually pulled back from its highs, yet another indication that investors were not desperately looking for a safe haven.

  • Finally, the Dow hit our 1st posted down side target (7200) and 2nd downside target of 6500 in one shot without mounting a significant rally. It has now pulled back over 50% from its all time high and normally when a market hits such an extreme point, it mounts a decent to a very strong rally.

We also decided to take two readings of all the 3 moving averages we maintain; one reading was taken on the 24th of February and the other on the 10th of March, a day after the Dow put in a new low.

Moving averages of new highs and New Lows

Feb 24th 2009 readings
Moving average New Highs New lows
20 day 175 2320
100 day 45 747
I year 15 720

20 day moving average of new lows = 4615 (New all time low set on Sept 16th 2008)

1 year moving average of new highs = 10 (New all time low set on Nov 25th 2008)

1 year moving average of new lows= 2225 (New all time low set on Sept 16, 2008)

The 20 day moving average of new highs was 260 on the 13th of February and despite the Dow trading below its Nov lows, the 20 day moving average of new highs did not experience a massive pull back. It dropped from 260 to 175. The 20 day moving average of new lows dropped to 2320, still below the Sept 16th record low of 4615. As the Dow went on to put in new lows, by logic this number should have plunged also; something appears to be amiss here.

The number of new highs on the 1 year moving average was 50% that set on the 25th of November 2008. Again this is not what one would expect when the markets go on to put in a new 52 week low. Thus something does not quite add up here, could the professionals be setting up a bear trap for the masses?

March 10, 2009 Reading
Moving average New Highs New lows
20 day 235 745
100 day 55 365
I year 20 320

A day after the Dow traded below 6500, the readings are significantly higher from those taken two weeks ago on the 24th of February; once again, one would have expected the moving averages of new lows to sky rocket and the moving average of new highs to plunge; instead the opposite occurred. This is yet another very strong inter market positive divergence signal.

Conclusion

Despite looking for negative reasons to support the view that this market was going to crash and burn, we did not find such evidence, and so we are forced to remain bullish, at least on the short to intermediate time frames. We have always placed an emphasis on contrarian data (technical and Psychological) and this data is not supporting a crash and burn view.

From a psychological perspective, the silver lining is that the number of contrarians has now dropped seriously and two leading economic indicators the Baltic dry index and copper are both diverging from the general markets.

Finally, last Tuesdays (10th of March) volume came in at 9.8 billion shares the highest reading in weeks, the day Dow was trading close to its 52 week lows before reversing to end the day on a positive. This suggests that there are buyers out there and that despite the Dow taking out its Nov lows, a new wave of sellers has still not emerged. Once we enter a serious selling mode, volume on down days will continuously overwhelm the volume on up days.

Random musings

The next bubble

Yields on bonds are near zero on the short term and very low on the long term. America is dependent on huge inflows of foreign capital, and we are sure in the long term these investors are not going to be willing to lend the US money for virtually no interest. If these inflows were to slow down just a little, bonds could experience a very severe drop and this would mean rates would increase substantially. Just as we warned all our subscribers well in advance of the dollars pending rally, even though all the experts were stating that the dollar was going to crash, we are now doing the same with bonds and interest rates.

Overseas subscribers who listened to us and moved their funds out of the Euro, British pound, Swiss franc, etc, are sitting on very nice gains. A rise in interest rates will lead to a strong rally in commodities, especially those that fall in the energy and precious metals sector. If you are heavily invested in treasuries, it would be wise to start closing these positions out.

This 32 year old chart very clearly illustrates the extreme move in bonds and how this market is a bubble just waiting to pop. The first warning sign of big trouble will be when bonds trade below 111 for more than 9 days in a row. The next warning sign will be a break below 104 for 6 days in a row and the final sign will be when bonds close below 96 on a weekly basis. We expect this correction to be very severe and before a long term bottom is put in, bonds could very well trade down to the 40 ranges. If bonds trade down to their 1980 levels, this would equate to an interest rate in the 18-21% ranges if not higher. If interest rates ever get there one can only imagine at what prices Gold, Silver, Palladium and oil will eventually trade at.

In the short term we expect bonds to pull back to the 120-123 ranges and then mount one more rally that could drive bonds to put in a new series of new 52 week highs. This process could take the whole of this year, but the next series of highs will mark a long term top and after that one can expect bonds to a long term corrective phase and for interest rates to start rising. As we have stated before we are now in a new period, expect markets to move rapidly from one phase to another.

Commercial real estate

Just as individuals over borrowed to purchase properties they could not really afford because of ultra low interest rates, the same problems are waiting to hit the commercial real estate sector. Over 500 billion dollars of commercial loans financed at extremely low interest rates will re set in the next 2-3 years. When these loans re set, interest rates will move from the fake ultra low teaser rates to market rates and payments could in some cases more than double. One of the biggest areas to get hit will probably be large shopping mall complexes.

Health Care

We stated a few weeks ago that medical tourism would start to become the norm one day as health care costs are rising at unsustainable levels. The closure of several large hospitals in the U.S. is the first sign that the system is going to break down; this breakdown will be severe and painful for those employed and involved in this sector, but it will eventually lead to better and more affordable medical care. Countries such as India, Philippines and Thailand stand to benefit tremendously as result of this new medical tourism phenomena.

Conclusion

Out of all 3 pending bubbles the one that is most likely to pop now is the bubble in the Bond markets. Investor's flung massive amounts of money into bonds last year when they panicked, dumped all their holdings and fled for the hills. Make sure you have little to no exposure to this market. Remember nothing in this world is free and when you think it's free, you actually end up paying twice if not three times as much. On the same token the government is dreaming if they think worldwide investors will continue to invest in short term debt when interest rates are close to zero.

"Only the unknown frightens men. But once a man has faced the unknown, that terror becomes the known." ~ Antoine De Saint-Exupery 1900-1944, French Aviator, Writer

 

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