Summary of Index Daily Closings for Week Ending June 18, 2004

This week the Dow Jones Industrial Average was essentially flat, up 6.31 points, in dull trading on light volume as options expired. The Trannies took a run at 3,080, its high for the rally since March 2003, but failed. Maybe Monday. This leaves us with a Dow Theory upside non-confirmation by the Industrials, a Bearish indicator. The Industrials will have to surpass 10,570 to confirm the Trannies. The sideways action has reduced the overbought condition of the market somewhat, allowing for a bit more rally before the great decline - the Plunge Protection Team willing.

The NASDAQ Composite remains in a Bearish pattern of declining tops, a Bearish Head & Shoulders, and a Bearish Rounded Top. It finished the week slightly above a point of convergence with its 50 day moving average and its 200 day moving average. The S&P 500 also remains in a downtrend channel, and the S&P 500 to VIX ratio sits at a Market Top signal of 75.92, up from last week.

This week's market newsletter is a bit longer than most, for there is much to cover. We continue to believe the Federal Reserve is hyper-liquefying the markets for good reason and we will explore that issue in great detail, beginning on page 10. For you dads out there, Happy Father's Day.

This week the Short-term Technical Indicator Index comes in at negative (40.25), indicating a market decline is probable. This indicator is a useful predictor of equity market moves over the next two weeks, both as to direction and to a lesser extent strength of move. For example, readings near zero indicate narrow sideways moves are probable. Readings closer to +/-100 indicate with a higher degree of confidence that an impulsive move up or down is likely over the short run. Market conditions can change on a dime, or the Plunge Protection Team can come in and temporarily stop market slides, so it may be unwise to trade off this weekly measured indicator. While markets could rise next week a bit more, the Short-term TII, with a time horizon of two weeks, continues to see trouble. Last week's warning may have been early. We'll see.

The Intermediate-term Technical Indicator Index is useful for monitoring what's over the horizon - over the next twelve weeks. It serves as an early warning system for unforeseen trend changes of considerable magnitude. This week the Intermediate-term TII comes in at negative (31.17), indicating that a decline is probable. Massive infusions of M-3 are respected by this indicator, and have reduced the severity of this reading.

The charts on pages four and five (courtesy of www.stockcharts.com) show that there are three major world equity averages crashing at the same time, the plummets starting in April. Russia's Moscow Times ($MTMU), China's Shanghai ($SSEC), and India's ($BSE). None appear to be over yet. The risk to western markets is that these declines spread as all economies are intertwined more than ever before. While the mainstream financial media chooses to ignore these threats, the Fed has not.

India's topping action just prior to its crash looks eerily similar to the topping action in the Dow Industrials. Both indices show a series of declining tops over a four month period, with the distance between the first top and the last declining top in the fourth month measuring a mere 3 percent. India topped in January 2004, then fell gently through April. Then it crashed, a vertical descent, so far 29%. The Dow topped in February and has had four months of gentle descent. Is a crash next?

Typically we can rely on the CBOE total volume Put/Call Ratio to guide us as to when equity markets are nearing tops and bottoms, with ratios approaching 1.00 or higher signaling bottoms and ratios under .60 signaling tops. A study of the above chart going back five years shows this to be true most of the time. The yellow arrows highlight times where bottoms were signaled.

What has struck so many market analysts as odd recently are the very high Put/Call ratios we have been seeing lately - at an apparent top. If we are at a top, then shouldn't the Put/Call ratio be approaching .60? On June 14, 2004 it was 1.15 and hit 1.28 the next day. Bulls are quick to point to this as a clear sign this market is about to turn up with a vengeance. But is it? Better look again.

The Dow Jones Industrial Average had been declining steadily since May 2001, and was down about 1700 points as of September 10th, 2001. On September 10th, the Put/Call ratio spiked to 1.01, yet did not signal a bottom, but rather signaled the start of another severe down-leg caused by the 9/11 terrorist attack on the World Trade Center and Pentagon. There has been a great deal of speculation that folks "in the know" bought puts heavily the day before this tragic event, figuring markets would tumble. Maybe so, maybe not. But the timing is fascinating to say the least, for the day before 9/10/01, on 9/7/01 the Put/Call ratio was a neutral .84.

A second anomaly to the normal correlation occurred in June 2002. Once again we had a situation where prices were sliding from a high, from March through June. On June 14, 2002, the Put/Call ratio spiked to 1.15. This should have marked a bottom, but instead a crash of nearly 2000 points started four days later on 6/18/2002. Is this what we are about to witness now? On June 14th, 2004, the ratio again spiked to 1.15, but the DJIA doesn't appear to be at a bottom. Is a crash next?

If ever there was a chart that looked ugly, and signaled a stock index about to float down the river, it's the Philadelphia Semiconductor Index ($SOX). Take your pick. Rounded Bearish Top, Bearish Head & Shoulders, Declining Tops Series - it all spells crash. It is coming, and may be the first U.S. Stock Index to bail. Compare this to India's Index chart. Similar start. The Moving Average Convergence/Divergence is breaking down hard after prices took a 23.20 point, 4.9 percent walloping this past week. It has crossed below its slower moving average (thin blue line) and broken below zero. The RSI has room to fall. The minimum downside target for this index is 300 according to the Head & Shoulder pattern. Prices have blown by their 50 day MA and 200 day MA.

Another index - see page 10 - that appears to be in real trouble is the Morgan Stanley REIT Index ($RMS). It appears a crash is in process. This index fell 138 points from a high of 664 to 526 in the month of April, a 20% plummet, then retraced a corrective Fibonacci 61.8 percent to around 610. In Elliott Wave parlance, these waves look like 1 down and 2 up of a five wave down sequence. Wave 3's are usually the most severe, and that wave looks about to begin - the crash's next leg.

Indexes with Bearish Rounded Topping patterns include the AMEX Retail Holders (RTH), the NYSE Financial Index ($NYK), the London Financial Times Index ($FTSE), the DJ France Stock Index ($FRDOW), and the DJ Germany Stock Index ($DEDOW). We can see a Bearish Head & Shoulders top in the AMEX Broker/Dealer Index (XBD), a Bearish Triple Top in the Morgan Stanley Consumer Index ($CMR), and a Bearish Double Top in the DJ Canada Stock Index ($CADOW).

The Economy:

Busy week. Here goes. The Federal Reserve let us know on Wednesday that Factory Output rose 1.1 percent in May, the largest monthly increase in six years. The Commerce Department reported that Housing Starts fell a smidgeon in May from April, but was the sixth highest on record. If interest rates rise, who is going to buy all these new homes? Commerce also noted that Retail Sales popped up 1.2 percent in May.

One of the big stories this week was the inflation reports. The Consumer Price Index rose 0.6 percent in May according to those sharp-shooting numbers crunchers at the Labor Department. That annualizes to 7 percent. But wait, excluding Food and Energy - as if energy has nothing to do with cost push inflation - "core" CPI was a mere 0.2 percent. Of course the CPI excludes real estate from its computations. A low CPI means the Federal Government can stiff the poor souls on social security and pensions with increases tied to the CPI. Perfect. Yeoman's job over there in Labor. I doubt seriously if we'll be hearing about Secretary Chao's resignation any time soon. Meanwhile, the Producer Price Index was reported to have risen 0.8 percent, according to Labor - that's over 9.0 percent annual inflation. Not to worry. "Core" was only 0.3 percent.

So what does the Federal Reserve have to say about all this? Federal Reserve Governor Mark Olsen was quoted by www.cnnmoney.com as saying, "It is a time to be alert to inflationary pressures." They quoted Chicago Federal Reserve President Michael Moskow as saying, "Currently, the federalfunds rate is very low, and this degree of policy accommodation cannot be maintained indefinitely." And they quoted St. Louis President William Poole as saying, "If it looks like the signal is really there, then my personal position would be that it would be appropriate for the FOMC (Federal Open Market Committee) to move further and faster than priced-in in the market today." Poole votes on rate hikes. Cleveland Federal Reserve President Sandra Pianalto warned that a failure of the Fed to react quickly to the threat of inflation "puts our hard-won credibility at risk," according to CNNMoney on Monday. So wouldn't it be a perfect Master Planner stroke to hold off raising Fed Funds from 46 year lows, using the inflation rhetoric to create a surprise that pushes markets higher?

Well, the venerable Chairman's nomination was approved by the Senate Banking Committee, as Greenspan is back for a fifth term that takes him into his eighties. Full Senate ratification is a certainty. The only dissent came from my favorite baseball Senator, Jim Bunning, the fiercest competitor I've ever seen don pinstripes. He threw a high heater at the Fed Chair just like he never backed down from Willie Mays or Hank Aaron. I remember sitting next to my dad, watching Jim pitch a perfect game on Father's Day 1964. Good for you Jim. Keep firing fastballs; hold the chief accountable. Somebody has to.

The U.S. Trade Deficit ballooned to a record $48.3 billion, despite a falling dollar, an annualized pace to hit nearly $600 billion. Consumer Confidence rose in June to 95.2 from 90.2 in May, according to the University of Michigan. That is good news for stocks.

Now to the wisdom portion of the news: Bill Gross, respected Chief Investment Officer at Pimco, was quoted in the Financial Times as describing the global economy as "a very unstable environment which can turn any minute. More than any point in the past 20 or 30 years, there's potential for a reversal."

The Labor Department reported Jobless Claims declined to 336,000, still far too high in a supposed recovery.

And to repeat what I reported in this past week's Midweek Market Update, the 9/11 Panel found no link between the attacks on the World Trade Center and the Pentagon and Iraq. There was "no credible evidence" that Iraq was tied to al-Qaida. In other words, the reason given the American people for sending our boys and girls to Iraq, in harm's way, was a sham.

What does this sham mean? Here's a quote from James Moore's bestselling book, Bush's War for Reelection, John Wiley & Sons, Inc., copyright 2004, quoting a dead soldier's father:

"I'm not an emotional person on a lot of things," he said. "But this is just such total bull.... This is just such a horrible waste, and it didn't need to happen, and that's the frustration of this. He's a young man who didn't need to die. We didn't need to waste all of his talents on... Iraq, and he's blown to bits.

"But that's the worst memory, knowing how he died. This beautiful person that we knew, was blown apart, literally blown apart, and for what? He died that horrible death and left all these things behind, his beautiful daughter, his beautiful wife, a life that would have been nothing but success. They'd had a good life, and now there's nothing."

I highly recommend this book which is featured at Borders bookstores or available at www.amazon.com.

Money Supply, the Dollar, & Gold:

M-3 rose $6.0 billion the week of June 7th according to the latest figures from the Fed. Nonseasonally adjusted M-3 grew $64.5 billion for that one week. In the past 11 weeks, M-3 has grown $189.2 billion, and $195.8 billion for non-seasonally adjusted. This is a huge increase in the money supply, far more than we should be getting in a robust recovery, the sort of growth you would expect in a crisis, given the track record of the Fed. For seven weeks in a row, M-3's eight-week increase has grown at a clip faster than 1.5 percent, a benchmark indicating crisis management. More on this later.

The U.S. Dollar looks like it is trying to form a Bearish Head & Shoulders Top. A break below 87 will confirm this pattern. If it confirms, we are looking at a minimum downside target of 82. After an impulsive decline from 92 to 88, the dollar has corrected about a Fibonacci 61.8% and looks ready to turn back down.

Gold is battling to remain in its long-term uptrend. So far, so good. This week's inflation numbers helped, I'm sure. The AMEX Gold Bugs Index remains in trouble, finishing off a symmetrical triangle serving as a wave 4 up of an Elliot Wave 5-wave impulsive down. This index is also in the midst of a crash. A likely bottom for this major decline is in the low 140 area.

Money Supply Chronicles:

Recent growth in M-3 is unprecedented in the context that we have no known crisis, yet the Fed has elected to allow M-3 to grow at historic highs. In reviewing M-3 growth over the past 25 years, there have been only 16 occasions where M-3 growth exceeded 1.5% over a trailing eight week period, for six weeks in a row. In other words, M-3 was growing gangbusters in a relatively short period of time. In every instance except the current one, a known crisis or perceived calamitous threat existed. In every instance the Fed was either flooding the economy with liquidity in response to a widely known crisis or in preparation for a publicly-known threat - except now.

What follows is a chronicle of the dates when M-3 grew more than 1.5% over an eight week period, for six weeks in a row (meaning the Fed kept pumping money into the system - their infusion was more than a one-shot anomaly, was rather the executed planned sustained market-liquefying strategy). If you consider there were 216 six-week segments over the past 25 years, 16 instances of massive liquidity infusions are not many. Therefore, if we see one such period come our way, as we have in April and May 2004, we should sit up and pay attention, for as you'll see in a moment, these occasion are rare and indicate something is up, some financial-system threat or crisis looms.

1. From April 26th through June 8th 2004, inclusive, we have had seven weeks in a row where a trailing eight week increase in growth of M-3 was 1.5% or greater. Yet the Master Planners have not communicated, nor are we empirically aware of any crisis that threatens the economy. This is the only time we've seen this pattern of M-3 growth where a crisis or perceived threat was widely unknown.

2. From November 2002 through December 2002, M-3 increased 1.5% over a trailing eight week period for 7 weeks in a row. This was done in response to a stock market crash that resulted in Bear Market lows on October 9, 2002 in the DJIA. The Industrials fell 1,767 points, or 19.5 percent, just prior to this Fed liquidity injection. Crisis known.

3. From September 17th through October 29th, 2001, the Fed pumped massive liquidity into the system in response to the 9/11 attacks. Crisis known.

4. From March 26th through May 7th, 2001, M-3 grew massively in response to a stock market crash where the DJIA fell 1,480 points, 13.5%, from 2/5/01to 4/3/01. Crisis known.

5. From December 25th, 2000 through February 26th, 2001 massive M-3 pumping occurred in response to three contemporaneous threats: a) Oil prices rose to $35.14/barrel, a post Gulf War high; b) the NASDAQ crashed 2,595 points, 61.3%, from 9/1/00 to 4/4/01; and c) the nation was dealing with a potential constitutional crisis over the election of the president, the hanging chads business in a brother's state, and a turn to the Judicial Branch of government for resolution. What if Gore hadn't played the Great Statesman and never conceded? Good time to go heavy on liquidity. Crisis known.

6. From August 14th to September 18th, 2000 massive M-3 growth was facilitated in response to a stock market crash where the DJIA fell from 11252 on 8/28/00 to 9975 on 10/18/00. Crisis known.

7. From March 6th to April 24th 2000, the Fed pumped M-3 in response to a stock market crash where the DJIA fell from 11,722 in January to 9,796 in March. Crisis known.

8. From November 1, 1999 through January 2000 the Fed flooded the market with liquidity in preparation for the widespread perceived threat of Y2K. Threat widely known.

9. From August 24th, 1998 through November 30, 1998 the Fed pumped M-3 in response to three crises: Russia defaulted on its domestic debt and the ruble collapsed on August 17th, closely followed by the Fed's bailout of Long-term Capital Management on September 23rd. Both of these events occurred on the heels of a stock market crash where the DJIA fell 1798 points, 19.2%, from 9337 in mid-June to 7539 in August. Crises known.

10. From March 9, 1998 to April 13, 1998 the Fed raised M-3 extraordinary levels in response to collapsing Asian markets and the threat they posed to U.S. markets, in the words of Fed Chairman Greenspan himself. Threat widely known.

11. From July 28, 1997 through September 15, 1997, the Fed mysteriously boosted M-3 by crisis levels, apparently in further response to the financial threat from collapsing Asian markets. Then, as if on cue, the DJIA suffered its largest one-day drop ever in October1997 (before the 684 point drop on 9/17/01), showing the Fed was wise to pre-liquefy markets. Threat somewhat known.

That does it for the Greenspan era. For the thirteen years from 1985 through 1997 the Fed did not increase M-3 even once at crisis proportions (more than 1.5% over an eight week period for 6 consecutive weeks). This included the stock market crash of 1987. Some liquidity was added in response to that event, but nowhere near levels for events chronicled herein.

12. From May 28, 1984 through July 2, 1984 M-3 rose at crisis levels in response to an 8.4 percent drop in the DJIA from 1186 in May to 1086 in June 1984. Crisis known.

13. From March 12, 1984 through April 30, 1984 the Fed raised M-3 at crisis levels in response to a mini stock market crash where the DJIA dropped 11.6 percent from 1286 in January 1984 to 1137 in February 1984. Crisis known.

14. The Fed pumped M-3 into the economy at extraordinary levels from January 1983 through March 1983 in response to an economic recession that included Housing starts falling to 36 year lows and U.S. Auto Production coming in the lowest in 24 years. Threat known.

15. M-3 again flooded the market between August 1981 and January 1982 as the Fed responded to a mini stock market crash where the DJIA fell from 960 in August to 824 in September, a 14.2 percent drop. Crisis known.

16. Again the Fed liquefied markets at crisis levels from March 1981 through May 1981, responding to a recessionary threat. Threat known.

If we look at today, we see M-3 rising at what we have defined here as crisis levels, short-term infusions of money into the system in amounts not seen during benign times. In every case noted, the massive M-3 infusion was either in response to a well-known, publicly communicated crisis, or was in anticipation of a threat to the financial system that the public was aware of such as Y2K - every instance except the current one. So why is M-3 being pumped into the economy at levels previously only seen during crises or threats? You don't suppose it was done simply to ensure that markets held up during the Fed Chairman's reappointment testimony? I can't believe that is the case. Was it to stop the decline in equities, the "normal" correction from March through May? Or is there something else out there that has hit the Fed's radar screen as a threat sufficient to warrant crisis-level market liquidity? The point is, current M-3 infusions are outlier, and beg the question, so what's up? Don't we have a right to know? Americans always knew in the past when a threat warranted massive M-3 infusions. Why can't we know now? If there was a threat, but it is now over, why not tell us?

If it is really nothing, if no imminent threat exists, then what business does the Fed have in pumping M-3 at current levels? Is it to buoy markets in an election year? But then that would be the politicization of the chartered independence of the Federal Reserve. Say it isn't so. What then? We are told the economy is recovering nicely, jobs are plentiful, happy days are here again. Then why all the money being pumped into the system when inflation is rising?

M-1 versus M-3:

The above analysis is based upon seasonally adjusted M-3. The analysis is very similar using non-seasonally adjusted M-3. What about M-1? M-1 is totally irrelevant for any meaningful analysis of money supply because it fails to include the majority of items that are money. M-1 is limited, is essentially just checking accounts (to oversimplify slightly). It fails to consider money sitting in savings accounts, or in time deposits, or in retail money market mutual funds, or in repurchase agreements, or in Eurodollars as money. In other words, M-1 fails to count most of the real, liquid money out there. So it is meaningless to analyze. It's like analyzing the sales of automobiles, but excluding Chryslers, Toyotas, and SUVs. Ridiculous. M-3 includes all of M-1 plus all money substitutes used in lieu of checking accounts. It is the best measure of money.

How does the Fed control M-3?

The Fed controls money supply by buying or selling anything - usually Treasury securities are the item of choice, although during Plunge Protection times, indirectly equities get purchased. When money is sent to the Fed (the Fed sells securities), it is no longer money available for usage in the economy and M-3 shrinks. When the Fed buys securities, it creates money out of thin air and pays for the securities with manufactured money which goes into the economy and is then counted as part of M-3. Money to pay for securities does not have to end up in a checking account. It can end up in a repurchase agreement (part of M-3, not part of M-1), or in any other deposit vehicle. Thus, any transaction between the Fed and a banking firm affects M-3 directly, but not necessarily M-1 directly. M-3 can then grow or multiply as new dollars placed into the economy by the Fed are loaned out to businesses, consumers, or government entities.

Excess dollars placed inside banking institutions do not have to have the necessary affect of reducing the Fed Funds rate, or causing it to plummet. Rather, banks can quickly find uses for the new money injected into the economy that provide greater returns than from federal funds (selling the excess money to another institution overnight). For example, banks can buy securities or make loans to customers who buy assets, perhaps real estate, bonds, or stocks. Loan demand can be created by offering interest rate or term specials, advertising, or forbidden-and-not-to-be-spoken relaxed credit standards - getting money into the hands of people who otherwise wouldn't be approved to borrow it. Eventually the excess money pumped into the economy by the Fed creates more demand for assets and pushes prices of financial, real estate and commodities up - ergo a debt bubble leads to asset bubbles.

The Fed injects M-3 into the system when it believes the economy will need liquidity to meet the growing demands for capital normally associated with a growing economy. If businesses need to expand to meet the growing demand for its products or services, banks better be able to get their hands on money to lend. The Fed makes sure they can. If the economy is in danger of overheating, the Fed can put on the brakes and slow the expansion of M-3 so that bank lending is limited.

But the Fed also injects M-3 into the system at crisis levels, unusually high rates of growth in short periods of time, to alleviate an anticipated contraction in M-3 due to the threat of deflation - the abrupt unwanted decline of near-money assets, financial instruments perceived by consumers, businesses, and local governments as easily convertible into cash. Thus, whenever we've seen a dramatic decline in the Dow Industrials, or seen a financial markets' disrupting-event such as Long Term Capital Management or 9/11, or the threat of disruption such as from Y2K, the Fed prudently floods the economy with liquidity to make up for the anticipated decimation of existing money supplies. So why is the April to June 2004 period's money supply level being grown at historic crisis proportions? I repeat, what's up? Gee, maybe its simply someone new manning the funds desk, an inadvertent screw up. That thought is for the patsy journalists who choose to ignore the facts, and prefer to trash the messenger.

Note: Just for the record, our comment in our May 28th 2004 issue, no. 54, was completely accurate that "in the past 4 weeks (from that point), M-3 is up a whopping $155 billion, a $2.0 trillion, 22.2 percent annualized pace. Since the Dow Industrials topped in February, M-3 is up $280 billion. The entire money supply in the U.S. was $2.0 trillion in 1981. The Fed is now on a pace to grow M- 3 by that amount over the next twelve months." Many have questioned the math. It's not that hard, but I'll roll it out just the same. Right off the Federal Reserve's website, they reported Seasonally Adjusted M-3 on May 17th to be $9222.7 billion (and since revised it a hair to $9222.6 b.). They also reported Seasonally Adjusted M-3 to be only $9068.9 billion four weeks earlier on April 19th, 2004. The difference is $153.7 billion (rounds nicely to $155.0 billion). The annualized pace of that growth is arrived at by taking the four week growth and dividing it by 4, then multiplying the average one week result by 52 weeks in a year. Result: An annualized growth pace in dollars of $1,998.1 billion (rounds nicely to $2.0 trillion), which when divided by the starting measuring point, April 19th's $9068.9 billion M-3, we get an annualized percentage rate of growth of 22 percent. Voila!

Bonds and Interest Rates:

The next chart shows the ten year U.S. Treasury Note. We see a Bearish Head & Shoulders that has confirmed to the downside, with an expected minimum downside target of 98ish.

Backing away from the technical analysis stuff for a second, the consensus is that interest rates must go higher given rising inflation and a recovering economy. The problem with this scenario is the debt bubble. Rising rates will destroy consumer spending. Consumers are up to the armpits in home equity debt, an interest sensitive vehicle. Rising rates mean rising monthly payments on incomechallenged consumers. Rising interest rates also means substantial increases to lease payments offered on new vehicles. To follow would be consumer spending cutbacks as disposable income is shaved. Also to follow would be higher delinquencies and bankruptcies. Loan demand would shrink, especially mortgage lending, affecting home purchases. Then would come a real estate contraction. I don't see how the Fed can raise short-term interest rates when it is increasing M-3 at crisis proportions. I will not be shocked if they pass on June 29th. Deflation is the far greater risk. Hidden, but there.

Bottom Line:

It is clear the Federal Reserve considers the current period a crisis and grave threat to the health of our financial system as they have increased the M-3 spigots to the same degree as they did in 15 other crises or grave threats over the past 25 years. Yes, they have confirmed our Crash concerns. It is apparent to this analyst that the stock market crashes occurring in Russia, China, and India are the crisis - or one arm of a wider crisis - the Fed is liquefying markets against. The price action in these markets can easily spill over into western markets as all economies are now intensely intertwined. I don't know if there is more to this threat than Asian markets crashing. That's the $9.2 trillion dollar question. Defensive strategies are warranted.

"If you do not listen, and if you do not take it to heart
to give honor to My name," says the Lord of hosts,
" then I will send the curse upon you, and I will curse your blessings;
and indeed, I have cursed them already,
because you are not taking it to heart."
Malachi 2:2

Be sure to read Grant Noble's excellent article on The CPI, the Fed, and the Coming Election, available in the Guest Article section at www.technicalindicatorindex.com.

Special Note: Be sure to register under the subscribers' section at www.technicalindicatorindex.com for e-mail notifications of our new mid-week market analysis, usually available on either Tuesdays or Wednesdays. These midweek updates will only be available via e-mail and in the future will not be posted on the web.

Note: VIX, CRB down. Dollar, Gold Oil up.