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Stocks and Bonds May Head Down Together This Week

Stock Outlook:

Stocks have defied our expectations for even the slightest correction. But the longer this euphoric mood carries on the more vulnerable the market becomes. Small caps appear to have completed a "five wave" advance from the October 25 lows and a break below the second trendline support in the S&P 500 (shown below) now crossing at 1180 would likely lead to a healthy correction back to 1160. This means stocks must rally immediately at the open or fall below this support. So Monday morning will likely set the tone for the week. However, our forecast is for only a shallow correction that will then lead to the next and final leg higher targeting 1250 by January.

Meanwhile, recall that we first highlighted the S&P500 to Vix ratio in September when we pointed out it was heading up to test its all time high from August 2000. This month the ratio reached new all time highs above 90.

So, four years later the S&P is 50% off its highs while the Vix has been cut in half. There is little difference in the euphoria seen today in the market and that in 2000. On the one hand a lack of fear is bullish for the market as it is animal spirits that drive prices higher. And certainly, earnings did improve. But the Dow/Gold ratio has actually declined. This environment reminds us of the late 1960s when inflationary pressures were brewing but the public only saw a continuation of the bull market. At that time interest rates were dramatically higher unlike today where 30-year yields are below 5%.

Measured by the relative Vix, investors are twice as bullish today than they were through the late 1990s. The chart above shows a five-month cycle top window in the SPX/VIX ratio. We feel this may lead to a short-term correction before the final highs are recorded later this year, or early next year. Our interpretation of this market since October 26, 2004 is that we are in the final wave up in the advance from the October 2002 lows. Final waves are built on euphoria and hype and are often fully retraced.

Bond Outlook:

Last week we posted a research piece showing bonds were nearing a significant turn date between December and February. Specifically, we said bond prices should head down hard during this time.

The chart below shows a nine-month cycle top window (blue) and the crash low cycle turns (orange) that also are spaced nine months apart. The next turn is scheduled for November 25. If this holds then we expect to see a major move higher in bond yields on Monday or Tuesday at the latest.

Since the longer maturity bond (represented here by TLT, the Lehman bond ETF) is more susceptible to a sudden rise in rates we remain short TLT and look to add to this position.

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