The study below originally appeared at Treasure Chests for the benefit of subscribers on Monday April 25th, 2005.
While we are seen by many to do the opposite, in the end, and in spite of what may appear to be complex methodologies, our goal in market forecasting is to reduce the amount of effort expended in reaching a high probability conclusion whenever possible. One of the more obvious opportunities that arise in this regard is when a market is testing the all important 200-day moving average (DMA), which is exactly what is happening in the broad measures of US stocks at the moment. As you will see below, and depending on how they are measured, some of the indexes have already broken down, and appear to be simply testing those breaks as we speak. But, when you dig a little further beneath the surface, and even though a study of trend changes as it pertains to penetrations of the 200 DMA is within the bounds of 'keeping it simple', in order to be thorough, we are going to turn a few extra pages for you right now, just to make sure our views are still in good shape.
To begin this exercise, we would first like to review the primary reason(s) we think stock markets in the US (and around the world) could be in big trouble this year, where if not sooner, later they will likely fall dramatically due to a cornucopia of imbalances associated with endeavoring to maintain what Central monetary authorities define as 'price stability'. Therein, and as alluded to above, as we see it, the primary reason stocks may suffer a significant correction beginning this year, a correction of 'Grand' scale, is primarily due to authorities having no other alternative than to allow such an outcome unfold, or simply due to miscalculation, with the main point being their tinkering has run amuck. Central monetary authorities have taken it upon themselves to attempt managing the prices of everything from the cost of money, which is to be expected, but would have been better left completely to market forces, to the currency, and to the stock markets as part of the Plunge Protection Team, more commonly referred to today as the Working Group On Financial Markets.
Right now, authorities are faced with some fairly unpalatable alternatives in terms of juggling all these markets at the same time. It appears that because of the degree of internal imbalances in the US, primarily surrounding debt related issues on both official and consumer levels, foreigners have decided to slow the accelerated subsidization necessary to maintain price stability in domestic debt markets such that if money supply growth rates are not seen slowing, the US Dollar (USD) will collapse prematurely because of possible net withdrawals. We say 'prematurely' to ensure you understand that based on the current global economy, which is in fact a US banking interest construct, the USD must eventually fall in offset of increasing deflationary pressures as economic conditions continue to erode. What price managers do not want to happen to the USD, but what they might get with the stock market however, as they may have managed themselves into a corner now with all the bubbles floating around, is a crash, where if the Fed tightens too much, this miscalculated tinkering could prove very costly to investors. (See Figure 1)
Furthermore, in today's case, blowing bubbles would not be isolated to the stock market, as not only would stocks be under pressure in such circumstances, but also all equity groups, including real estate and commodities, would be hit given the deflationary implications associated with plunging paper markets. Indeed, we could finally be witnessing the "Catch - 22" scenario at work regarding money supply and keeping all the balloons pumped up, where a mistake will be made by authorities at some point soon (perhaps it has already occurred signaled by the meaningful breaks in stocks that have transpired), as they slow growth rates in monetary largesse sufficiently to prevent the USD from crashing. Again however, caught by the Catch - 22 ironic outcome, in attempting to prevent the USD from crashing through a slowing of money supply growth, which causes all of the interrelated equity bubbles to burst, debt markets in the States will undoubtedly not escape the fate that always accompanies over-leveraged circumstances in the end, and crashes will occur in elements of these markets in all likelihood as well. Thus, it is the magnitude(s)s of all these factors (bubbles), created by an overbearing Central authority, that has set the stage for 'Grand Cycle' price tops in everything from corporate paper issues to your humble abode at this time, and of course the stock markets which is the focus of this study. (See Figure 2)
In an effort to be completely clear about our opinion on the degree of a top in stocks we are witnessing at present, and unlike those who are bearish and of the opinion year 2000 highs were definitional tops in stocks, we are of the opinion true highs (Grand Super Cycle Degree) in the broadest sense of the word were not put in until last month, as presented above in the S&P 500 Equal Weighted Index. The significant understanding here is that stocks are not given a higher weighting in the index if their market capitalization is growing faster than the others (i.e. based on relative size), which as you can see has a dramatic effect on overall index levels of the same stocks. Furthermore, peaks and troughs are seen at different times when compared to the 'market weighted index' because price patterns of all stocks within the measure have an equal influence on overall values, which allows for growth of smaller issues to play against the larger at various times. When we take this knowledge into consideration, one realizes the mania in stocks never left the market in 2000; it just shifted to smaller issues. Therein, retail market players shrunk not in desire, but in numbers and funds available for investment. So, while institutions continued to pound away at the large caps, the small retail money (speculators) adapted to this environment by systematically moving through smaller scale manias within smaller issues. This trend is best evidenced in a plot of the Market Weighted S&P 600 SmallCap Index, which also peaked last month, and is now bullishly testing its 200 DMA from above, not below, which is the case in all market weighted measures so far. (See Figure 3)
One should note as it pertains to not only equal weighted indexes reaching all time new highs, but also market-weighted indexes, whether hitting their highs or not, all of these plots counted in fives off of 2002 low values, which strengthens the hypothesis we witnessed 'Grand' scale events in proper measure during March of this year. For the benefit of those tuned into Elliott Wave Theory (EWT), the fact widely followed market weighted indexes counted off the bottom in fives rather than threes, but failed to reach previous highs (due to well-funded manic moves in the previous leaders never to be seen again), is concrete proof stocks were moving impulsively over the past few years, and meaning the impulses were terminal. Technically, the Market Weighted S&P 500 Index suffered what is termed a 'fifth wave failure' in March, where a high confidence confirmation of this would be witnessed with a move through the 'golden ratio' retracement of the 2002 to 2005 impulse. (See Figure 4)
The only hope bulls have at this point is enough energy remains in the market to carve out two more impulsive waves higher in years ahead, as measured by the Market Weighted S&P 500 Index. But this does not appear likely considering we still reside within what is considered the upper reaches of peak earnings from a historical perspective. Of course this may not prevent interested parties (price managers) from attempting to squeeze the S&P 500 back above its 200 DMA, not that this is a problem for the Equal Weighted Index as of yet. Unfortunately however, this condition is somewhat more of a problem for the market weighted Dow, the index the world watches, where it is still trading some 200 points away from the 200 DMA, which is now turning bearishly lower. (See Figure 5)
Furthering our hypothesis the mania never left the market can be derived via a look at the Dow Transports off of the 2003 lows, which certainly gave bears a difficult time over the past two years with the parabolic gains into a dramatic top last month. The election was coming and GW's War On Terrorism wasn't enough to guarantee a round trip ticket in the White House, so the propaganda machine was put to work, which sent this heavily China trade geared index soaring. (See Figure 6)
As an exemplar of what happens to markets post mania, where without exception new sheep must be grown before the herders will have another opportunity for a mass sheering, the 200 DMA for the NASDAQ is turning lower now as well. This is especially bearish considering market weighted absolute prices are still some 60 percent off all time highs. (See Figure 7)
Of course, we do not want to appear fixated on the bearish side of the equation, which has been an expensive viewpoint over the past few years. But, as you may know, since the 2002 lows, we did not become bearish on stocks until the first quarter of this year, where we have been mapping out a strategy for our subscribers to take part in what may be looked back on as one of the greatest shorting opportunities in history. And although we must continue to use guarded language in the short-term, as stocks are now oversold in various measures, it is our considered opinion the ultimate outcome in 2005 will be negative for stocks, with the pattern being very similar to that found in 2000, and as highlighted above in black. Further to this, we are fully cognizant various bullish interpretations can be applied to the markets at present, although more and more of them are falling to wayside as time passes, but where a scant few vestiges of bullish posturing remain. An excellent example of this is found in the plot of the S&P 400 MidCap Index, where the bulls are seeing the price action as an omen more is to come; but where bears are seeing the 'Three Peaks And A Domed House' formation that is normally a precursor to substantially lower values in the offing. (See Figure 8)
Moving back to the Market Weighted S&P 500 Index to wrap things up today, and providing further concrete technical evidentiary that the bulls have to put up or shut up in the very near future, is the fact from a symmetrical perspective in what appears to be an 'inverse head and shoulders pattern', the time allotment for a bullish pullback has already lapsed, marked by the thickened orange interval marked '1' (on the right) found in the plot below. (See Figure 9)
In observing technical conditions in the above figure, one should be aware of the integral importance symmetry plays in establishing the validity of a formation. Thus, if prices do not get back above the 200 DMA of the Market Weighted S&P 500 Index in short order, yet another nail will be put into the coffin of the bulls, and where market observers will then be compelled to rely on increasingly fewer technical indications, like Fibonacci retracements, in order to measure if the impulse from 2002 lows has marked the 'beginning of the end' with respect to the 200-plus-year Grand Super Cycle rally in stocks; or, whether the bulls still have some further steam they need to vent. We find it very telling, and not a coincidence, that the 200-plus-year-old New York Stock Exchange [NYSE] is going public here at the top. The players are leaving the game because they see the writing on the wall undoubtedly.
Good investing is harder to do these days, so be careful out there.
Special Acknowledgement: The above was prepared in cooperation with Ron Griess of the Chart Store, where all of the base charts were sourced.