The following is an excerpt from a commentary posted at Treasure Chests on Friday, October 14th, 2005.
The Working Group On Financial Markets was in the market yesterday propping the NASDAQ because it's falling apart when measured by breadth. We know they were intervening because anybody who works for his / her money does not buy into a market showing a 2 to 1 negative breadth profile while prices are mysteriously levitated. Crashes occur under such circumstances, when the manipulators are forced to 'give up the ghost'. But in this case, we are talking about unlimited manmade power (printed fiat digits) coupled with no sense of good measure. Thus, it should be of no surprise to anyone stocks moved higher Friday.
Does this mean price managers will be successful in supporting the markets this time around however, where we are having a hard time getting past the fact both stocks and bonds are now falling together, just like in 1987 prior to the stock market crash? Further to this, and although we have triggered a confirmed 'buy signal' on the monthly CBOE Volatility Index (VIX) plot, which is significant, it's also true prices turned lower right on queue yesterday, repelled by the 155-weekly exponential moving average (EMA). (See Figure 1)
Figure 1
So, the question then arises, 'Is this time different, where we can expect meaningful follow-through in stocks to the downside?' While we will not review all of the fundamental reasons espoused in recent weeks that constitutes the backdrop for a meaningful correction in stocks (you can do this yourself), here are a few more technical ones that point to this possibility.
Firstly, we would like to point out, and as alluded to above, that both stocks and bonds are falling together at present, which is a reflection of what is termed 'stagflation'. In this regard, and further to what we have been discussing in recent weeks, price managers are caught between a 'rock and a hard place' right now, because if the Fed increases money supply growth rates, gold will explode over $500, a definite risk as defined by the Dow / Gold Ratio, where here too a confirmed 'sell signal' was triggered this week. In the balance then, where investors are literally fleeing those things that will suffer from runaway inflation, 10-Year Treasury Yields (TNX) are poised to surprise many here and break meaningfully higher, evidenced by a 'diamond' breakout in the Relative Strength Index (RSI) on the attached plot. One should note the probability of this being a false move is low due to the fact RSI broke out prior to price. (See Figure 2)
Figure 2
Whether it's the inflation or stagnation component of the stagflation equation that is making investors flee US assets right now is of little import to us, because quite frankly, the global economy is so flimsy, either could end up being the 'real reason' in the end. That is to say, if imbalanced / speculative markets decide to snap, there won't be too many commentators on television talking about inflation anymore. In this regard, and in answering the big question of whether the secular downtrend in stocks has resumed on a confirmed basis or not, because we want to be sure, the S&P 500 (SPX) / VIX Ratio is signaling we are definitely on the right track, because this time around, it's actually broken significant channel support. (See Figure 3)
Figure 3
As you can see above however, closing values did manage to hold minor degree sinusoidal support yesterday, but this should only sponsor a test of the channel break in our opinion as indicators are suggesting downside risk is still very apparent. This means that unlike 1987, stocks will probably not gap down next week, but rather rally slightly early in the week, followed by a resumption of a more deliberate downtrend later on. If such a sequence were to unfold, the majority of any losses would not be experienced until the following week, as with the pattern seen in October of 1929. Such an outcome would make a great deal of sense in that the 1929 crash in US stocks was a 'Supercycle' event, where in fact it could be argued we are in the midst of topping a 'Millennium Cycle' at present.
This of course does not mean percentage losses to be expected will not be the same no matter what pattern the decline takes, where on a ratio related basis compared to the '87 sequence (~ 1/3), and working off Fibonacci resonance signatured support at 1164 on the SPX, and then 1078 (the initial target), we would expect to see prices approximately 8 percent lower at some point over the two weeks or so if a route were to unfold. One should note this support is also long-term trend-line channel support, where a breach could trigger a move to as low as 500, the counter-bubble target. (See Figure 4)
Figure 4
Easily discernable in the indicators above is the fact significant diamond breaks have now occurred across the board, with RSI the last to go just this week. Again, from here it's common to see a rally in testing such a break, but this could also happen from lower trajectories, or not at all, as the stock market is still very overbought long-term. For this reason, trying to trade a counter-trend rally at this point should be considered an exceptionally risky proposition.
Moving into a look at the oil complex now, where we think the plight of oil stocks over the next little while will do much to signal what we should expect out of the economy, as well as stocks in general (think the inflation case), we are of the opinion many investors / institutions / hedge funds must be heavily over-weighted in this sector at present based on recent price action. In fact, some would compare current conditions to bubble proportions in other sectors (like the go-go stocks of the 60's), but then, what isn't in this state these days.
Anyway, and to cut to the chase, one may wish to cover some of their put positions on the group, where I don't mind telling you we covered some of our profitable positions yesterday, but this should in no way be considered advice for you to do the same. Therein, we would definitely cover all positions if the 'head and shoulders pattern' (H&S's) in the Amex Oil Index (XOI) shown below traces out in coming weeks, as this would likely constitute a bottom of sorts, but even if this particular pattern does not materialize, we should see significant weakness in the group heading into next year, so patience will likely prove a virtue in the end. (See Figure 5)
Figure 5
As you can see above, many outcomes are possible in coming days, including a rally most probable from a technical perspective at the moment. After that however, oil stocks are due for a second leg down in their corrective process at a minimum, where we definitely would not want to see both the oils and gold stocks falling at the same time. (See Figure 6)
Figure 6
Without a doubt, if unleaded were to break support here, this would send oil stocks lower, as not only would crude crack $60, natural gas would probably head somewhat lower as well. Here they are in the order ascribed above. Unleaded first. (See Figure 7)
Figure 7
Then Crude. (See Figure 8)
Figure 8
And last but not least, natural gas, which could be an economy killer this winter. (See Figure 9)
Figure 9
There you have it for today, where although it does not look likely stocks will gap down Monday now, later next week, and the following week, could prove to be interesting nonetheless. Maybe Refco was the pin that pops our asset bubbles, who knows? As always, to be forewarned is to be prepared for the sound minded.
Good investing all.
