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Are We There Yet?

Dear Speculators,

Before we begin our work in earnest this week, a couple of notes on the Dynamic Trading System (DTS).

First, we have heard reports that there is someone running around loose claiming to be trading his own version of the DTS. If so, please be assured any such claims are misleading at best and mendacious at worst. The Dynamic Trading System, which is proprietary, which was rigorously tested before it was launched in real time, and which our subscribers have come to trust and embrace as both an analytic tool and a trading model, is alive and well, but is offered exclusively through The Agile Trader. "Another version" of the DTS should not be confused with the DTS. "Other versions" bear no analytic or practical relationship to the DTS and have no results, either real-time or back-tested to support them.

In the Options Service the DTS has garnered +1255% in position gains with +175% in gross total return since inception in April 2005. If you would like to read more about The Agile Trader Index Options Service CLICK HERE.

In the E-Mini Index Futures markets the DTS has netted position gains of +383% with +95% in net total return since inception of our model portfolio in July 2005. If you would like to read more about The Dynamic Trading System in the Index Futures markets or subscribe to The Agile Trader Index Futures Service, please click HERE.

(Note: All trades were executed in customer accounts in real time on the Dynamic Trading System's signals. However, because these results are representative of a compilation of accounts (and not one single account) and trades were executed by the Futures Commission Merchants and/or Securities Brokers who held limited power of attorney for the customer accounts, and not directly by The Agile Trader or by Dog Dreams Unlimited Inc., results are, for all regulatory and compliance purposes, hypothetical, with all disclosures and caveats applicable as disclosed below. Please see the Important Disclosures below my signature. -AO)


We've chosen the title of today's note as an homage to the end of the Summer Driving Season. And while we mean it as a tribute to our (occasionally obnoxious) children's incessant questions, we're more seriously applying the query to whether the stock market has reached the final destination of its 4-Yr Cycle, which is to say the final low from which a new cyclical bull market can begin to establish itself.

And our answer today is that we do not think that it has.

This chart tracks all the SPX's 4-Yr Cycles since 1962, scaled as percentage gains off the cycle lows. Each cycle begins with the low formed between Sep. 30 and Nov. 19 of Year One of the cycle (1962, 1966, 1970,…1998, 2002, 2006). The current cycle (red) is moving toward its terminus, having completed trading-day #983, with roughly 25 trading-days (5 weeks, give or take a few weeks) to go.

We're clearly getting very close to the end of what is, more often than not, the most bearish part of this cycle. But in light of the market's recent strength I had to ask myself whether the cycle might not terminate early and allow the SPX to start climbing during the month of September. And, while anything is possible in the markets, there is only one precedent in Year 4 of the cycle for the SPX making a new 2-yr high during the month of September. That one precedent was September 1986 (brown line on the chart). And, as you can see, that very brief high was followed by a sharp retrenchment.

September is notoriously the worst month of the year for the SPX. Since 1962 the monthly close of the SPX has been down in September 57% of the time, with only the month of July joining September with its head below sea level. Moreover, during Year 4 of the 4-Yr Cycle (that's where we are now) the SPX has closed down in September 70% of the time, with an average monthly change of -3%.

The average gain of the "up" Septembers in Year 4 of the cycle is +3.5%. The average loss of the "down" Septembers is -5.8%. So, both in terms of frequency and average magnitude of W's vs. L's, we have entered into a period that is extremely dangerous for the bulls.

Zooming in more closely on the 4-Yr Cycle and eliminating the both the very strong and very weak ones to focus more closely on those that resemble the current cycle, we see that the SPX is closely tracing out the benign pattern that we have been forecasting since last December.

Since the summer lows we have been discussing the high probability of a weak-ish rally to re-test the spring high (near +65%). That test is currently underway. But, "weak" you say? Yes, weak. Why? Because the volume commitment has been no better than puny.

This next chart is what I call the VolVol chart. It tracks the SPX against its Volatility and Volume.

The top pane shows the SPX. Below that we see Volume bars (note the recent declining trend). The 3rd pane (red line) shows the SPX's 10-day volatility (on the same scale as the VIX, now quite low, below 5%). And the bottom pane shows the 10-dma of volume, which has hit its lowest point since the light holiday trading of late December '03.

The yellow highlights appear where 10-day volatility drops below the very low 5% level. And as you can see, those highlights are associated with near-term pullbacks on the SPX

So, what are we looking at? A rally up to test the SPX May high on extremely contracted volume and volatility, both of which conditions leave the index extremely vulnerable to a near-term retrenchment. And we're seeing this as we head into the teeth of the weakest month of the year during the worst year of the 4-Yr Cycle.

Could the market go up? Sure it could. There are very few if any certainties in the stock market (except that it will go up and that it will go down). But trading profitably over the long term is mainly about stacking the odds in one's favor. And, as stacked odds go, they are not currently in favor of the near-term bullish case beyond Wednesday when a (very slight) seasonally bullish "zephyr" expires.


So, what are the factors working against our September Bear Case?

First and foremost, Oil.

With both horizontal support and Crude's line of rising lows broken to the downside, there is now a significant swath of resistance in the $70-$74 band. If that area keeps a lid on Price, then we could very well see a drop to the $62 area.

With Crude Oil dropping, the Fed's recently-more-dovish inflation stance would appear to be warranted.

But let's keep an eye on Gold as well.

This chart has been consolidating since mid July and in which direction it breaks out of its triangle could be key in understanding the market's inflation expectations. A breakout above the triangle (upper limit now near $640/oz) could be "talking to us" again about higher inflation while a breakdown below $600-$610 might raise discussions about tightening monetary conditions and diminishing inflation expectations.

The price of Gold may ultimately be tied to Japanese interest rate policies, as are the prices and yields of US Treasuries. If the markets perceive that Japanese growth will remain moribund and that their interest rates will remain very close to zero, then the global carry trade will live on, with marketeers of all persuasions borrowing Japanese Yen at virtually no cost (save for Currency Risk) and investing those very cheap Yen in all manner of instruments from Gold and Oil to stocks and bonds, as well as US Housing.

And the footprints of this kind of action would be seen in continued asset and commodity inflation as well as, ultimately, in rising goods and services inflation.

On the other hand, if Japanese growth is perceived to be healthy, and the likelihood of rising Japanese rates is seen to be higher, then the global carry trade would likely start unwinding again, with liquidity again being drained out of the global financial system.


We would also continue to watch the Y/Y change in Average Hourly Earnings (AHE) as a key correlate of inflation.

These 2 series have a +0.79 correlation coefficient. So, despite the broad sigh of relief breathed by the markets last week when the M/M AHE came in at a tame +0.1%, the trend in AHE is sharply higher at present (red line, +3.9% Y/Y), and has been since early 2004.

If the 4% level holds as resistance for the red line on this chart then the inflation picture may turn out to be as benign as the Fed's recent dovish rhetoric suggests. However, if we see much of a rise above +4%, then the odds will be very strong that the Fed will be tightening further, and that would be rough on the stock market.

Best regards and good trading!

 

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