Monday, June 28, 2010

Once More Up, Then the Big Down

The ingredients for a classic head and shoulders topping pattern in the stock market are all present. That suggests one more rise and then a massive grinding move down to 2009 lows.

Officially, of course, everything's peachy with the economy. Europe is fixed, China is booming, consumer confidence is rising, and we are encouraged to resume our borrow and spend ways as the economy will not "double-dip" into recession. The economy will not slide into another recession, we are reassured constantly, even though roughly 80% of Americans don't think we ever left the recessionary quicksand.

Please see "Two Scoop Special": Double-Dip Recession Guaranteed (May 21, 2010) for more.

Courtesy of Imperial Economics, here is a chart of the growth rate of the Economic Cycle Research Institute's (ECRI) Leading Indicators (WLI). (Please visit Imperial Economics to view a the full version of this chart.)

Needless to say, this chart does not inspire the confidence that the Mainstream Media and Central Governments are so desperately attempting to inflate. The WLI appears to be moments away (figuratively speaking) from slicing into recession territory.

I have made a few notes to indicate the past few bubbles and recessions. The spike down of the Global Financial meltdown was truly significant, as was the stimulus-juiced spike of "recovery." (Recovery if you are a bank, recession if you are a debt-serf.)

The mere whiff of recession cratered the stock market. If we glance at a long-term weekly chart of the S&P 500, we can easily see the euphoric spike of the initial "V-shaped recovery" which was followed by a slower but steady rise to a classic top in April as the SPX kissed the 200-day moving average.

MACD is now threatening to drop below the neutral line for the first time since July 2009, and the stochastic is oversold. The decline in MACD is bearish, and the stochastic could stay oversold for an extended time.

I have a funny feeling the market "should" crash but instead it will do the opposite and rise once more before "The Big Down Move" The Powers That Be fear and loathe kicks in. Here is the moment when the stage falls silent and I ask you to re-read the HUGE GIANT BIG FAT DISCLAIMER below which states that these are the freely-offered (i.e. you get what you pay for) random observations of an amateur and they are not intended as investment advice.

Time and again the real economy has shown unmistakable signs of serious illness, yet the market rallies--often in most peculiar ways such as "ramp and camp Mondays" in which the market shoots up and stays elevated all day with essentially no volatility. Another favorite move is a down day that is erased with a sharply manic rally which begins liftoff at 3:45 pm sharp. Hmm.

So given the tenuous causal connection between the real economy and the market, we should be on the lookout for yet another rally which flies in the face of reality.

Here is a daily chart of the SPX which reflects the dual forces at work. The MACD reflects a major decline in the market, but on a short term basis, it is signalling a Bullish divergence (rising as the market fell). This is setting up a classic head-and-shoulders topping pattern:

There are two key reasons to suspect the market will rise to the 1,150-1,175 range. One is that the right shoulder can be expected to reach the previous line of resistance shown--the left shoulder around 1,150.

The other is the possibility that there will be time-symmetry in the head-and-shoulders pattern. Note that it took about 3 months for the market to top from the right shoulder. Symmetry suggests that the right shoulder will form around 3 months out from the top in late April. That would target early July as the high point of this final rally which will complete the head-and-shoulders topping pattern and set up a long, grinding decline to the 2009 lows around 667.

For those of a fundamenal analysis bent, please read U.S. Profit-Margin Outlook `Extremely Bad' and glance at the accompanying chart, which shows U.S. corporate profits reached an all-time high in Q1 2010, blowing past the highs of the dot-com era and the credit/housing bubble peak in 2006-2007.

Exactly what drivers are there for future gains in corporate profits? I can't think of any, short of Martians landing and going on a shopping spree with gold they manufacture in their spacecraft. On the negative side, we have:

1. The rising dollar is a huge headwind to sales in the Eurozone and elsewhere.

2. The low-hanging fruit of pushing the workforce to produce more output for the same salary/wages have all been picked.

3. The inventory build-out is done for everything but the iPhone 4 and iPad.

4. So-called "fiscal austerity" (when did living within one's means become some sort of brutual "austerity"? Talk abour propaganda!) in the eurozone and U.S. states will remove tens of billions of dollars from corporate sales.

5. Global overcapacity is alive and well. There is overcapacity in everything manufactured except the iPhone 4, and that will be in glut by 2011 as well.

6. Uncle Sam is not distributing trillions of dollars quite as freely. There seems to be some glimmer of awareness that there could be consequences of squandering trillions of borrowed dollars on essentially worthless projects such as occupying Iraq, inflating the housing market by socializing the entire mortgage market, propping up Fannie Mae, Freddie Mac and FHA, etc.

7. Housing is rolling over now that the socialized mortgage market has been tentatively allowed to go off life-support (it is wheezing and turning blue in the face, not signs of vibrant health).

8. There is no pricing power anywhere once stimulus-goosed demand declines to organic demand (flat to down).

For those who want to exit long positions, there may yet be a golden opportunity to do so. It's even possible that the Powers That Be squeeze the market so tightly that we see a double top around 1,200, just to frustrate the Bears one last glorious time.

As they say, keep an eye on the referee as the Bull and Bear duke it out. Here is my long-term look from May 26: Stocks Due for a Bounce, But Long Term...

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