Saturday, October 25, 2008

A Contrarian's Call for a Major Rally

Now that virtually the entire world is panicky and many are expecting a real crash in the stock market, I am forced to predict a major rally is about to start.

First, please read (or re-read) the HUGE GIANT BIG FAT DISCLAIMER below; this is not investment advice, it is simply the ramblings of one amateur observer.

Why forced? By many things, starting with the charts. Chart reading 101 teaches us that the charts are about the only objective source of information we have, and also to look for divergences between price and various indicators, as divergences tend to hint at future price movements.

Other tools are Elliott Wave Theory and fibonacci projections. Mish provided an excellent snapshot of Elliott Wave analysis, which calls for a (weaker than Wave 3) up Wave 4: S&P 500 Crash Count, eventually followed by a much larger Wave 5 down.

That makes sense to me, and I am not disputing the extreme likelihood of further declines in the stock market. I am simply predicting a huge rally is about to begin which will blow away the Bears for two months--very likely through the last week of the year.

As for fibonacci projections, respected observers such as Enrico Orlandini have spotted key levels at 10,725, 9.913, 9,063, 8,146, 7,470 and 5,890 while the astute technical analyst Rick Ackerman recently set a downside target of 6,195. I have posted charts courtesy of frequent contributor Harun I. which identified approximately 10,700, 9,880, 9,100, 7,200 and 6,000 as key levels.

Interestingly, the DJIA dipped down to 8,187 on Friday, a mere 41 points from a key level of support at 8,146. I would say that's close enough to count as a test of support.
Let's look at the multiple divergences in this chart of the Dow Jones Industrial Average:

Please go to for the charts.

1. Despite a near-collapse in Asian markets--Japan's Nikkei was down almost 10%-- the DJIA didn't even hit its previous low, nor did volume get close to recent highs. It sure looks like sellers are exhausted, as the index notches a higher low and couldn't even punch below the lower Bollinger band.

2. ADX is well below the extremes reached in July, meaning the trend is less extreme than it was then.

3. DMI- is declining, and DMI+ is rising, suggesting the selling trend is lessening and the buying trend is rising, albeit marginally.

4. MACD is at an extreme, yet divergence has risen to neutral.

5. The natural target is the old support at 10,700, which happens to converge with the 50-day moving average.

There are a number of other forces at work which act as feedback loops for a rally.

1. If the Plunge Protection Team and the Powers That Be want McCain to have any chance at all of winning the Presidency, they have one week left to launch a rally.

2. This New York Times graphic How This Bear Market Compares (thank you, Dr. R. Kent for the link) reveals that this decline has dropped further and faster than virtually all other Bear markets in the past 100 years. That alone speaks to the notion that "nothing goes up or down in a straight line" and hence no matter how horrible the global economy might be, the market is due for a sharp rally.

3. The market has discounted virtually all government actions and bailouts as useless or ineffective. Yet the wheels of these feedback loops are still grinding, and to dismiss them because they didn't magically "fix" the markets so far does not mean they will have zero positive effect. Were they wise, and will they have long-term positive effects? I would say no, but nonetheless to dismiss them all as having no potential positive short-term effects seems rather myopic.

4. There is $6 trillion sitting on the sidelines in the U.S. alone, and trillions more in non-U.S. accounts ready to jump in once a "bottom" has been "officially" recognized. Not everyone has been wiped out in the past 6-week decline.

5. The U.S. is widely perceived as having led the rest of the world in the meltdown of its financial and housing sectors. This perception might well lead potential investors to look for the "recovery" to start first in the U.S. The rising U.S. dollar is another reason for non-U.S. investors to buy U.S. shares, as this is a "double bet" on both the dollar and the U.S. economy's relative strengths.

6. Fund managers are looking at zero bonuses and plentiful pink slips unless they can close out 2008 with some sort of recovery/rally which cuts their current losses. That gives those who actually control much of the liquid wealth of the nation an extreme incentive to launch a momentum rally, regardless of fundamental economic issues.

7. As I have repeatedly stated, the market is not in the habit of giving gifts; any Bull rally will take along the fewest possible participants. Many potential Bulls are looking for a "capitulation" such as a one-day 1,000-point decline in the DJIA.

That would be nice, because then we could all jump in at a clearly marked "bottom." But because everyone is looking for such a neatly-lit (in neon) bottom, I doubt it will happen. That would make catching the bottom far too easy, and the market is not going to take 90% of investors along for the rally. It will rally against all reason and against all odds, leaving skeptics and fundamental-analysis types watching from the sidelines for the "capitulation" which is too widely anticipated to ever happen.

If it was so easy to catch the bottom, we'd all be millionaires.

What will happen instead is the market will begin rallying as skeptics and pundits are still asking, "Where is the bottom?" By the time the market has risen 20%, then it will be clear the bottom of this leg is already in.

8. Seasonally, November and December are typically rally-mode months.

9. Mutual funds close their fiscal-year books in October, so redemptions and portfolio rebalancing has required massive selling in October. Once October is history, the rally can begin in earnest.

10. The market hates uncertainty, and once the U.S. presidential election has been decided one way or the other, the market will have yet another reason to rally.

11. Large traders are net long, and commercial traders are basically neutral. Betting against "the house" is occasionally successful but I wouldn't make a habit of it.

12. The put-call ratio (the number of bets that the markets and stocks will decline versus bets that they will rise) are astoundingly bearish; for instance, based on the put-call ratio, perhaps 10% of traders expect oil to rise and about 90% are expecting it to fall further.

The market never rewards 90% of the players, period. Sorry. Been there and been burned. I'll take the 10% bet, thank you very much, and thank you for the cheap calls. But be my guest and bet on future declines; you have nearly the entire world alongside you. I'll take the contrarian bet against the consensus for the simple reason the market never rewards 90% of the punters, and there is almost universal fear and loathing and panic right now--in other words, for those going long via calls and futures, it doesn't get any better than this.

I have recently made the case here that oil and oil stocks are due for a bounce. Based on the punditry and the put-call ratio, most observers are looking for oil to drop to $50/barrel or even $10/brl. Maybe it will eventually, but right now I am seeing evidence that a near-term bottom is in and a rally in petroleum and natural gas is about to begin.

Note the double bottom and plentiful divergences in this chart of Anadarko Petroleum. Maybe oil is heading for $50/barrel, but again, if "nothing moves in a straight line" then these divergences suggest a strong counter-rally is poised to begin.

At least that's my amateur read. I may have missed something huge and vital and thus I could be horribly, catastrophically wrong. It wouldn't be the first or last time.

Essayist Zeus Y. has graciously answered reader's followup questions regarding his series of essays on credit default swaps, and provided yet more answers to "to whose benefit?"
Toxic Liabilities Are Not Assets:
Sooner or later we have to recognize a massive fraud has been perpetrated. It needs to be revealed that major companies have trillions of dollars of junk on their books and are likely not solvent according to traditional notions of solvency. So we have a Catch-22, but not one that will be solved by hiding: expose the fraud and risk likely short-term collapse and re-scaling of economic confidence and systems, or cover the symptoms, hide the toxins, and allow them to fester and rot out the economy in a prolonged sickness that may spread and gain momentum beyond attempts to assuage the problems."

I highly recommend reading the entire essay, as Zeus lists seven excellent propositions for fixing the fundamental issues.

And for your listening pleasure/amusement: Patriot Express (in disguise) sings Sarah Palin, Queen of the Red party. The lyrics helpfully pop up for your reading pleasure.

Thank you, Derek S. ($20), for your much-appreciated donation to this site. I am greatly honored by your support and readership.

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