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Imminent Decline Dead Ahead

by Michael Nystrom
Sunday September 17, 2006
Cambridge, MA

Part II
Part III

In my last Commodities Outlook , I promised to take a technical look at the stock market. Three weeks ago, there wasn't much going on and I didn't have much to say about it, but I knew we were approaching a point of clarity. That point is now here: A number of factors are converging this week that I think will lead to a substantial reversal. While I normally don't like to go out on such a limb, there are enough factors lined up this time that I think it is warranted, and if I am wrong, it should be immediately obvious. This week is do or die time for the market.

Ford's Example Let's start off by looking at the chart of the Ford Motor Company. Last Friday, Ford announced big news and the stock got killed - down almost 12% in one day! The price action in Ford, I think, is a preview of what we're going to see going forward in the general stock market.



Since mid July, Ford's stock rallied over 50%. It was an impressive gain, but the price action was purely technical: It was a standard short-covering rally with prices advancing steeply over a short period of time on very little volatility. There was a jittery drop in mid-August but a quick recovery and resumption of the steady upward progress, culminating in a two-day price explosion just before Friday's big bomb.

Why did Ford rally? For the past several years, and certainly through the entire recent rally, the situation at Ford was grim and getting worse: The company was/is/has been losing market share, losing money, has high costs, the wrong products, etc, and everyone knew it and had known it for years. There had been no change in Ford's fundamentals. The fuel for the brief, sharp rally was therefore provided by bears who were short and got caught in a typical short squeeze. In this case, the squeeze culminated in a mini buying panic that sent the stock up nearly 9% in just two days before the big drop on Friday.

The funny thing in this case is that Friday's sharp drop was precipitated by news that Wall Street usually likes: Ford is laying people off, slashing jobs, slashing salaries, cutting costs and closing plants. Under Wall Street's standard logic, what is bad a company's employees is usually good for its stock price. (In this instance, however, Ford is also suspending its dividend, which is very bad for shareholders and a sign that things are very grim indeed.)

Parallels to the General Market

Now I'd like to look at the lessons that Ford holds for the overall market, represented by the S&P 500 cash index. Like Ford, the SPX has had a decent rally from mid July to present - close to 8% - while the news for the real economy has been getting progressively worse. The housing market is really slowing down, the trade deficit just hit a record high, and corporate layoffs are surging. We've had no fundamental change in this story, and in fact things appear to be getting worse.

But while the real US economy - the economy that is involved in making things - seems to be on the ropes, the financial economy - the one that is involved in using money to make more money - seems to be doing just fine, as measured by a single indicator: Interest rates. They're coming down. And the most recent data indicates that the Fed is done raising them. This single factor is the primary impetus behind the current rally. It is what has gotten the ball rolling, and short covering is taking care of the rest. But to see how this one is going to end, just refer back to the Ford chart above.



Look at the shape of the most recent rally, from the July lows. From a classical technical analysis perspective, this is called a rising wedge. From p. 189 of Edwards & Magee's technical analysis classic, we learn that:
Once prices break out of the Wedge downside, they usually waste little time before declining in earnest. The ensuing drop ordinarily retraces all of the ground gained within the Wedge itself, and sometimes more (p.189)
From an Elliott Wave perspective, this is called a rising diagonal or an ending diagonal:
An ending diagonal is a special type of wave that occurs primarily in the fifth wave position at times when the preceding move has gone "too far too fast," as Elliott put it…In all cases, they are found at the termination points of larger patterns, indicating exhaustion of the larger movement." (EWP , page 36) Furthermore, "A rising diagonal is bearish and is usually followed by a sharp decline retracing at least back to the level where it began." (EWP, p.39)
To make matters even worse for the bullish case, the index is right at resistance provided by both the upper end of the diagonal, but also by the recent May highs. Sustaining an advance beyond this resistance will not be easy. And Friday's price action was weak: The market hit its high in the first hour of trading, then spent the rest of the day giving back its gains. Based on the indicators I look at, this market is overbought at multiple levels of trend: monthly, weekly, and daily. Like with Ford, all it needs now is a trigger to set it off.

Fed Meeting Wednesday

That trigger will most likely be provided by the Fed Meeting on Wednesday. The consensus is that the Fed is done raising rates, and when it comes to Fedwatchers, the consensus is usually right. I don't expect any surprises from the Fed on Wednesday. However Fed Meeting days are always among the most volatile and exciting trading days, producing huge intraday moves - usually in both directions - as the market digests the pseudo news of the Fed's decision. Since the consensus opinion has already been factored into prices, the market should sell off after the announcement. And if by some fluke the Fed decides to raise rates, the market is really going to tank. It is a lose-lose situation. Whatever happens in between, the market should end the day lower than it starts on Wednesday, and lower on Friday than it starts the week on Monday. (And if other market players have already come to this same conclusion, the sell off might start bright and early Monday morning.) Based on both the Elliott Wave interpretation and the classical technical analysis view, the swift decline should take the SPX back down to the 1230 area. Since there is a similar pattern developing on the Dow, the decline should bring the index down to the 10,750 area, with further bearish potential ahead on both indices.

But what about the price of oil, you ask? Since it's falling, isn't that fundamentally bullish for the market? And since interest rates are falling, won't the housing bubble be able to reflate? The short answer is, no. Falling oil prices reflect falling demand, which signals a recession. And yes, the housing market may see a second wind due to falling interest rates, but it is likely to be no more than a dead-cat bounce. The top is already in.

Caveat and How you'll know if I'm wrong

At this point, I'd like to issue a very clear warning. I am not an investment advisor, I don't have a crystal ball, and the only account I manage is my own. I don't write a newsletter - the periodic articles I write are a way for me to focus my thoughts and help me figure out just what is going on in the market, and I enjoy the feedback I receive from readers.

Nothing about the forecast I've laid out above should come as much of a surprise to anyone who follows the market and understands some technical analysis. Furthermore, we're in mid-September heading into October - one of the worst times of the year for the stock market. If I can see all this developing, plenty of other people can see it as well. In some ways, this all seems too obvious, too easy to be true. As John Mauldin put it in his most recent column, "The market…is designed to cause the most pain to the largest number of people." All of the above is my best guess, based on my experience, but it is all just a guess and I could be very wrong indeed.

I think we're in for a big decline this week. However, if the market instead decides to power up through the May highs, we could be going much, much higher as a lot of people, including me, are forced to cover their shorts!

At the end of this week I'll issue an update with an assessment of my prediction, and how things actually panned out. I'll either be crowing, or I'll be eating crow! Either way, it is going to be fun, and we're in for an exciting week.

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For more articles like this, please see the Archive


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