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May 30, 2004

Financial Markets Forecast and Analysis
by Robert McHugh

Summary of Index Daily Closings for Week Ending May 28, 2004

Date	DJIA	Transports	S&P	NASDAQ	Jun 30 Yr Treas Bonds
May 24	9958.43	2865.36	1095.34	1922.98	105^12
May 25	10117.60	2930.98	1113.05	1965.38	105^21
May 26	10109.89	2939.92	1114.94	1976.15	106^05
May 27	10205.20	2951.89	1121.26	1984.50	107^05
May 28	10188.45	2948.01	1120.68	1986.74	106^18

The Dow Jones Industrial Average rose 221.71 points this week, in line with the direction of our expectations - but a larger, earlier move - as our Short-term TII came in last week at positive 22.00.

Let me just say from the outset that the Federal Reserve has confirmed our Stock Market Crash forecast by raising the Money Supply (M-3) by crisis proportions, up another 46.8 billion this past week. What awful calamity do they see? Something is up. This is unprecedented, unheard-of pre-catastrophe M-3 expansion. M-3 is up an amount that we've never seen before without a crisis - $155 billion over the past 4 weeks, a $2.0 trillion annualized pace, a 22.2 percent annualized rate of growth!!! There must be a crisis of historic proportions coming, and the Federal Reserve Bank of the United States is making sure that there is enough liquidity in place to protect our nation's fragile financial system. The amazing thing is, the Fed's actions mean they know what is about to happen. They are aware of a terrible, horrific imminent event. What could it be?

One can draw no other conclusion except that the Fed is acting irresponsibly in its managing the money supply, in fulfilling its duty to "maintain a stable currency." I reject the notion that the Fed is acting irresponsibly. No, something is up, bigger than we have ever seen in the history of the United States. Let me ramble. Perhaps they simply see the ominous technical landscape we have been warning about in recent issues, and are attempting to pull out all the stops to avert the predicted crash. The recent rally in just about everything is similar to 2003's market behavior when the Fed pumped massive amounts of liquidity into the system during the first half of the year. This time seems different. The amount of liquidity is too large. The Fed is deflating the value of the monetary base by a fifth! Why are they willing to do this? Wisdom says something bad is up - big time.

This week the Short-term Technical Indicator Index comes in at negative (3.50), essentially flat. Still, there could be volatility, even to the upside. This indicator is a useful predictor of equity market moves over the next two weeks, both as to direction and to a lesser extent strength of move. For example, readings near zero indicate narrow sideways moves are probable. Readings closer to +/- 100 indicate with a higher degree of confidence that an impulsive move up or down is likely over the short run. Market conditions can change on a dime, so it may be unwise to trade off this weekly measured indicator. Massive increases in M-3 have reduced negativity in this indicator. It appears the Intermediate reading is dominating the Short-term at this time.

The Intermediate-term Technical Indicator Index is useful for monitoring what's over the horizon - over the next twelve weeks. It serves as an early warning system for unforeseen trend changes of considerable magnitude. This week the Intermediate-term TII comes in at negative (48.48), warning that a major decline is probable. Massive infusions of M-3 are respected by this indicator, and reduce the severity of this reading.

There is a bit of a battle going on between the Fed and the forces of market collapse. The current price pattern is eerily similar to past thousand point + declines.

The Topping Pricing Pattern we see today is nearly identical to what the Dow Jones Industrial Average traced out in late 2001 into early 2002. This analog is presented above. It is astonishing how prices are moving in precise pre-crash fashion, including the recent rally since the 9907 closing bottom on May 17th, 2004. There are some striking parallels here. Both patterns hit some sort of high or low on January 28th (+/- 1 day) and again on May 17th. June 18th was the start of the crash in 2002 and is a likely date for the coming 2004 crash to also start, given that June 15th, 2004 is the phi mate of the major low in the Bear market so far, October 9, 2002. The number of trading days from the start of the Bear Market in the DJIA, 1/14/00 to 10/9/02 is 687 days. The number of trading days from 1/14/00 to 6/15/04 is 1111 trading days. 687 divided by 1111 equals the Fibonacci ratio .618. The number of trading days from 10/9/02 to 6/15/04 is 424 days. 424 divided by 1111 equals the Fibonacci ratio .382. The sum of .382 plus .618 equals 1.000 (See chart below).

Should this analog hold up, keep in mind 2002's crash was over 2000 points and lasted two months, concluding on July 23rd. It contained a few minor rallies - short covering events that served the Bearish purpose of working off deeply oversold conditions - but the fall was essentially vertical. If you are staring at June 15th as if it is some sort of magical date, be careful, for it is not. It is simply a guidepost. Given the strong undercurrents of the current rally, June 15ish, 2004 is likely to be a top. That top could hit any time between now and late June for this phi mate of 10/9/02 to be a valid .382 to .618 golden ratio approximation, given the very lengthy period of time this Fibonacci ratio is measuring to identify a probable turn date. We believe this June 15th turn date will be an extraordinary trend reversal kickoff given the extraordinary landmark its 10/9/02 mate is - the low for this 4 year old Bear market. The analog suggests the end could be July 23rd. The Fed's crisis liquidity infusions coming at this time seems to validate the above analog and major Fibonacci turn date profile.

The McClellan Oscillator's behavior has been nothing short of bizarre in spectacular fashion, declining to historic oversold lows (-358) on May 10th, then catapulting to historic overbought highs only a few weeks later, hitting +336 on Friday May 28th, a phenomenal 694 point swing in only 15 trading days. Even more amazing is that prices are up only about 3 percent over this interval. The strangeness of this event compares with the strangeness of the Federal Reserve pumping an annualized $2.0 trillion into the economy. When taken as a whole with the June 15th phi relationship to the start of this Bear on 1/14/00 and the low for this Bear on 10/9/02, one has to conclude something unique, perhaps never seen before is right around the corner - something bad.

Overbought readings (over +150) usually occur a few days or weeks before market tops. We sit at a reading that is more than double the overbought threshold. Markets can rise during overbought levels - for a while even - but once we reach extreme overbought levels, you usually don't see significantly more price upside. For those of you interested, the McClellan Oscillator computes the 39 day exponential moving average of the difference in advancing issues vs: declining issues from the 19 day exponential moving average. It essentially measures the momentum of breadth. What we've seen is a lot if issues moving up at the same time, but not by a lot.

Tim W. Wood (www.cyclesman.com) has found an ominous looking, highly reliable bearish pattern in the DJIA, Three Peaks and a Domed House. Another red light flashing the threat to the current market picture. Contact him at his site for more information about this pattern's dire forecast.

The above chart above compares the price action of the S&P 500 with the S&P 500 to VIX Ratio. VIX is a measure of options volatility risk, primarily the risk of writing puts when markets are moving down. The ratio measured in this chart is an analysis initially made know by Wally Hertler. The ratio in essence correlates equity price moves with options writers' confidence.

By charting the two together, we see that there is near-perfect correlation. The SPX/VIX ratio shown in magenta can be interpreted to mean that whenever it rises above 68.00 (right scale), a market top in the S&P 500 is highly probable. Conversely, whenever the SPX to SPX/VIX ratio declines below 35.00, we are likely to be at or near a bottom in the S&P 500. Options writers tend to get complacent (options premiums decline as measured by the VIX) as prices rise, thus increasing this ratio's value.

Take note that the recent rally since May 17th has pushed this ratio up to 73.38 as of May 27, 2004, signaling we are approaching a major top. The decline since March in the S&P 500 failed to send this ratio below 35, therefore a major bottom is not yet in the cards. Note the action in 2002 just before that crash. The ratio couldn't fall below 50 during the start of the decline, then spiked up near 68.00 on the countertrend rallies that set up the crash. Ditto 2004.

The above chart shows the Elliott Wave count for both the Dow Industrials and the Transports. Both averages are in primary degree wave (3) down. Once the five sub-wave (red numbers) minor degree wave completes (after the crash), we will have completed intermediate degree wave (i) - not shown. Minute degree wave 2 (green) up is about to finish, probably at the resistance levels marked by their upper trend-channel lines, at Fibonacci .786 of wave 1 (green) down in Trannies (2965), and at Fibonacci .618 of wave 1 (green) down in the Industrials (10,316).

The next break should be the expected crash, minor degree 3 (red). It is at that time the long awaited lower-low confirmation of the Industrials wave 1 (red) down is made by the Trannies. Should Trannies top red wave 2 up's 3007 level, it would likely mean that red wave 2 up has shifted to the new high.

The downward trend-channels remain valid for both averages, with all trendlines clean, marked by at least two price points. The current rally fits nicely inside this trend-channel, and is serving the useful Bearish purpose of putting equity markets at overbought levels, sort of like filling the fuel tank for a long and extraordinary decline.

The Economy:

Are there any excuses in these economic numbers for the Fed to keep short-term interest rates at 46 year historic lows? My guess is something in here, along with the next couple of week's batch of figures, will offer them the justification they need - that or an equity event.

Consumer Spending was reported to be up 0.3 percent in April. The Chicago Purchasing Managers Report showed strength in manufacturing in the Chicago area, up to 68.0 in May from 63.9 on April's survey.

First quarter GDP was revised up to 4.4 percent growth from 4.2 percent according to the Commerce Department.

Existing Home Sales were up 2.5 percent according to the National Association of Realtors. However, New Home Sales plummeted 11.8 percent in one month, the largest monthly drop in 10 years according to the Commerce Department. That helps the Fed. Good job Commerce.

Durable Goods Orders dropped 2.9 percent in April, the largest drop in nearly two years. Yeoman's job, Commerce Department.

Jobless Claims came in at an unacceptable 344,000 last week, and of course the Labor Department revised last week's figure up to 347,000. Big dilemma for Labor next Friday. Do they show more outstanding temporary and part-time jobs growth for banner headlines that "all is well, so vote for Dubya," or do they show jobs growth deterioration to help the Fed protect the Debt Bubble? Hmmm. Buy a bag of popcorn for this one.

Confidence is down significantly. The ABC News/Money magazine Consumer Comfort Index fell to (minus) -16 from the prior reading of (minus) -11. Confirming this was the University of Michigan Consumer Confidence reading for May, 90.2, down from 94.2 for April. This index's performance is highly correlated with movements in equity markets, a short-term leading indicator.

Money Supply, the Dollar, and Gold:

Normally my take on rising M-3 is that it means most markets, especially equities, will rise (see issues nos. 50 and 52 in the archives at www.technicalindicatorindex.com). However, the unprecedented pre-crisis liquidity infusions we are seeing this past month are saying something else. The amount of growth is too much, too soon, indicative of an unseen (to all but the master planners) imbalance about to blow. The Fed knows something, and their massive infusion of liquidity is a signal that a crash event is not only imminent, but likely unavoidable. The extraordinary M-3 growth we are seeing is the level of liquidity infused to halt crashes, and to fuel post-crash recoveries. Given that M-3 increases take 1 to 6 months to affect markets, that means what has just been injected into the economy should be kicking in around mid to late summer, just about when the 2002/2004 analog suggests the coming crash should end.

There has never been a six-week infusion of M-3 of this size preemptively (before a crash has occurred) in the history of the United States.

There was only one other time we saw this level of M-3 growth over a six week period in the history of the United States, and that was AFTER 9/11/01. The Fed rightfully pumped $170 billion into the system the week of 9/17/01. They did a good job doing so. After the stock market crash of 1987, the Fed increased M-3 a mere 0.08 billion, or at the time 2.2 percent, from 3.61 to 3.69 trillion.

But in the past 4 weeks, M-3 is up a whopping $155 billion, a $2.0 trillion, 22.2 percent annualized pace. Since the Dow Industrials topped in February, M-3 is up $280 billion. The entire money supply in the U.S. was $2.0 trillion in 1981. The Fed is now on a pace to grow M-3 by that amount over the next twelve months.

We've had five equity crashes since this Bear market began in 2000. Here are the annual M-3 growth figures:

2000 - up $568 billion, up 8.6%.
2001 - up $900 billion, up 12.6%.
2002 - up $521 billion, up 6.5%.
2003 - up $272 billion, up 3.2%.
1st 5 months of 2004 - up $400 billion.

What bothers me most about this crisis level of liquidity infusion is that it is coming before a widely known catastrophe. This is bad for the Dollar and good for Gold. The chart below (courtesy of www.stockcharts.com) shows the U.S. Dollar breaking down hard.

The AMEX Gold Bugs Index ($HUI) has completed an exact 50 percent corrective retrace of its 80 point April/May crash, and has stalled at its declining 50 day moving average. The rally appears to be losing steam and another leg down to new lows appears in the cards. The 50 day moving average is significantly below its 200 day moving average, and the 200 day may soon be heading south. Massive injections of M-3 are good for Gold and should be good for the mining stocks - eventually. M-3's behavior will speed some nation's decision to back its currency with the yellow metal, as it precipitates competitive currency devaluations into fiat chaos. When is the question.

Bonds & Interest Rates:

As far as short-term interest rates, you can bet that if the Fed is pumping liquidity like there is no tomorrow, they surely WILL NOT raise short-term interest rates when they meet the end of June. The Debt Bubble lives to pay another day.

Bonds have benefited from all the M-3 being injected. That's how money gets into the system - the Fed buys bonds in exchange for electronic money, created from the deep inner world of the black box. Bonds could go either way. With all the M-3 devaluing the dollar, foreign investors could not only not buy, but could dump Treasuries. So foreigners sell Treasuries and the Fed and every US government agency buys them. This is a manipulated market at this time, so forecasts are as good as future Federal Reserve Notes. The chart is ugly on its own merits, with the 50 day MA looking like it wants to dive below the 200 day MA. Tonight they sleep together. The retracement so far has been a Fibonacci 38.2 percent of the March to May mini-crash. Should an equity event unfold, bonds could rally all the way back up to recent highs.

Bottom Line:

The Federal Reserve, contrary to our oftentimes cynical commentary, is not going to inflate the Money Supply 22 percent simply to get Dubya reelected. That sort of M-3 rise creates substantial financial risks that don't justify its necessity. No, something horrific is on the horizon - and soon. Perhaps the Open Market Committee was treated to a preview of The Day After Tomorrow - and they believed it! I don't want to be an alarmist, but I am reporting what I see. Like in the movie, it may be time for prayer. The Master Planners' prayer is that all markets float higher on the rising tide of swelling money and that the coming catastrophe be mitigated or delayed. Should they be successful in extending the Bubbles, greater imbalances emerge and the ultimate market event will be worse than if now. Defensive strategies are warranted.

"But be sure of this, that if the head of the house
had known at what time of the night the thief was coming,
he would have been on the alert and would not
have allowed his house to be broken into."
Matthew 24:43

Special Note: Be sure to register under the subscribers' section at www.technicalindicatorindex.com for e-mail notifications of our new mid-week market analysis, usually available on either Tuesdays or Wednesdays. These midweek updates will only be available via e-mail and in the future will not be posted on the web.

Note: VIX is complacent, Dollar falls, CRB, Gold, and Silver rise as M-3 rockets higher!

Robert D. McHugh, Jr. Ph.D.
Main Line Investors, Inc.

Robert McHugh Ph.D. is President and CEO of Main Line Investors, Inc., a registered investment advisor in the Commonwealth of Pennsylvania, and can be reached at www.technicalindicatorindex.com. The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. Editor shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.

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