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August 20, 2007

Stock Market Outlook: Looking Forwards by looking Backwards
by Steve Saville

Below is an extract from a commentary originally posted at www.speculative-investor.com on 19th August 2007.

Looking ahead by taking note of the past

With reference to the following chart of the S&P500 Index (SPX), note that:

1. The SPX has dropped sharply since peaking in mid July.

2. On Thursday of last week it spiked downward to support defined by its March low and then staged a huge recovery to end the session with a small gain.

3. Spurred by the Fed's help, but mostly in response to the market's extremely 'oversold' status, there was significant follow-through to the upside during Friday's trading session. Consequently, Thursday's downward spike looks like a successful test of support.

A short-term bottom might have been put in place last Thursday, but history and commonsense suggest that the ultimate correction low is not yet in place despite the 'oversold' extremes being registered by several indicators. The commonsense aspect is that the senior stock indices have only been declining for about 4 weeks and at last week's intra-day lows had only fallen by around 10% from their highs. This seems like too little in terms of both time and price considering the extent of the underlying problems being signaled by the interest rate markets. The historical aspect is that when intermediate-term stock market corrections begin in July they normally don't end until October.

To illustrate the historical precedence we have included, below, charts showing the performance of the SPX during 1990 and 1998. With reference to the first of these charts, notice that the mid-July peak in 1990 was followed by: a) a sharp initial decline to a mid-August low; b) a rebound from the August low to an early-September peak; and c) a second decline that bottomed during the first half of October. The second chart reveals a similar pattern, although in this case the initial decline ended in spectacular fashion during the final week of August

In the historical examples cited above, the October low (the ultimate correction low) was not far below the August low. The question is: was an August low put in place last week (as per the 1990 model) or will there first be another plunge (as per the 1998 model)?

If forced to choose we'd say that the August low was put in place last week, but it's not necessary for us to choose or to bet on any particular near-term outcome. The points we want to make today are:

1. The correction is probably not going to end until the first half of October

2. If the market makes new lows during the first half of October it will be important to look for reasons to turn bullish rather than get carried away by the immense negativity that will undoubtedly be evident at the time, regardless of how terrible the news backdrop happens to be. In fact, the worse the news backdrop in early October the more likely it will be that a sustainable low is being put in place. Recall, for instance, that the October-1990 bottom occurred amidst fear that a major Middle-East war was about to erupt and that the October-1998 bottom occurred amidst fear that LTCM's demise was going to precipitate a total financial collapse.

Now, even if an important low is put in place in October of this year it won't necessarily mean that the cyclical bull market is intact. It might, instead, mean that the first downward wave in a new cyclical bear market has come to an end, in which case a multi-month rally from the October-2007 low would be followed by a decline to new lows during 2008. The next question, then, is: has the cyclical bull market that began in March of 2003 come to an end?

At this stage we don't think so. Our reasoning is that multi-year equity bull markets are generally brought to an end by a substantial rise in interest rates or a huge upside blow-off. Both of these factors were present in 2000, but neither of them is present today.

Will a Fed rate cut help?

The following chart shows that the three-month T-Bill yield has just plunged from 4.8% to 3.6%. This means that there has ALREADY been a substantial rate cut. In other words, a Fed rate cut won't do anything that hasn't already been done.

Steve Saville
Hong Kong

Regular financial market forecasts and analyses are provided at our web site: http://www.speculative-investor.com/new/index.html. One-month free trial available.

Copyright © 2003-2008 Steve Saville

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