Financial Markets Forecast and Analysis

By: Robert McHugh | Sun, Feb 29, 2004
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Summary of Index Daily Closings for Week Ending February 27, 2004

Date DJIA Transports S&P NASDAQ Mar 30 Yr Treas
Feb 23 10609.62 2854.06 1140.99 2007.52 112^27
Feb 24 10569.37 2859.31 1139.10 2005.44 113^04
Feb 25 10604.62 2868.96 1143.67 2022.98 113^07
Feb 26 10580.14 2891.78 1144.92 2032.58 112^27
Feb 27 10583.92 2902.19 1144.94 2029.82 112^14


(Next Two Weeks)
Substantial Rise Low      
Market Rise Medium   Very High   80%
Sideways Medium   High   60%
Market Decline High   Medium   40%
Substantial Decline Medium   Low   20%
      Very Low Under   20%
(Next 12 Weeks)
TREND PROBABILITY   Substantial   800 points+ (DJIA)
Substantial Rise Low   Market Move   200 to 800 points (DJIA)
Market Rise Medium   Sideways   Up or Down 200 (DJIA)
Sideways Medium      
Market Decline High      
Substantial Decline High      

This week the Dow Jones Industrial Average fell 35 points, closing at 10,583.92. Last week's Short-term Technical Indicator Index reading of negative (30.00) pointed toward this week's decline. In fact, our Short-term TII has been accurate in forecasting the market's direction seven weeks in a row. The extent of the declines the past several weeks has been minimal with no clear impetus to buy or sell, likely in part because the short-term bearish technical picture is clashing with the rising crest of the ten week cycle. There has been a mixed bag of news, and investor perceptions of the forces of inflation vs. deflation remain at a standstill. Volume is average whether on up or down days, and breadth has been unimpressive. Thus we snooze and wait for some sort of breakout in equities.

Friday's action was interesting. The Dow Jones Industrial Average has been down six of the past eight weeks. This week, Friday looked like a nice little "up" day, but selling took over the last half hour and drove prices down to merely a modest gain. What's all this mean? The pros aren't comfortable holding stocks over the weekend. This is bearish action.

Equities Markets Technical Indicator Index (TII) ™    
Week Ended Short Term Index Intermediate Term Index    
Oct 24, 2003 (27.63) (43.96)   Scale
Oct 31, 2003 (21.38) (55.42)    
Nov 7, 2003 0.50 (53.47)   (100) to +100
Nov 14, 2003 (42.75) (52.33)    
Nov 21, 2003 0.38 (51.90)   Negative  (Bearish)
Dec 5, 2003 (31.75) (55.18)   Positive  (Bullish)
Dec 12, 2003 (5.83) (54.43)    
Dec 19, 2003 (6.50) (47.03)    
Jan 2, 2004 (48.17) (40.33)    
Jan 9, 2004 (96.50) (39.28)    
Jan 16, 2004 (20.00) (40.65)    
Jan 23, 2004 (8.13) (32.15)    
Jan 30, 2004 2.81 (25.98)    
Feb 6, 2004 11.75 (20.19)    
Feb 13, 2004 (68.25) (22.19)    
Feb 20, 2004 (30.00) (22.36)    
Feb 27, 2004 (31.00) (20.17)    

This week the Short-term Technical Indicator Index comes in at negative (31.00), meaning we can expect the equity market to move down next week. 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. The first few days each month have a positive bias, but look for selling by the end of next week.

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 (20.17), warning that a significant reversal remains at risk over the next three months. Massive increases in M-3 could mitigate the damage or the timing, and in fact recent increases have reduced this indicator's negative readings.

The sideways action we've seen the past several days has served the bearish purpose of working off a somewhat oversold condition without the aid of a strong or persistent rally. The McClellan Oscillator rose from an oversold minus 180 on Monday February 23rd to a neutral minus 4 reading on Friday February 27th, yet the S&P 500 only moved sideways, rising a mere five points, from 1140.99 to 1144.94. This sets up the bears for more decline over the coming week or so.

We have yet to see a five percent correction since this rally began last March, very unusual price action. Yet insiders continue to dump, and a myriad of contrarian sentiment indicators warn of a top. Confidence is plummeting, the VIX is at levels seen at tops, the put/call ratio and bullish advisor sentiment are at levels seen at tops. The Fibonacci time/price relationships presented in last week's newsletter remain valid for a top. Price/Earnings ratios remain frothy. So we're due for some sort of meaningful correction. For more evidence, let's study the language of the markets.

The University of Michigan's Consumer Confidence Index fell from 103.8 in January 2004 to 94.4 in February 2004. The decline in consumer sentiment was confirmed independently by the Conference Board (a research group out of New York) measure. Since both measures show an approximate 9% decline in February, this confidence plunge is likely not a statistical anomaly; it is real.

The Chart above compares the U. of Michigan index with price action in the Dow Jones Industrial Average over the past seven years. What we see is that the two go hand-in-hand, that the patterns have near-perfect correlation month to month. Further, if one index strays from the other, the two ultimately find each other within the next month or two. Such divergences are rare, the only significant one occurring in 2001. At that time, the confidence index plummeted ten percent before the DJIA followed. Once the DJIA caught up, both measures fell another fifteen percent.

Well, we now face another significant divergence and once again the Confidence Index is leading the DJIA to the downside. So, either Confidence will reverse course and rise back up to levels consistent with the DJIA, or the DJIA is about to decline nine percent. My bet is that Confidence will lead the Dow. Note that Confidence seems to peak around February each year, then decline sharply, with the DJIA quickly on its heels.

The two charts on the next page revisit the Dow Theory Divergence between the Industrials and the Transports. The Transports hit a closing top on January 22nd at 3080, which was confirmed by the Industrials on January 26th at 10,702. Then on February 11th, 2004 the Industrials hit another closing high of 10,737. The Transports have not only failed to confirm that new high, but instead have since plunged seven percent, or 226 points, to a closing low this past Monday of 2854. It has rallied back some but as of today still remains a whopping 178 points, or 5.7 percent away from confirmation. This is a particularly strong divergence. Should both the Transports and the Industrials decline below recent lows, below 10,470.74 in the Industrials and below 2822.11 in the Transports before the Trannies can exceed 3080, this would announce a highly reliable Dow Theory "sell" signal, gang way below. Either one of two moves are most probable over the next several months. Either Trannies are about to rally like mad or the Industrials are likely to take a nasty fall. We watch and wait.

The NASDAQ Composite has broken down below both its one year rising trend-channel and below its 50 Day Moving Average. While false breakdowns can occur, and did occur in this average back in July 2003, the current breakdown is larger and comes after an extended rally. Odds are this breakdown is the real deal.

The Economy:

Fourth quarter 2003 GDP was revised up by the Commerce Department, to 4.1 percent. That's nice. That was a nice quarter. Doesn't mean a thing about this quarter or next quarter. Markets discount the future, they don't react to the past.

In the meantime, Durable Goods Orders fell sharply in January 2004, down 1.8 percent. Transportation orders took it on the chin big-time, which may help explain the recent demise of the Dow Transportation Average's one year rally.

On to Housing, the key to the Master Planner's economic recovery strategy. We learned this week that Existing Home Sales fell 5.2 percent in January according to the National Association of Realtors. New Home Sales fell 1.7 percent in January according to the Commerce Department, to their lowest level since May 2003. And we got a warning from Alan Greenspan about the systemic risks inherent in the balance sheets of Fannie Mae and Freddie Mac - the two government sponsored housing mega-lenders - which he believes threatens the financial system.

The ever-prescient Mr. Greenspan also warned this week that the Federal Budget Deficit threatens bigger problems down the road. His solution included a suggestion to cut future Social Security benefits. Hmmm. Let me get this straight. Let's keep the "who cares" dividend exclusion that went a long way toward creating this burgeoning budget beast, and cut social security. Sounds a bit elitist to me. Now before my fellow Republican readers get all bent out of shape with that leftist statement, keep in mind that when the Depression hits - and don't think it can't - a great deal of your safety net, your 401(k), your home value, your stock portfolio, your U.S. dollar denominated savings balances will be wiped from the face of the earth. How? DEFLATION. Everything drops in value. That lousy $12,000 annual check from the government will look mighty good to you when all damnation breaks loose. Ahhh, rest assured that John Kerry is taking good notes.

Jobless Claims . . . again, 350,000 good folks collecting government checks for the first time last week. This number just doesn't seem to improve, does it? The reason for last year's tax cut was to create jobs, we were told. Lot's of jobs. Well, China's creating jobs I suppose. Since March 2001, 2.3 million U.S. jobs have been lost, yet we've just enjoyed nine straight quarters of robust GDP growth. If GDP growth of 8 percent and 4 percent doesn't create jobs, then we're up to our armpits in deep dark nitrogen-rich humus. Wait until Wall Street gets wind of an administration change. Phew.

Is it any wonder Consumer Confidence took a flying leap in February? Consumers hear boneheaded remarks by the Chairman of the White House Council of Economic Advisors Gregory Mankiw and St. Louis Fed Governor William Poole that exporting American jobs overseas is a good thing, and this week we hear Fed Governor Edward Gramlich mention that the 9 point plunge in February's Consumer Confidence figures was "modest." Gosh, if this fodder keeps up, against my better judgment I may have to add a feature to this newsletter called the "Boneheaded Quote of the Week." We received two confirming independent accounts that Consumer Confidence declined nine percent this month, one from the University of Michigan and the other from The Conference Board, a research group out of New York. Steve Hochberg and Pete Kendall of Elliott Wave International ( pointed out in their March issue of the Financial Forecast that sudden sharp plunges in Consumer Confidence have preceded the last two recessions.

Money Supply, The Dollar, & Gold:

M-3 reportedly rose 36.8 billion this past week. But what exactly does this mean? Thanks to the many of you who passed along information about the accounting rule change that was apparently implemented by the Fed. John Mauldin's piece, Barbarians at the Fed, available at does a nice job identifying the M-3 incongruity. Apparently FASB's FIN 46 was implemented since January 2004, however past M-3 figures were not adjusted for comparative purposes. Thus the humongous reported increases in M-3 of late, an 12 percent annualized pace, may in fact be much less, perhaps only up by 1 percent annually, in terms of prior comparative M-3 figures.

Still, even under the new accounting, since December 31st, M-3 is up 165.8 billion, a 12.2 percent annualized rate of growth. Massive liquidity pumping. Why? I suspect because we are once again on the precipice of the deflation abyss. Here's how it's working. Massive liquidity must flow somewhere so it flows into all commodities. Crude oil hit a high this week as did the CRB index. So did silver. Yet, with all this liquidity, why did the Dollar rise and Gold fall? Because in deflation, the most valuable asset at its onset is cash. Cash to buy things. The fact that the dollar is gaining in value in the face of massive liquidity is evidence deflation is upon us. Gold is falling temporarily as it moves inversely to the dollar. Silver is seen more as a commodity - it is used in industry for the manufacture of goods - so it does not follow Gold down. But at some point in this deflationary spiral, Gold will be perceived as money, and like the dollar, will rally.

Bonds and Interest rates:

Interest rates, long-term or short, are going nowhere - well maybe down. This is nonnegotiable in the face of deflation risk. There is a reason the Fed is keeping short rates at 46 years lows. Fear of deflation. There is a reason the long bond was up this week - deflation. It is happening folks. Hidden from our view, but known to the master planners. They must avoid deflation at all costs. They see the technical landscape for equities. Stocks are set to fall (deflation), a little now, a lot soon. The Fed is pumping money into the system to once again stave off a crash. They succeeded last spring. Risks run high again and they have acted in kind. So interest rates are going nowhere. Good for debt holders, bad for savers.

Bottom Line:

The innocent are in place for slaughter. Mutual fund cash is at its lowest since early 2000 when the last equity market massacre occurred. Record bullish sentiment has idle dollars in play. The economy is not creating jobs, the economic numbers are uninspiring, and cheerleading is at its fervent finest. The technical picture for equities calls for at least a 5 to 10 percent imminent correction. There should be some bounce after this, followed by a severe slide. But, and this is a big but (did I write that?), massive infusions of M-3 have mitigated equity market declines in the past, and may succeed again. It is no coincidence we are seeing the money spigots opened full throttle now. But remember what M-3 is. It is essentially deposits in banks. How do deposits grow? By increasing credit - debt. This cure is only exacerbating the imbalance. As credit eventually contracts, as debtors finally say, "no more!" M-3 contracts - deflation - too few dollars chasing too many goods. And sadly, deflation increases risk of depression. Be very cautious.

"Thus says the Lord, your Redeemer, the Holy One of Israel;
I am the Lord your God, who teaches you to profit,
Who leads you in the way you should go."

Isaiah 48:17

Key Economic Statistics
Date VIX Mar. U.S. $ Euro CRB Gold Silver Crude Oil 1 Week Avg.
9/26/03 22.21 94.25 114.45 240.50 380.8 5.14 28.16 8952.9 b
10/03/03 19.71 93.53 115.40 242.55 369.4 4.83 30.10 8950.4 b
10/10/03 18.51 91.79 117.85 246.75 374.1 4.90 31.99 8915.4 b
10/17/03 17.62 92.61 116.33 242.00 372.2 4.94 30.70 8903.5 b
10/24/03 17.70 91.46 118.04 249.50 389.2 5.16 30.16 8892.7 b
10/31/03 16.00 92.98 115.57 247.00 384.6 5.06 29.11 8876.5 b
11/07/03 16.84 93.20 115.11 249.75 383.4 5.05 30.85 8876.8 b
11/14/03 17.33 91.58 117.60 256.25 398.0 5.41 32.37 8860.6 b
11/21/03 18.98 90.72 119.09 250.50 396.0 5.29 31.61 8851.4 b
11/28/03 16.32 90.28 119.65 253.25 398.0 5.39 29.96 8850.0 b
12/05/03 17.23 89.17 121.60 256.00 407.3 5.49 30.73 8837.8 b
12/12/03 16.46 88.44 122.74 261.75 410.1 5.64 33.04 8839.2 b
12/19/03 15.71 88.53 123.58 259.50 409.9 5.72 33.02 8827.1 b
1/02/04 18.30 86.93 125.76 256.75 416.1 5.96 32.52 8833.6 b
1/09/04 16.79 85.40 128.19 266.50 426.8 6.49 34.31 8870.0 b
1/16/04 14.98 88.05 123.57 265.50 407.0 6.33 34.00 8898.0 b
1/23/04 14.88 88.81 125.81 266.50 408.0 6.36 34.94 8915.7 b
1/30/04 16.46 87.48 124.42 262.10 402.9 6.25 33.05 8949.8 b
2/06/04 16.00 86.15 126.83 260.50 403.6 6.27 32.43 8941.3 b
2/13/04 15.62 85.68 127.25 264.85 410.8 6.58 34.56 8956.1 b
2/20/04 16.05 87.40 126.96 264.50 397.5 6.53 34.25 8992.9 b
2/27/04 14.53 87.89 124.52 273.90 396.8 6.71 36.16 -

Note: Note: The VIX hit a new low. The CRB, Silver, and Crude all hit new highs.

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Robert McHugh

Author: Robert McHugh

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

Robert McHugh

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 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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