Financial Markets Forecast and Analysis

By: Robert McHugh | Sun, May 23, 2004
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Summary of Index Daily Closings for Week Ending May 21, 2004

Date DJIA Transports S&P NASDAQ Jun 30 Yr Treas
May 17 9906.91 2812.33 1084.07 1876.64 105^13
May 18 9968.51 2842.36 1091.53 1897.82 105^05
May 19 9937.71 2836.71 1088.67 1898.17 104^15
May 20 9937.64 2830.12 1089.18 1896.59 105^13
May 21 9966.74 2861.75 1093.59 1912.09 105^00

(Next Two Weeks)
Substantial Rise Low      
Market Rise Medium   Very High   80%
Sideways Medium   High   60%
Market Decline Medium   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 Very High      

The Dow Jones Industrial Average fell 46.13 points this week, in line with our expectations as our Short-term TII came in last week at negative (25.75). Most of the damage occurred on Monday (Mondays are starting to be bad equity market days) with the rest of the week gyrating in an ultimate sideways move. Interestingly, over the past week and a half a significant amount of the oversold condition of the market has been worked off without much price rise - a bearish omen.

This was the first week the DJIA remained under the psychologically important 10,000 level on a closing basis every day since the first week of December. This means markets are consolidating under 10,000, getting comfortable with the idea, and thus are preparing for more decline. Volume on the sideways corrective mini-up days was abysmal - a bearish sign.

The put/call ratio (a contrarian sentiment indicator) is at high levels, but the 10 day moving average is not yet outlier (our figure shows .87 - 1.00 is an oversold extreme. Even so, until this ratio begins to turn down, the risk that equities decline remains. A buy signal will be generated if this ratio turns down. We are not there yet.

Equities Markets Technical Indicator Index (TII) ™    
Week Ended Short Term Index Intermediate Term Index    
Jan 16, 2004 (20.00) (40.65)   Scale
Jan 23, 2004 (8.13) (32.15)    
Jan 30, 2004 2.81 (25.98)   (100) to +100
Feb 6, 2004 11.75 (20.19)    
Feb 13, 2004 (68.25) (22.19)   (Negative)  Bearish
Feb 20, 2004 (30.00) (22.36)   Positive  Bullish
Feb 27, 2004 (31.00) (20.17)    
Mar 5, 2004 16.00 (17.17)    
Mar 12, 2004 ( 9.00) (14.70)    
Mar 19, 2004 (12.00) (27.60)    
Mar 26, 2004 73.00 (38.35)    
Apr 2, 2004 (3.00) (35.61)    
Apr 16, 2004 (43.00) (29.90)    
Apr 23, 2004 94.00 (22.69)    
Apr 30, 2004 (33.25) (34.88)    
May 7, 2004 (28.75) (47.75)    
May 14, 2004 (25.75) (66.45)    
May 21, 2004 22.00 (67.23)    

This week the Short-term Technical Indicator Index comes in at positive 22.00. 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 - highly unusual.

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 (67.23), warning that - even if there is a short-term period of calm - the Bear is about to break into the tent.

I received several e-mails this week asking about non-seasonally adjusted M-3 and its influence on future Dow Industrials' price movements. The next two charts show both non-seasonally adjusted M- 3 and seasonally adjusted M-3 vs: the DJIA. In both cases, M-3 seems to affect DJIA price movements similarly. The seasonal adjustments do not distort the predictive nature of M-3 on stock price movement. It would appear that M-3 in both cases is a good predictor of future DJIA price action, with lead times of one to six months. Whenever M-3 (seasonally adjusted or raw) plateaus or falls, the DJIA has fallen, and in most cases crashed since 2000. Whenever M-3 rises, the DJIA has subsequently risen.

It also seems that the longer M-3 plateaued or fell, the longer in time the decline/crash took to complete. There also appeared to be a time correlation between rising M-3 and rising DJIA prices. This would seem to imply that the recent six month plateau in M-3 portends a significant time of decline in DJIA prices before they rise in earnest. This would be consistent with our other technical analysis work.

The above chart (courtesy of shows that the Dow Industrials are having a devil of a time busting back up through their 200 day moving average. Prices keep pounding their head against this formidable ceiling, and given the continued failure to follow through on morning rallies this past week, you have to believe prices will give up the ghost and head lower before a sustained short-term rally can unfold.

The price action the past week has formed a textbook perfect triangle continuation pattern (denoted in green). When you see these symmetrical triangle formations, they indicate a pause or breather before prices continue in the same direction they were headed before the pattern. It's as if the market stops to rest, to test if prices have moved (in this case) down enough to create sufficient buying interest to reverse the trend. If prices form a symmetrical pattern, then the conclusion is no, and prices soon decline further (had prices been rising before the symmetrical triangle pattern developed, then after the pause, prices would rise further, continuing the prior trend). Often what follows is an even stronger move than what had preceded the triangle. As sellers see that buyers are not able to push prices decisively higher, another wave of selling occurs, with panic selling a risk. The 200 day moving average sitting atop this triangle augments the pattern's Bearish implications. The magenta lines show the downward trend-channel in force and helps us identify where the next wave down could lead. Included is an alternate - but similar - Elliott Wave count to the one I posted in 5/19/04's Midweek issue.

Call me crazy, but the delay in the Trannies confirming the Industrial's May 17th lower low is just that, a delay. The Elliott Wave count provides a key clue - it has not completed its downside move in the Trannies. I believe it will and that once complete, we will have our Dow Theory "sell signal" confirmation.

The recent sideways action has served the Bearish purpose of working off extreme oversold conditions without having to give back much price action to the upside. The MACD has not reached similar oversold readings as it did in February and March. The RSI also never reached oversold levels during the latest move down. There is a massive Rounded Top pattern here, a reliable pattern that portends more downside. We are one more decent sell-off from seeing the 50 day moving average break down below the 200 day moving average, with both averages heading lower.

Yes I see a possible Bullish Head & Shoulders pattern as well, but I'm going to cast my vote that the Elliott Wave and the Rounded Top patterns trump the bullish case, that the bullish head and shoulders pattern will fail.

The Economy:

The Conference Board reported that its Index of Leading Economic Indicators was up an uninspiring 0.1% in April, far below its March 0.8 percent reading. Both M-3 and stock market performance are components of this index. M-3 was up and stocks were down.

The Federal Reserve reported that Industrial Production grew 0.8 percent in April after falling 0.1 percent in March. Capacity Utilization came in at a sub par 76.9 percent, although it was the highest reading since 2001. These sort of numbers should convince the Fed to bump short-term rates. You'd think. But then again, May's New York State Empire Manufacturing Survey fell to 30.2 in May from 34.0 in April according to the New York Fed. However, both readings are considered strong. The Philadeplphia Fed's take on manufacturing showed the Mid-Atlantic Regional Manufacturing Index falling to 23.8 in May from 32.5 in April.

Chain-Store Sales were reported to be up 4.8 percent in May this year versus May last year, according to Redbook Research, as reported on Another report by the International Council of Shopping Center and UBS indicated sales were down 0.8 percent for the week ended May 15th, 2004. Think high gas prices had anything to do with this?

We learned this week that Housing Starts fell 2.1 percent in April according to the Commerce Department.

Jobless Claims rose 12,000 to 345,000 for the week ended May 15th, 2004 according to the Labor Department, up for the second week in a row. It's the wrong trend for an economy supposedly creating 300,000 jobs per month. The ABC News/MONEY Magazine Consumer Comfort Index came in at – 11 on a scale of plus or minus 100. It should be interesting to watch this number as consumers adjust to higher gasoline prices.

78 year old Fed Chairman, Alan Greenspan was rewarded for gallant performance with another 4 year term. He's been on the job for 17 years. When he took the job in 1987, M-3 was 3.6 trillion. Today it is over 9.0 trillion. The growth in M-3 during the venerable Chairman's reign, about 5.5 trillion is more than twice the entire growth in M-3 over the previous entire existence of the United States. So, we shrug, what's a little M-3 among friends?

Money Supply, the Dollar, and Gold:

M-3's growth last week was a far more reasonable 3.2 billion. Still, since April 1st, M-3 is up 117.4 billion. That annualizes to 1.0 trillion in M-3, for an 11.2 percent rate of growth. For the past three weeks M-3 is up an incredible 107.9 billion, an annualized growth rate of 20.6 percent. Clearly the Fed has been spooked by something, and is flooding the markets with crisis levels of liquidity. What they see or have knowledge of we can only speculate. But something is up, for we cannot accept the premise that this sort of growth is simply political, to get Dubya reelected. Right?

The Gold and Silver Mining stocks are not finished their ultimate decline. The rally over the past two weeks is a corrective move, working off some of the extreme oversold condition that the recent crash created. Look for Fibonacci retracement of the recent decline, either a 38.2, 50.0 or 61.8 percent retracement before declining again in earnest. I believe a general equity market decline will pull mining stocks down during the last leg of the mining stocks' multi-month crash - an echo crash so to speak.

The corrective retracement we currently see is likely forming the right shoulder of a massive Bearish Head & Shoulders pattern that will help us define this crash's ultimate bottom. The distance from the top of the head to the neckline is the minimum projected distance of further decline from the neckline. The pattern is also a textbook Bearish Rounded Top with a Double top forming the Head of the still-forming Head & Shoulders Bearish pattern. It is ugly. Sorry gold and silver fans. This index looks like it will ultimately drop to under 95.

A similar directional (but not as price catastrophic) intermediate-term fate for Gold, I'm afraid. The recent rally is a corrective retracement of the recent decline with more decline to follow. Why? I believe because in spite of massive creation of M-3, deflation is closer than we want to believe. The catalyst could be debt repayment - the end of the massive debt bubble - the end of spending with borrowed dollars. At some point in this coming financial onslaught, some wise nation will decide to back its currency with gold, igniting a glorious bull run for Gold and the Mining stocks. So long term, the coming dips in Gold and Mining shares should be an incredible buying opportunity.

Bonds & Interest Rates:

The last time we had an oil crisis in the United States, back in 1973/74 and again in 1976 through 1980, we saw rising interest rates and falling stock prices. As oil prices rose, it created costpush inflation, forcing the inflations expectations component of interest rates to rise, which adversely spilled over into equities. Robert Prechter in his latest issue of The Elliott Wave Theorist, May 20, 2004 ( points out that in 1973/74 "the stock market had its biggest decline in over 40 years" and between 1976 and 1980 "the DJIA lost 25 percent of its value."

As in most markets we've been studying this week, extreme oversold conditions are being worked off in either sideways or corrective retracements. The long bond is no exception. But the overriding technical landscape is ominous - in the case of the US Treasury Bond, a massive Bearish Head & Shoulders pattern just waiting for a drop in prices below 100 to confirm a move to the 80s.

Unwittingly, the Fed's massive infusions of M-3 may be setting the stage for fulfillment of the coming Bond Market collapse. Even more unwittingly, the stock market crash the Fed is trying to prevent with its massive infusions of liquidity is the one natural event that could stave off a bond collapse, generating a flight to quality. But natural forces are not at work here and the language of the markets is telling us everything is about to deflate.

If the Fed believes the economic numbers coming out, believes corporate earnings portend economic boom times, then it has no business leaving short-term interest rates at 46 year historic lows and it has no business pumping M-3 at Banana Republic rates of growth. The truth is, there is a crisis on the horizon, something that will pose huge risk to financial markets. The Fed knows something. Follow their actions and that will tell you all you need to know.

Bottom Line:

Our Short-term TII is picking up the probability of a net rise in equities over the next two weeks. However, over the very short-term horizon - next 2 to 4 days - I expect a sharp brief decline, a spike down that temporarily exhausts selling. 9750 is a likely target. Below that is possible but shorts increase their risk by holding below there. The Memorial Day holiday weekend is a feelgood time and a likely spot to kickoff the two to three week mini-rally we expect (minor degree wave 4 in Elliott Wave parlance). This rally will merely serve the Bearish purpose of working off oversold conditions, likely positioning markets in Bearish overbought territory. If so, June 15th's key Fibonacci turn date may be a high - a lower high than the tops in February to April. Defensive strategies are warranted.

"So watch yourselves, lest you forget
the covenant of the Lord your God, which He made with you,
and make for yourselves a graven image in the form of anything
against which the Lord you God has commanded you.
For the Lord your God is a consuming fire
a jealous God."

Deuteronomy 4:23,24

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Key Economic Statistics
Date VIX Mar. U.S. $ Euro CRB Gold Silver Crude Oil 1 Week Avg. M-3
12/12/03 16.46 88.44 122.74 261.75 410.1 5.64 33.04 8812.9 b
12/19/03 15.71 88.53 123.58 259.50 409.9 5.72 33.02 8807.2 b
1/02/04 18.30 86.93 125.76 256.75 416.1 5.96 32.52 8819.8 b
1/09/04 16.79 85.40 128.19 266.50 426.8 6.49 34.31 8828.5 b
1/16/04 14.98 88.05 123.57 265.50 407.0 6.33 34.00 8850.4 b
1/23/04 14.88 88.81 125.81 266.50 408.0 6.36 34.94 8870.6 b
1/30/04 16.46 87.48 124.42 262.10 402.9 6.25 33.05 8901.7 b
2/06/04 16.00 86.15 126.83 260.50 403.6 6.27 32.43 8891.6 b
2/13/04 15.62 85.68 127.25 264.85 410.8 6.58 34.56 8904.2 b
2/20/04 16.05 87.40 126.96 264.50 397.5 6.53 34.25 8942.7 b
2/27/04 14.53 87.89 124.52 273.90 396.8 6.71 36.16 8959.1 b
3/05/04 14.52 88.75 123.28 274.00 401.6 6.99 37.26 8970.8 b
3/12/04 18.21 89.60 121.80 272.00 395.6 7.06 36.19 8961.7 b
3/19/04 19.15 88.56 122.47 280.20 412.7 7.56 37.62 9002.3 b
3/26/04 17.12 89.30 120.90 278.25 422.3 7.71 35.73 9012.8 b
4/02/04 15.81 88.80 121.12 280.00 421.1 8.15 34.39 9055.4 b
4/08/04 16.38 89.82 120.56 284.00 419.9 8.09 37.14 9045.8 b
4/16/04 15.00 90.18 119.50 276.75 401.6 7.14 37.74 9062.0b
4/23/04 14.01 91.34 118.18 267.50 395.7 6.16 36.46 9064.9 b
4/30/04 16.69 90.76 119.70 270.75 387.5 6.07 37.38 9111.5 b
5/07/04 18.13 91.30 118.83 270.40 379.1 5.58 39.93 9169.6 b
5/14/04 18.47 91.81 118.69 267.00 377.1 5.72 41.38 9172.8 b
5/21/04 18.44 90.53 120.05 268.75 384.9 5.87 39.93 -

Note: Mild corrections off of extremes in most of the above.

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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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