Financial Markets Forecast and Analysis

By: Robert McHugh | Sun, Oct 3, 2004
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Summary of Index Daily Closings for Week Ending October 1, 2004

Date DJIA Transports S&P NASDAQ

Jun 30 Yr Treas

Sep 27   9988.61 3177.35 1103.59 1859.88 113^26
Sep 28 10077.40 3208.56 1110.06 1869.87 113^16
Sep 29 10136.24 3239.59 1114.80 1893.94 112^20
Sep 30 10080.27 3243.51 1114.58 1896.84 112^07
Oct 1 10192.65 3298.80 1131.50 1912.20 111^15

(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 closed up 145.41 after hitting a bottom of 9988.61 on Monday. Last week we mentioned that the move down from September 7th's top should finish just below 10,000, which "should be followed by a strong minuette degree wave ii up from oversold levels that moves prices back into overbought territory." This week we saw just that. This rally is coming on strong volume and improving breadth, with new 52 week highs expanding Friday. It probably has another week or so to run before reversing into what should be a powerful move down.

The Transportation Average hit another high Friday for the move since early 2003, while the Industrials did not. This is another in a series of non-confirmations between these two Dow Indices, a major, flagrant Dow Theory warning that there is something seriously wrong with this rally, that the new highs in the Transports should not be trusted.

Rallies inside secular Bear markets are often violent and surprisingly sharp as shorts must join in the buying fray to cover their positions at the first hint of a trend change. Ironically, those most pessimistic about the markets fuel its rally. Manipulators often accomplish short-covering by buying futures, priming the pump so to speak. But we also witnessed some cyclical buying Friday. Here's some numbers to chew on: Since the Bear Market began with the DJIA topping on January 14th, 2000, the first trading day of a calendar quarter has been up 63.1 percent of the time (12 out of 19 times). Amazingly, the first trading day of the month has also been up exactly the same percentage of times, 63.1 percent (36 out of 57). Of the last five October 1st's (the first trading day of the fourth quarter), four of them were up, three up sharply. 10/1/00 was up 49 points, yet two weeks later the DJIA had lost 725 points. 10/1/02 was up a whopping 346 points, yet nine days later the DJIA had lost 652 points. 10/1/03 was up 194 points and gained another 332 the rest of that month. And of course Friday 10/1/04 saw a 112 point rise. Big rises the first day of October do not portend Bull market runs.

Equities Markets Technical Indicator Index (TII) ™    
Week Ended Short Term Index Intermediate Term Index    
June 4, 2004 (55.75) (34.07)   Scale
June 11, 2004 (77.75) (25.92)    
June 18, 2004 (40.25) (31.17)   (100) to +100
June 25, 2004 (34.00) (26.10)    
July 2, 2004 (41.50) (27.64)   (Negative)  Bearish
July 9, 2004 (32.50) (30.21)   Positive  Bullish
July 16, 2004 (33.75) (41.99)    
July 23, 2004 (59.00) (49.98)    
July 30, 2004 46.25 (52.18)    
Aug 6, 2004 (38.00) (50.40)    
Aug 13, 2004 (15.75) (49.03)    
Aug 20, 2004 9.25 (43.82)    
Aug 27, 2004 9.25 (39.81)    
Sep 3, 2004 (39.25) (40.06)    
Sep 10, 2004 (49.25) (45.78)    
Sep 17, 2004 (69.00) (44.73)    
Sep 24, 2004 (52.25) (42.02)    
Oct 1, 2004 25.50 (37.23)    

This week the Short-term Technical Indicator Index comes in at positive 25.50, indicating a mild market upswing is probable. 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, or the Plunge Protection Team can come in and temporarily stop market slides, so it may be unwise to trade off this weekly measured indicator.

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 (37.23).

The next two charts update analogs of the 2000 to 2004 Bear Market with Secular Bears of the past, first an average of the 1929-1936 and 1968-1975 periods in the DJIA, the second the Nikkei from 1985 through 1998. In both cases, crash scenarios remain valid as correlations continue to hold. Both analogs suggest investor psychology is ripe for a crash.

Secular (long-term) Bull and Bear Markets are confirmed whenever the 20 month moving average crosses above (Bullish) or below (Bearish) the 40 month moving average. These crossovers/ unders are infrequent and signal continuance of the primary trend for the foreseeable future. The above chart of the S&P 500 shows that about fifteen months after the Bear began, confirmation came with a cross-under. The downtrend continued another year and a half. Then the intermediate-term trend turned up in October 2002. That rally stalled in early 2004 and we've seen a sideways to down move ever since. To answer the question whether the uptrend is expected to resume and continue for another year or so, we should watch for a decisive crossover of the 20 month above the 40 month. Interestingly, today we find ourselves at a critical juncture as both moving averages sit at the same level. So we should have our answer soon. A break to the upside would point toward another strong leg up in the averages. A failure to crossover, and a decline in the 20 month MA that widens appreciably below the 40 month MA would signal the Secular Bear market since 2000 was alive and well and prices are likely to fall much further. That's the big picture at this juncture.

For clues as to whether the 20 month is likely to cross above the 40 month anytime soon, we can turn to the next two charts, the relationship between the 50 day moving average and the 200 day moving average for the S&P over the past five years, and an up close view as of now. The five year chart makes the point that crossovers and unders are rare events and extremely reliable indicators of future trend extension. There have been only three. The third occurred as recently as 8/18/04. It was a cross-under - which is Bearish. The divergence between the two moving averages has been widening and is now decisive. It is reasonable to expect the current down-trend to continue for a while and that means we should not expect the Secular Bear from 2000 to be ending any time soon.

The above chart updates the SPX/VIX ratio as of October 1st, 2004. Complacency is nearing a six-year high, a contrary indicator that warns in neon flashing lights that a major decline - a stock market crash - is imminent. How imminent? We don't know. But what we do know is that the equity market is primed for a negative surprise that should trigger panic selling. Friday's reading was 88.75, the second highest registered since 1998. The last time we saw that level, markets fell out of bed. There have been no paradigm shifts. Valuations remain excessive, fundamentals are a mess, earnings are disappointing; we have a major Dow Theory non-confirmation getting worse - with history telling us such divergences lead to crashes; analogs of past crashes fit, and the Elliott Wave count is set for impulsive wave 3 down. I take this chart very seriously. The problem with it is time-precision. It can sometimes act as an intermediate-term indicator rather than short-term.

For short-term timing, the next chart seems more precise. The 10 Day Average Call/Put Ratio warns of significant short-term trend changes whenever the indicator falls to 1.00 or rises to 1.40. At 1.00, significant market rallies unfold within a few days. At 1.40, meaningful market declines begin. Friday, October 1st's 10 day average Call/Put ratio was 1.09, in no-man's land. However, another week of rally could push this indicator closer to the 1.40 area. We will be watching this carefully for a sell signal.

The next chart is updated to incorporate the latest new high in the Trannies reached on Friday. The chart is very clear that flagrant divergences with the Industrials have led to stock market crashes each and every time over the past five years.

Since February 2004 the DJIA has bounced up and down from the upper to lower boundary of the downward sloping trend-channel, almost like clockwork - but not this time. Major lows occur on strong volume, panic selling, spike declines that often reverse the same day or the next. Intermediate declines have bottomed this year with MACD readings below -50, and actually closer to -100. These multi-week declines have also bottomed with RSI readings at oversold levels - around 30. None of these criteria occurred for the decline from September 7th, 2004 through September 27th (closing price basis). Thus we believe this decline is more significant than March's, April/May's, or July/August's, that this decline has much further to go, has good probability of breaking the lower trend-line, maybe not immediately, but before the end of October as wave iii of 3 of 1 of (3) down completes.

The next order of business for the Bear is for minuette degree wave ii up to complete. Friday's thrust higher on strong volume is typical of the personality of countertrend rallies - strong and fast. A 61.8 percent retrace of i would take the DJIA to 10,216. A Fibonacci .786 retrace would take prices to 10,280. The Bullish alternate count is that if prices exceed September 7th's 10,363.36 level, and bust up through the upper boundary of the downward sloping trend-channel, then the entire move down from February 11th through August 13th (intraday) is minor degree wave 4 down of intermediate degree wave C up of primary degree wave (2) up from the October 9th, 2002 low. The move up from August 13th would then be the start of the final leg-minor degree wave 5 of C of (2), likely a short wave (or truncated) since wave 3 extended, and 5's top would mark the beginning of a massive decline.

Rising Bearish Wedge Termination Pattern in the Dow Transports

Another reason we remain Bearish equities is because according to Dow Theory, one of two things must occur: either the Industrials are about to rise above their February 2004 highs and confirm the Transports new high Friday, or the Trannies are about to dive along with the Industrials, with each confirming lower lows. But they will get back into sync. Of the two possibilities, we favor the Trannies declining to join the Industrials. The above chart (courtesy of shows a Rising Bearish Wedge - a termination pattern often seen at the end of strong, lengthy runups. What is occurring to create the Rising Bearish Wedge is that demand is being met by more and more supply the higher that prices move.

Robert Prechter describes the above pattern in his outstanding book, Elliott Wave Principle, Frost and Prechter, New Classics Library, 2001 (available at as an Ending Diagonal Triangle. He notes that these patterns often end with a smaller degree 5th wave (v above) inside the Diagonal Triangle spiking above the upper boundary line - a "throwover." This final spike usually occurs on high volume. He states on page 39, "A rising diagonal is bearish and is usually followed by a sharp decline retracing at least back to the level where it began."

The MACD is curling higher and the RSI is not overbought. This portends more upside short-term, likely the "throwover" Prechter describes. A sign that this rally is nearing completion, of a subsequent reversal, is that prices have reached the top Bollinger Band, a place where sell-offs are born.

The Economy:

According to Redbook Research, U.S. Chain Store Sales rose 2.9 percent from a year earlier - but declined 0.3 percent from the prior week, for the last week of September. The U.S. Census Bureau reported that New Home Sales were 9.4 percent higher in August than in July. I wonder how much downsizing is going on?

The news breaks down from here. The Economic Cycle Research Institute's Index of Leading Economic Indicators fell again last week. The Commerce Department reported that Consumer Spending was flat in August versus July. Big ticket items such as appliances took a hit.

The Labor Department announced worsening employment conditions. Initial Jobless Claims rose to 369,000 for the week ended September 25th. Over 2.8 million good folks are receiving unemployment checks. Millions more no longer qualify, as their benefits have dried up, yet they remain unemployed or underemployed. But this administration did a yeoman's job eliminating taxes on dividend checks, so why be concerned about employment?

Merck crashed after yanking its arthritis drug due to dangerous side effects. Merck's stock (MRK) lost 24.5 percent for the week, closing at $33.31. And finally Oil closed above $50 per barrel. Hooray for Texas oilmen! Hooray for Arabian sheiks!

Consumer Confidence fell to 96.8 in September from 98.7 in August according to the Conference Board.

Money Supply, the Dollar, & Gold:

M-3 exploded higher, up $44.1 billion on a seasonally adjusted basis for the latest week reported, September 20th. Could this be the commencement of a "get Dubya elected" campaign from the Master Planners? One week does not make a trend, but this bears watching. Liquidity has proven in the past to be the tide that "lifts all boats." Since June 28th, M-3 is up only 9.3 billion, a four-tenths of one percent annualized increase. Our research shows that whenever M-3 rises for two months, equities rise. Conversely, whenever M-3 plateaus or declines, equities decline.

The trade-weighted U.S. Dollar looks like it is ready to fall. Prices finally broke from the vertex of a Symmetrical Triangle this week - as expected to the south. Symmetrical Triangles are continuation patterns and are considered Bullish in uptrends and Bearish in downtrends. The probability is high that breakouts will be in the same direction as the prior trend - in the current case down. Often what follows is an even stronger move in the same direction as the prior trend. What is happening here is buyers are not able to push prices into a new trend. As sellers see this weakness, they gain confidence that the past trend will resume, forcing a breakout to the downside.

The Dollar sits at the top boundary of its long-term falling trend-channel, and declined this week to the neckline of its potential Head & Shoulders Top pattern identified in prior weeks' issues (see archives at

Once prices break below 87, the small Head & Shoulders Top will be confirmed with a decline to the low 80s expected. Should price action defy the odds, a decisive break above 91 would be Bullish.

But the Elliott Wave count we believe to be most accurate at this time for the Dollar shows that prices have further to fall. Intermediate degree waves (1) down, (2) up, (3) down, and (4) up of a fivewave primary trend decline are complete. Where we are now is the start of minor degree wave 3 down of intermediate degree wave (5) down of primary degree wave 1 down. The trend-channel and this count suggests prices could fall even further than the Head & Shoulders pattern targets, possibly as low as the mid to high 70s. But it could take a while. The MACD is negative as momentum is to the downside. The RSI is not oversold.

Gold is at a critical juncture. It has retraced a Fibonacci .786 of the decline from the second peak of the March 2004 Double Top. Any further rise from here would signal that the Double Top pattern is irrelevant to Gold's Bullish long-term ambitions. However, prices have reached the upper boundary of Gold's short-term rising trend-channel at the same time its RSI indicator has reached overbought levels, the same place where prior tops - short-term or intermediate-term - have occurred. So there is a good probability that Gold will correct from here, at least to the lower boundary of its long-term rising trend-channel. The MACD would argue that Gold may rise further as short-term momentum remains up. Long-term we continue to believe that Gold will run much higher, that some astute nation will back its fiat currency with the metal (China?), and that world demand will increase sharply as other currencies are forced to follow.

The Mining Stocks ($HUI) have retraced just shy of a Fibonacci .786 of the decline from January 2004's grand top to May's bottom, minor degree wave 1 down. Prices have traced out a nice a-b-c corrective minor degree wave 2 rally, with a classic minuette degree subwave i up, ii down, iii up, iv, down and v up sequence for minor wave c up. Per the textbook for wave 2 terminations, the fifth wave of the c wave has traced out a terminating diagonal triangle (a rising Bearish Wedge) that looks to be complete - or very nearly so. The RSI is at an extreme overbought reading, implying the HUI has started its intermediate degree wave 3 down of primary degree (1) down. While momentum as measured by the MACD is still up, its slope is flat, indicating the rally is about out of gas. A multimonth decline should begin soon. A rally above 258 means the grand Bull market is not over, negating the above Elliott Wave count, and prices could go much higher. We don't expect that to happen at this time.

Bonds & Interest Rates:

Bonds took the hint from the Federal Reserve that interest rates are headed higher. A decline decisively below 100 would confirm an ominous long-term Bearish Head & Shoulders Top in 30 Year U.S. Treasury Bonds. Should this occur, the minimum downside target is 82. The rally since July 2003 has retraced within one point of .786 of the move down from the Head. The Elliott Wave count shows that intermediate degree waves 1 down and 2 up have completed and wave 3 down is now underway. The MACD is rolling over and the RSI has retreated from overbought levels. An equity event could rally Bonds, counting as a corrective minor wave 2 inside 3 down.

Bottom Line:

The first day of each month and each quarter seems to bring a sense of optimism - new opportunities, hope for greater earnings, pension and social security checks in the mail, portfolio rebalancing - putting new money to work. The rally Friday is a Bear trap. Optimism will fade as a surprise selloff occurs. The question is, can Dubya's alert team delay the carnage until after November? Will the Fed open wide the liquidity spigots, quid pro quo? Regardless, the economy is weakening, the deficits are horrendous, Iraq is a black hole sucking blood and money from our nation, interest rates are on the rise, and the charts are warning all is not well with the world. Caution is warranted.

"For the eyes of the Lord move to and fro throughout
the earth that He may strongly support those
whose heart is completely His."

2 Chronicles 16:9

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Key Economic Statistics
Date VIX Mar. U.S. $ Euro CRB Gold Silver Crude Oil 1 Week Avg. M-3
4/30/04 16.69 90.76 119.70 270.75 387.5 6.07 37.38 9171.5 b
5/07/04 18.13 91.30 118.83 270.40 379.1 5.58 39.93 9230.2 b
5/14/04 18.47 91.81 118.69 267.00 377.1 5.72 41.38 9232.3 b
5/21/04 18.44 90.53 120.05 268.75 384.9 5.87 39.93 9278.0 b
5/28/04 15.52 88.98 122.10 276.25 394.0 6.11 39.88 9251.6 b
6/04/04 16.57 88.50 122.93 274.75 391.7 5.81 38.49 9255.6 b
6/11/04 15.10 89.23 121.01 269.25 386.6 5.78 38.45 9265.9 b
6/18/04 14.95 89.41 121.17 267.75 395.7 5.98 39.00 9305.7 b
6/25/04 15.19 89.22 121.41 270.75 403.2 6.12 37.55 9296.2 b
7/02/04 15.15 88.18 123.09 265.50 398.7 6.01 38.39 9327.7 b
7/09/04 15.78 87.41 124.10 269.00 407.0 6.46 39.96 9244.0 b
7/16/04 14.43 87.12 124.36 271.50 406.8 6.72 41.25 9239.4 b
7/23/04 16.50 89.23 120.88 269.50 390.5 6.33 41.71 9260.5 b
7/30/04 15.27 90.12 120.10 267.00 391.7 6.56 43.80 9273.0 b
8/06/04 19.34 88.45 122.69 268.25 399.8 6.77 43.95 9266.9 b
8/13/04 17.98 87.97 123.68 269.19 401.2 6.62 46.58 9248.9 b
8/20/04 16.00 88.22 123.03 279.50 415.5 6.87 46.72 9260.3 b
8/27/04 14.74 89.80 120.20 275.00 405.4 6.58 43.18 9296.9 b
9/03/04 14.28 89.56 120.66 275.25 402.5 6.59 43.99 9286.6 b
9/10/04 13.75 88.60 122.61 272.50 403.8 6.16 42.81 9278.7 b
9/17/04 14.03 88.10 121.76 275.75 407.6 6.28 45.59 9273.5 b
9/24/04 14.28 88.59 122.57 278.50 409.7 6.42 48.08 9317.6 b
10/01/04 12.75 87.77 124.07 284.75 421.2 6.94 50.12 -

Note: VIX dives to a new low, Dollar is down, everything else is up.


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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