Financial Markets Forecast and Analysis

By: Robert McHugh | Sun, Oct 24, 2004
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Summary of Index Daily Closings for Week Ending October 22, 2004

Date DJIA Transports S&P NASDAQ Jun 30 Yr Treas
Oct 18 9956.32 3382.71 1114.02 1936.52 113^03
Oct 19 9897.62 3345.34 1103.23 1922.90 113^12
Oct 20 9886.93 3386.74 1103.66 1932.97 113^31
Oct 21 9865.76 3430.49 1106.49 1953.62 114^01
Oct 22 9757.81 3371.94 1095.74 1915.14 114^06

(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 down 175.57, in line with last week's Short-term TII reading of negative (24.50). Despite the Trannies hitting a new high for their rally since March 2003 on Thursday - another divergence between the Industrials and Trannies fresh anew - they sold off hard on Friday. While the hedge funds and speculators search for something to send into a mania, hoping for a greater fool to take them out before inevitable collapse, approaching this market as if a zero sum game, the NASDAQ - still down over 60 percent since its high - taught us, this too shall pass.

The Industrials hit an intraday low on Friday 1000 points below their high for the year on February 19th, 2004, and are now down 6.7 percent for 2004. Today, October 22nd, 2004, was our Fibonacci phi mate turn date we've been targeting for months now, so today may represent a bottom - likely a minor bottom. Then again, we continue to see a cluster of Fibonacci trading days coming in from now until November 1st, so if this decline wants to run further, it can. We have reached an oversold level here, with the DJIA approaching the lower boundary of its declining trend-channel that began in February; thus it would make sense for a minor bounce to occur from here and last through the election. However, a decisive break below this lower boundary line would warn that a stock market crash may be unfolding.

Equities Markets Technical Indicator Index (TII) ™    
Week Ended Short Term Index Intermediate Term Index    
June 25, 2004 (34.00) (26.10)   Scale
July 2, 2004 (41.50) (27.64)    
July 9, 2004 (32.50) (30.21)   (100) to +100
July 16, 2004 (33.75) (41.99)    
July 23, 2004 (59.00) (49.98)   (Negative)  Bearish
July 30, 2004 46.25 (52.18)   Positive  Bullish
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)    
Oct 8, 2004 (58.50) (35.56)    
Oct 15, 2004 (24.50) (35.48)    
Oct 22, 2004 (15.00) (36.93)    

This week the Short-term Technical Indicator Index comes in at negative (15.00), indicating a market decline is probable, but there could be some rally days as well. 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 (36.93).

The charts on the next page update Analogs we have been tracking with the Dow Industrials. The first one compares the price movement in 2004 versus 1987. Here we see a remarkably similar pattern. - almost day for day. Prices have reached the period where in 1987 the infamous crash occurred. But 1987 was not an election year, so it shouldn't surprise if this Analog diverges for a few weeks until the political uncertainties resolve.

The second Analog compares the Dow Industrial's 2000 to 2004 Beat market with Japan's Nikkei from its 1996 to 2004 Bear market. The results are similar. Again, at this juncture, the Nikkei fell 36.1 percent after a pattern of remarkable correlation.

So if both Analogs are to hold up, the Dow Industrial's must soon decline sharply. Analogs work because they capture the mass human psychology of fear and greed that affects prices based upon prior patterns of price behavior. But also, at some point all analogs break apart.

In our continued pursuit for charts and indicators that will clue us into the future direction of markets, the two charts on the prior page analyze the Dow Industrials in relation to their 200 Day Moving Average over the Bear market from 2000 to 2004 and over the Bull market period 1995 through 1999. This ratio has been fairly reliable at pointing out major - not short-term - turns.

During the past four years extreme oversold conditions have occurred whenever the ratio of the DJIA to the 200 Day Moving Average fell below 0.85, while extreme overbought conditions have occurred whenever this ratio rose to 1.00 or higher. The value in this ratio is to help identify when we may be at major bottoms or tops.

During the period from 1996 through 1999, during Bull market conditions, the oversold/ overbought extremes were measured from a higher pair of ratios. In other words the parameters shifted 0.15 lower during the Bear market than during the Bull market. From 1995 through 1999, whenever the DJIA to its 200 Day Moving Average ratio rose to 1.15 or above, an extreme overbought position was reached and a downturn followed. And whenever the ratio fell below 1.00, an oversold condition was evident and a resumption of the rally ensued.

If we move back into a Bull trend, it would be reasonable to expect a paradigm shift up in these overbought/oversold extreme readings to 1.15 and 1.00 again. As a note, under the assumption we remain thick in a Bear market, this indicator is telling us we are not at an extreme intermediate-term oversold position at this time, and thus a crash is possible.

The preceding chart compares the Dow Industrials with the 10 Day Average Call/Put Ratio. It measures sentiment and is helpful for contrary investing. The theory here is that when the majority is pulling in one direction, the majority is wrong and therefore a trend reversal is near. Our parameters for measuring extreme sentiment readings here are if the 10 Day Average Call/Put ratio approaches 1.40, sentiment is too positive and a significant decline is imminent. On the other hand, should this ratio approach 1.00, then sentiment is too negative and a significant rally is nearby. October 22nd's reading comes in at 1.13 - neutral - meaning we are not at an extreme and either the current downtrend has further to run, or a minor move up - corrective - is possible. But no major bottom or top is at hand. What was odd this week was that the ratio rose during a week that prices fell sharply. That is far too much optimism for a significant bottom. The daily Call/Put ratio was quite high the past five days. That means this indicator could move rapidly toward our 1.40 "Top" indicator.

The chart below also measures sentiment and provides contrary investors with a gauge as to when they might expect a major trend change. What is interesting here is that in spite of the 1000 point decline in the Dow Industrials since February 2004, sentiment from options writers remains complacent - positive - and thus we are very unlikely to see a huge Bull run up start from here. Readings below 35.00 indicate major bottoms. On October 22nd, we sit at a 71.71 reading - which just so happens to remain in the extreme over-optimistic area conducive to stock market crashes in the over the past six years. We define a crash as a decline of over 15 percent.

It is hard to dismiss the value of this analysis when the correlation is so strong, and it has been so useful in identifying the highest risk events for stocks - crashes - time and time again.

The Bullish argument has been that we started a Primary degree Bull market - some even say it is a longer term Secular Bull market - in October 2002, that the Bear ended then and the slowdown was relatively mild. Sorry, that is simply a work of fiction.

Here are the facts: The Dow Industrials started their resumption of the Bear Market in February with a ten month down-trend channel with a series of lower highs and lower lows, the latest lower low recorded today at 9753.02 intraday, close at 9757.81. The last minor degree wave 5 up was a truncated 5th - a terminal, a failure to make a higher high - on June 23rd, the Fibonacci phi mate of the low on October 9th, 2002. Perfect order. Since then, the trend has continued lower, validating the Bearish case. The minor degree down moves have come in five-wave (impulsive) counts and the up moves have come in three-wave counts (thus countertrend). If we were in a Bull market, this downtrend should have failed by now - it has not. And Bulls, no matter what other indices are doing, you are not going to see an equity advance worth investing in long-term that does not include the largest cap Blue Chips on the planet. To think otherwise is pure delusion, plain and simple. To the Bulls, I submit, something is seriously wrong with the advance from October 2002. That is exactly what the Dow Theory is saying at this time.

The short-term Elliott Wave count shows we may have hit a minuette degree wave iii down today, but it would count complete better with one more minor up-down move Monday or Tuesday.

That puts us at a bottom either today - our latest phi turn date, October 22nd, 2004 (see last weekend's newsletter no. 91 in the archives at or early next week within our trading day Fibonacci cluster from 10/25/04 to 11/01/04. The RSI is at oversold levels and the MACD is approaching levels where prior bottoms occurred. The next rally should be insignificant and short-lived - a minuette degree wave iv that could possibly take us through election day. Following that should be a minuette degree wave v to complete minor degree wave 3 of 1 of (3).

However, something else could be happening here of major significance. The equity markets, being led by the Dow Industrials, could be crashing. If so, we should see sharp selling accelerate sometime over the next two weeks - probably after a manipulated floor put on between now and the election is lifted, in early November. If that happens, then the minuette degree count we have labeled for the decline since September 7th (another of our Fibonacci phi turn dates) may in fact be a micro degree move inside a minuette degree. This would allow for a far more severe decline. Our next Fibonacci turn date is November 17th and it is possible that both October 22nd and November 17th would be bottoms inside a crash, with a minor retracement top occurring sometime in-between. This scenario is important because now may not be the time to go long just because it appears a Fibonacci phi turn date arrived as a bottom. A signal that the Industrials are headed for deep trouble would be if they decisively violated their declining trend-channel's lower boundary, falling below 9650. That should trigger panic selling, a flagrant Bearish breakdown from an orderly decline.

The Trannies hit their highest level in five years Thursday, and were very close to their all-time high. But they sold off hard on Friday and because the Industrials hit another new lower low while the Trannies hit a higher high, we have another in a long series of Dow Theory non-confirmations between the Industrials and the Transports. It is getting ugly. This sort of non-confirmation action means something is seriously wrong with the markets. While Dow Theory does not claim this sort of nonconfirmation action portends a decline - it simply says the rally of the Transports and the decline of the Industrials cannot be trusted - our study of such divergences over the past five years shows that in each instance, a stock market crash followed within months.

There are those who believe that the Dow Theory is suddenly dead because of this latest divergence, that the Transports no longer need to move in harmony with the Industrials because they now are busy transporting imported products no longer manufactured in the United States. Bunk. The airline component of the Transports is not making money and the PE for the Trannie index is ridiculous - over 90x. Does anyone really believe that the transporting of imported goods can sustain our economy?

Look at the chart below (courtesy of Both the pattern and the Elliott Wave count tell of a significant top. If so, then the odds favor the Trannies joining the Industrials in further decline, harmony being reached with confirmed lower lows. Friday's price action may have been the start of that convergence. How do we know the Trannies have - or are days away - from completing a significant top, from completing their wave 5 of a larger degree C? Because not only have they traced out a terminating Rising Bearish Wedge 5th wave of C, but inside that 5th, a lower degree 5th (i.e. "v") wave has also traced out another terminating Rising Bearish Wedge pattern. Both patterns look complete, with a common "throw-over" in process of wrapping up as well. These patterns are also known as Ending Diagonal Triangles in Elliott Wave parlance. The MACD is overbought. The RSI has broken down from extreme overbought levels, ripe for a decline.

A clue that the lows we are seeing in the Industrials is a minor low, not a significant low, is the price action in the S&P 500. These two indices should move in harmony as well, and we can see from the above chart that the S&P 500 is nowhere near the bottom of its Broadening Top pattern. Today's decline finally took the S&P below the prior low of 1,101 recorded on September 28th. So the series of lower lows remains intact. However, the wave count is nowhere near complete, and in fact is behind the leadership of the Dow Industrials. The above chart is suggesting a decline to at least 1040 before the next significant rally unfolds. Here's why:

1) A small Bearish Head & Shoulders Top has formed that has been confirmed with Friday's decline below the neckline, below 1,100. The minimum downside target being given by this pattern is 1048.

2) The Megaphone pattern's lower trend-line falls toward 1040 about the time we would expect prices to arrive there.

3) The Elliott Wave count we believe is most accurate - which is similar to the DJIA's, but not as far along - suggests much further decline since we are only finishing up a minuette degree wave i down, with a ii-up, iii-down, iv-up, and v-down remaining - plenty of wave action to move prices sharply lower.

The RSI is not at oversold levels seen at prior significant bottoms, but could rise a bit from here as a small corrective move unfolds. Same for the MACD. Any curl up would likely be a Bear Hook, a sucker play aimed to lure in the longs before breaking hard down again. This has played out many times in the past.

The Economy:

We learned that Mortgage Applications jumped - courtesy the rally in Bonds - according to the Mortgage Bankers Association, up 7.9 percent for the week ended October 15th. Housing Starts fell in September according to the Census Bureau, down 6 percent from August. Building Permits were up.

The Conference Board reported that its Index of Leading Economic Indicators for the U.S. fell for the fourth month in a row, down another 0.1 percent in September. It fell 0.3 percent in August, 0.3 percent in July, and 0.2 percent in June 2004. It hasn't fallen four months in a row since before 1996. There were clusters of declining months in 2002 and in 2000, but they both snuck a flat month inbetween decliners. If you count a five month period, and go back eight years, the only time we've had four decliners out of five was in 2000, the kickoff to the Bear market. Not good.

The Consumer Price Index came in low again, assuring Social Security beneficiaries a pauper's cost of living raise. The Labor Department, up for the Allegiance Award in Dubya's administration, reported that prices only rose 0.2 percent. They calculated that energy prices fell in September for the third month in a row #$%^&*(!@#, down 0.4 percent in September, helping keep consumer prices down. Crude is over $55 today as I write this missive and was under $30 a barrel a year ago. Duh, okay.

Alan Greenspan assured markets this week that Consumer Debt loads are just fine and dandy - so long as incomes and house values don't drop. Phew, that's a relief.

According to Challenger, Gray & Christmas, job cuts in the technology sector rose over 60 percent during the summer 2004, and the trend remains up. But the Labor Department came through with a much different picture, reporting that Jobless Claims fell seven percent last week, down 25,000. So isn't that great news, everyone is going back to work - and just in time for the election too. If Dubya gets reelected there will be three things we can count on: Death, taxes, and the enthusiastic reappointment of Labor Secretary Chao.

And a sad note: a once great company continues to disintegrate before our very eyes, AT&T reporting a $7.1 billion third quarter 2004 loss. Maybe it's part of a long-term strategy to report higher year-over-year earnings this time next year.

Money Supply, the Dollar, & Gold:

M-3 fell 35.4 billion last week, and hasn't budged since July 19th - three months ago. Our research shows whenever M-3 rises for two or more months, equities rise, and whenever M-3 declines or plateaus for two or more months, equities decline. Thus, M-3's lack of growth supports our intermediate- term view of an equity market decline.

We've been expecting the Dollar to break below both its Symmetrical Triangle pattern and the neckline of its Head & Shoulders Top pattern for a while, and this week it finally did. The tradeweighted U.S. Dollar fell sharply to close the week at 85.77. This decisive move south confirms the Head & Shoulders pattern as complete, increasing the probability that the minimum downside target for this highly reliable pattern will be met, which is 82.00.

The Elliott Wave count we've believed to be most accurate for the Dollar pointed toward this week's decline, and shows that prices have further to fall. Intermediate degree waves 1 down, 2 up, 3 down, and 4 up of a five-wave primary trend decline are in the books. Where we are now is the middle 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 suggests, possibly as low as the mid to high 70s. But it could take a while. The MACD is negative with momentum down hard. The RSI is oversold, but not at the level seen last January, thus could go lower before a corrective bounce pushes it higher. And the 50 Day MA crossed below the 200 Day.

Here's the problem. A falling U.S. Dollar puts the greenback at risk of losing its world reserve status. Further, a declining Dollar means foreign holders of financial assets such as stocks and bonds see their value fall on a currency exchange basis. It could put fear into foreign holders, enough to make them pare back their holdings, or heaven forbid, dump. This is what record trade and budget deficits accomplish. This is what exportation of our manufacturing base causes. But this is glorious for Gold.

Gold has retraced more than a normal Fibonacci .786 of the move down from April through May 2004, and seems ready to challenge the Double Top. A decisive break above 425 would be Bullish. The MACD refuses to roll over and the RSI is heading back up toward overbought levels. If prices can remain above 370, Gold remains Bullish. If prices can remain above the bottom trend-line, above 392, Gold would look strong. A push above 433 would negate the Bearish Double Top pattern with an all-clear signal for higher prices. The long-term trend is up.

Here's the deal with the HUI. It is in a long-term Bullish trend. The question is, where does it stand in the intermediate trend? The Elliott Wave count is ambiguous and can be interpreted three different ways. Two weeks ago we stated, "For the above count to be accurate, prices would have to decline immediately as they have retraced .786 of the move down from December 2003." They did. Any decisive move above 237 would mean one of the two other counts are in play. If the above count is correct, wave C down of corrective wave 2 down would likely take prices to a .786 retrace of Intermediate degree wave 1 up - to 138ish.

Should prices move decisively higher, a second possibility is that where we have labeled Minor degree wave A would in reality be Minor degree wave 4 of the rally from October 2002. That would mean we are rallying inside Minor degree wave 5 up, completing Intermediate 1 up. That would likely complete over the next two months, to be followed by a huge decline - corrective Intermediate degree wave 2 down, lasting half of 2005.

A third possibility is that should prices rise decisively from here, corrective Intermediate degree wave 2 completed where we labeled wave A down, and we are off to the races for a wondrous Intermediate degree wave 3 up to the stratosphere. Given the overbought conditions, this is the least likely scenario in our view.

Bonds and Interest rates:

The 30 Year U.S. Treasury Bond may have formed a Double Top to complete minor degree wave c of intermediate degree 2 up. That would be the top count for the most immediate Bearish case. However, wave c of 2 may want to extend - and can do so as long as it does not exceed 120. The ideal Bearish scenario is for prices to immediately decline from here as they have already retraced a Fibonacci .786 of intermediate degree wave 1 down. The RSI is moving back up again, re-approaching overbought levels. The MACD has curled up after declining hard last week, so in sum, Bonds appear a bit like a Hurricane, able to proceed against the upper atmospheric winds and go wherever they choose.

Should equities decline sharply, we would expect an initial flight to quality. But the intermediate fate of Bonds could change, and prices fall, should the Master Planners flood markets with liquidity, and refuel inflation fears. That might take a few months. But for the moment, it appears the Bond market senses deflation - perhaps a recession.

The massive Head & Shoulders pattern above has not yet been confirmed. It would take a decline decisively below 101.5 to achieve that, in which case the probability of a decline to the low 80s would then become quite high.

Back to the Dow Jones Industrials for a Moment:

We mentioned before that the DJIA has declined 1000 points from their 2004 highs back in February. If you go to page 2, take a look at our Intermediate-term Technical Indicator Index readings for the past several months. Further, if you go to our archives at, you can review these Intermediate-term TII readings for all of 2004. What you'll see is that this indicator has been perpetually negative. Why? Because - unlike our short-term indicator - it picks up the longer-term trend. It has been saying for a year now that stocks are far more likely to trend down than up. The level of the readings have been warning that equities would find themselves substantially lower longer-term, giving investors a guide for the primary trend. Our Short-term TII picks up the bounces inside the primary trend. We hope you'll find this helpful.

Bottom Line:

Fundamentals are frightening - unfunded liabilities that threaten the existence of Social Security and Medicare, huge Federal budget deficit, huge trade deficit, declining consumer confidence, phony unemployment numbers failing to tell the real story of underemployment, spiraling health care insurance costs, declining leading economic indicators, corporate earnings warnings, exportation of manufacturing, excessive consumer debt, bubbles in financial and real estate assets, record-setting oil prices, the Iraq mess - and the technical picture is even worse. Caution is warranted.

"The prudent see danger and take refuge;
but the simple keep going and suffer for it."
Proverbs 27:12 (NIV)

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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 9273.9 b
7/16/04 14.43 87.12 124.36 271.50 406.8 6.72 41.25 9238.8 b
7/23/04 16.50 89.23 120.88 269.50 390.5 6.33 41.71 9261.2 b
7/30/04 15.27 90.12 120.10 267.00 391.7 6.56 43.80 9273.9 b
8/06/04 19.34 88.45 122.69 268.25 399.8 6.77 43.95 9267.9 b
8/13/04 17.98 87.97 123.68 269.19 401.2 6.62 46.58 9250.2 b
8/20/04 16.00 88.22 123.03 279.50 415.5 6.87 46.72 9261.9 b
8/27/04 14.74 89.80 120.20 275.00 405.4 6.58 43.18 9298.6 b
9/03/04 14.28 89.56 120.66 275.25 402.5 6.59 43.99 9288.7 b
9/10/04 13.75 88.60 122.61 272.50 403.8 6.16 42.81 9281.1 b
9/17/04 14.03 88.10 121.76 275.75 407.6 6.28 45.59 9275.7 b
9/24/04 14.28 88.59 122.57 278.50 409.7 6.42 48.08 9320.7 b
10/01/04 12.75 87.77 124.07 284.75 421.2 6.94 50.12 9336.6 b
10/08/04 15.08 87.55 124.13 287.60 424.5 7.29 53.31 9296.3 b
10/15/04 15.04 87.20 124.73 286.45 420.1 7.11 54.93 9260.9 b
10/22/04 15.28 85.97 126.46 287.00 425.6 7.33 55.17 -

Note: VIX complacent, Dollar Plunges, Gold & Silver up, Oil sets a Record High


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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