Financial Markets Forecast and Analysis

By: Robert McHugh | Sun, Jan 9, 2005
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Summary of Index Daily Closings for Week Ending January 7, 2005

Date DJIA Transports S&P NASDAQ Jun 30 Yr Treas
Jan 3 10729.43 3760.37 1202.08 2152.19 112^17
Jan 4 10630.78 3678.33 1187.99 2107.86 111^25
Jan 5 10597.83 3653.29 1183.72 2091.24 112^02
Jan 6 10622.88 3667.12 1187.89 2090.00 112^03
Jan 7 10603.96 3636.78 1186.19 2088.61 112^03

(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 High      

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This week the Dow Jones Industrial Average closed down 179.05 points, realizing the risks noted from early December's Short-term TII readings now that the post election and Santa rallies are history. Every day so far in 2005, markets start out strong and end up down by the close - or in the case of Thursday, up but lower than at the open. The number of 52 week new highs has deteriorated from over 450 in early December to 58 Friday, January 7th, a momentum change. Volume has been up on down days and there is a Rounded Bearish Top in the Dow Industrials over the past month - both signs of distribution where those in-the-know quietly sell stock to those willing to pay too much at the wrong time.

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Equities Markets Technical Indicator Index (TII) ™    
Week Ended Short Term Index Intermediate Term Index    
Sep 3, 2004 (39.25) (40.06)   Scale
Sep 10, 2004 (49.25) (45.78)    
Sep 17, 2004 (69.00) (44.73)   (100) to +100
Sep 24, 2004 (52.25) (42.02)    
Oct 1, 2004 25.50 (37.23)   (Negative)  Bearish
Oct 8, 2004 (58.50) (35.56)   Positive  Bullish
Oct 15, 2004 (24.50) (35.48)    
Oct 22, 2004 (15.00) (36.93)    
Oct 29, 2004 39.50 (40.06)    
Nov 5, 2004 5.50 (35.28)    
Nov 12, 2004 (6.50) (27.63)    
Nov 19, 2004 (50.00) (23.18)    
Nov 26, 2004 (54.25) (26.88)    
Dec 3, 2004 (56.25) (30.50)    
Dec 10, 2004 (88.25) (42.42)    
Dec 17, 2004 (37.00) (44.25)    
Dec 22, 2004 26.25 (46.17)    
Jan 7, 2004 (13.50) (37.75)    

This week the Short-term Technical Indicator Index comes in at negative (13.50), indicating a sideways to declining move is probable, with a small turn up thereafter. 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 (37.75), intermediate-term risks mitigated somewhat by the dramatic rise in M-3.

The Dow Industrials finished the year 2003 at 10,453.92. A year and one week later, the Dow has managed to grow by exactly 150 points, a whopping 1.43 percent. During that same time period, the money supply as measured by M-3 grew by 7.6 percent, so the DJIA didn't even come close to keeping pace with monetary inflation. And it took a monster year-end rally from October 25th's 9749.99 to even get that far. This is not Bull market action. We remain in a primary Bear market from 2000 under Dow Theory, although the Elliott Wave count we believe to be most accurate will reflect that the worst by far is yet to come, in fact hasn't even really begun. PE ratios remain some of the highest in the history of the stock market, levels as high as seen at every single secular Bear market except the 2000 to 2002 decline, hardly the position to launch the next great equity climb to wealth and riches.

If you are an expert on Elliott Wave, you might want to fast forward to the chart on page 5 while we go over some history, philosophy and basics of EW on pages 3 and 4 for our newest subscribers.

One of the technical tools we use at is Elliott Wave analysis. Its founder, Ralph N. Elliott, was an accountant by trade, who in the 1930's noted that stock market prices form repetitive patterns he called waves. He became quite ill and took that bedridden opportunity to study the Dow Jones averages since 1896, the results of which he originated as the Elliott Wave Principles. His body of work was expanded upon through the years by such noted technical analysts as A. Hamilton Bolton of the Bank Credit Analyst, A.J. Frost, Richard Russell, Robert Prechter, Glenn Neely, and Zoran Gayer.

Elliott Wave is a measure of mass human activity as applied most commonly to the financial markets - although evidence is being gathered by Robert R. Prechter, Jr. that the principle applies to socio patterns as well (see his book The Wave Principle of Human Social Behavior and the New Science of Socionomics, New Classics Library, 1999). Elliott Wave confirms what God said through the writer of Ecclesiastes, "That which has been is that which will be, and that which has been done is that which will be done." The issue here is one of cycles, that all of nature repeats itself, which is especially true of the markets. These repetitive patterns can be recognized, and to some degree of success, anticipated.

In a gross oversimplification, in a nutshell Elliott Wave analysis goes like this: Markets reflect all information, and all knowledge available to man. They have a language of their own, and communicate where they are going next. Elliott Wave is one of many languages the markets use to tell us where they are headed next. Market moves are not reactive to news announcements, but rather independent of news. News comes as a result of the position of the Elliott Waves - the psychological state of man at that particular time. How news is interpreted depends upon the wave. If the wave formation indicates a Bullish move in progress, then bad news will be ignored or reacted to in a positive way, i.e.., markets will go up anyway. And, if the wave pattern is Bearish, then good news will be ignored or reacted to negatively - markets will sell off. Thus, it is helpful to investors if they are aware of the Elliott Wave position markets find themselves in, and which wave pattern is next expected to arrive.

Again, oversimplifying, and using the stock market as an example, in Elliott Wave analysis equity prices move up or down with the primary trend impulsively. These impulsive (dramatic) moves come in stair-step fashion, five waves at a time. Waves 1, 3, and 5 progress and waves 2 and 4 regress (or correct). The total move in the direction of the primary trend progresses because the sum of waves 1, 3, and 5 exceeds the sum of waves 2 and 4. Waves 1, 3, and 5 move in the direction of the primary trend, while waves 2 and 4 can either move in the opposite direction or sideways.

There are five-wave counts at a smaller degree inside each of waves 1, 3, and 5. There are threewave counts at smaller degree inside each wave 2 and 4. The five-wave counts are marked by numbers, 1 through 5. The three-wave counts are marked by letters, A-B-C. Inside the subwaves A and C are five-wave waves of even smaller degree. Inside the B wave is a subwave set of three waves. To recap, waves 1, 3, 5, A, and C are themselves made up of five-wave lower degree waves. Waves 2, 4, and B are built from smaller degree three-wave patterns. Waves 1, 3, 5, A, and C, push the direction of prices forward and waves 2, 4, and B correct or reverse the progress of the other waves.

Degrees of waves are distinguished based upon the time period they cover. Very long-term degrees of waves could cover hundreds of years, such as the Grand Supercycle degree. Very short-term degrees of waves might only cover a few weeks, or days. Elliott Waves can even be broken down and identified intraday by hour or minute.

There are certain rules that must not be violated for an accurate Elliott Wave count. There are three cardinal rules: 1) Wave 2, when it corrects wave 1, may never move prices beyond the starting point of wave 1. 2) Wave 3 may never be the shortest wave. 3) Wave 4 must never enter the price territory of the same degree wave 1. If any of these rules are violated, then the Elliott Wave count is wrong.

In addition to rules, what is extremely helpful is knowing the different personalities of each wave. Knowing personalities typical to each wave can sometimes clue us as to where we are in the count when it otherwise is unclear. I'll cover just a few that I've noticed. 1) Wave 3's are usually (not always) the most dramatic, most powerful, and extend the furthest. Usually. They usually show panic buying or selling where you see prices move almost vertical. Or, if prices move over long periods of time without corrections, oftentimes it means we are in a wave three of some degree. It might be a wave three inside a higher degree wave 1, 3, 5, A, or C. 2) Ending Diagonal patterns (Rising Bearish or Declining Bullish Wedges are often seen in wave 5's. 3) Wave twos often reverse so sharply, and so much of the previous wave 1's move, that it confuses the Elliottician as to whether in fact the trend has really changed or not. Retracements of as much as 61.8 percent or 78.6 percent are not uncommon in wave twos. 4) Wave fours are often lackluster, more sideways or choppy than twos (not always). Often they will form triangle patterns. Wave B's are often similar to fours. 5) When wave three's extend, oftentimes waves one and five will tend to equality or some Fibonacci ratio of each other that lends a sense of proportionality to the wave pattern such that waves one and five look somewhat similar. 6) If wave 2 retraced (zigzagged) a measurable percentage of wave 1 - was not sideways - then wave four will likely be more of a flat or sideways move and vice versa (the principle of alteration).

Once we've seen a 1-2-3-4-5 sequence that looks complete, next we can expect a reversal of that five-wave impulse wave's progress in the form of an A-B-C correction or partial reversal. Once both of these sequences have completed together, for example, once a 1-up, 2-down, 3-up, 4-down, 5-up, Adown, B-up, C-down sequence has completed, then we can expect this to repeat itself.

For a terrific book to study the elements of Elliott Wave, I suggest Elliott Wave Principle by Robert R. Prechter, Jr. and A.J. Frost, New Classics Library, 1978-2001. For a more advanced book on Elliott Wave, I suggest Mastering Elliott Wave, by Glenn Neely with Eric Hall, Windsor Books, 1990.

The charts on pages 5 and 6 show the Big Picture, the long-term Elliott Wave counts of largest degrees for the Dow Jones Industrial Average. Page five covers from 1900 to now, and page 6 zones in on the period from 1960 to now. EW is a bit like owning a compass. It is a terrific navigational tool to help us get our bearings of where the markets have been and where they are in all probability headed. The chart on page 5 (courtesy of shows the five largest degrees of trend. Robert Prechter's bestseller, Conquer the Crash, John Wiley & Sons, Ltd., 2002 does a great job taking us back to the long ago, faraway galaxy origins of the largest degree Elliott Waves (

The largest degree wave identified is the Grand Supercycle. For this degree we use Brownishred large Roman Numerals with brackets. Wave {1} peaked in 1718. Wave {II} down completed in 1784. Wave {III} up may have completed Monday of last week. Really? Really. If it did not peak then, it is very likely to peak in 2005 with a slightly extended count. The next largest degree of trend wave is the Supercycle wave, denoted by large purple Roman Numerals with parentheses around them.

The Big Picture Elliott Wave Long-term Count in the
Dow Industrials 1900 to 2005

The Supercycle wave began in 1784 (the start of Grand Supercycle {III}. Supercycle wave (I) up completed in 1830, Supercycle wave (II) down completed in 1860, Supercycle wave (III) up completed with the stock market crash of 1929, Supercycle (IV) down included the 1929 crash and lasted through 1932. The last leg of the Supercycle wave, (V), may have ended Monday December 27th, 2004. If not, then it should end in 2005 - 2006 at the latest - should markets choose to have an extended Intermediate degree wave count. The next largest wave degree, a.k.a. the Cycle degree wave, began in 1932. Its first leg up finished in 1937. A corrective Cycle degree wave II down (denoted by large Roman numerals in red) completed in 1942. Cycle III up finished in 1966. Cycle degree IV down was a somewhat sideways affair, choppy, and ended in 1974. The greatest Bull market of all time, Cycle degree wave V up, concluded - well perhaps - last week. Perhaps. The next largest degree Elliott Wave in U.S. history is the Primary degree wave. This showed up as a 1-2-3-4-5 sequence inside every larger degree mentioned to this point, and repeated each time there was an odd number wave of Cycle degree. Primary degree (1) up (denoted in dark blue) began in 1974 and completed in 1976. Primary degree (2) finished in 1982. Here's where confusion reigned recently. Primary degree (3) was thought by many to have ended in 1987, with primary degree (4) being the 1987 crash, and primary (5) ending in 2000. But the move up from last November's election argues that the 2000 top was really only primary degree (3), that the choppy sideways to down move in 2004 was primary degree (4) down, and the impulsive thrust up through 12/27/2004 was likely either the completed primary degree wave (5), or Intermediate degree wave 1 - the first of five legs - of primary degree wave (5) up. We'll know the answer to which is the correct interpretation for primary degree wave (5) by the extent of the decline that we are currently witnessing, that started December 28th 2004. If the Dow Industrials decline below their October 25th, 2004 intraday bottom of 9,708, then primary degree wave (5) has in fact topped in the last week of 2004. If this decline fails to take out 9,708 and instead reverses and reaches new highs above 12/27/04's 10,868.07, then a five-wave Intermediate degree up sequence is playing out that would portend a Grand Supercycle {III}, Supercycle (V), Cycle V, Primary (5), and Intermediate degree completed wave 5 top sometime later in 2005 - the final end of the Bull from 1784. Or, God help us, that moment has arrived as of last Monday, December 27th, 2004. Either way, prepare for the Bear. Prepare. Prepare. Grand Supercycle {IV} down is next, taking all lower degrees of waves with it.

The Big Picture Per the Long-term Elliott Wave Count in the
Dow Industrials 1960 to 2005

Here's why Bulls are not likely to see anything like they saw from 1982 through 2004 again for many many years to come: The rally from 1987 to 2000 happened during three degrees of trend of wave threes up - all at the same time. Remember, we characterized wave threes as the most dramatic, explosive, longest-lasting moves. Well, in the 1990s, we had an Intermediate degree wave 3 inside a Primary degree wave (3), inside a Grand Supercycle degree wave {III}. Of course markets rallied into irrational exuberance, to quote a wise sage. But the wave threes up are now over. Gone. Kaput. Sorry. Many Elliotticians thought the Grand Supercycle ended in 2000. But recent all-time highs in the Russell 2000 Small Caps, the Dow Transportation average, and the NYSE argue the case that it did not end in 2000, but is/has ended now. And it is perfectly apropos for major indices to have major divergences at such a momentous multi-century stock market top. No new all-time highs for the Dow Industrials, neither NASDAQ Composite or 100 indices, nor the weighted S&P 500. Going international, no new all-time highs in Japan's Tokyo Nikkei average. Except for the Industrials, these latter indices remain light years away from reaching new all-time highs. We concurrently see a huge Dow Theory non-confirmation - a four year divergence - between the Trannies and the Industrials. Simply a huge, momentous non-confirmation inside a still active Dow Theory sell signal from back in 1999. This extraordinary event is what one might expect at the cusp of a Grand Supercycle top. Many of you have seen the analogs we've presented from past secular Bear markets versus today. It is nothing short of astonishing how the patterns correlate and call for 30 percent plus equity market declines. The yield curve is flattening. Inverted yield curves forecast recessions with high reliability. The average equity market decline in recessions is over 40 percent. If 2005 is going to be kind to equities, it is likely the kiss of death, a black widow's sendoff to her mate. It means the final primary wave (5) up is going to see four more Intermediate degree waves - 2-down (now), 3 up, 4-down, and lastly 5-up. Maybe we'll see a 12,000 DJIA under that scenario. But afterwards, the waves turn down hard. Look at these long-term charts. They make sense. Critics of Elliott Wave must see that over time the wave principle is accurate. There is truly a human psychology convergence with market price behavior, and it is predictable.

Looking at the above chart of the Dow Industrials (courtesy of, we have relabeled the Elliott wave count we believe to be most accurate at this time to reflect the huge Bullish sentiment, the all-time highs in several other indices, and the recent price action of 2004. Essentially, 2000 marked the top of primary degree wave (3), not Primary degree (5) because the ensuing decline was choppy counting as a rare Triple Three Primary degree wave (4) concluding in October 2002. The rally from 2002 shows terrific proportionality and counts textbook clean as a five-wave impulse Intermediate degree 1-up, 2-down, 3-up, 4-down, 5-up sequence that completes Primary degree wave (5) up. The thrust down since December 28th fits this count. The decline for most of 2004 was an Intermediate degree wave 4, a choppy Double Three that ended on October 25th, 2004. The post-election rally counts complete as a final five-wave Minor degree sequence that composes Intermediate degree wave 5 up. Shorter-term, the decline this first week of 2005 counts well as an impulse down, with four of the five waves of what is probably a Minuette degree move down complete. The final Minuette wave v down looks to have started but needs another thrust lower to complete - perhaps around the 10,500 to 10,550 area. Then expect a corrective a-b-c Micro degree rally to complete Minuette degree ii up about a week to ten days from now. If a top is truly in, then a significant decline should follow thereafter in stair-step fashion. The alternate count is that the rally from October 25th in the DJIA is just Minor degree wave 1 of a five-wave up sequence that should culminate in a final top in 2005.

The Elliott Wave Long-term Big Picture in the S&P 500 1960 to 2005

The long-term view of the S&P 500 is similar to the Dow Industrials with a few exceptions. Notable is that the decline from 2000 to October 2002 is a clean A-B-C Primary degree (4) down, not the complex Triple Three the DJIA formed. Also notable is that the S&P 500 fell 50 percent from 2000 through 2002 and has only made up a little over half of this loss in five years. It remains 22 percent below its all-time high and likely is not going to get there for some time. We believe either the Grand Supercycle top is in now, or will be by the end of 2005 at the latest. More than likely this leaves the S&P 500 with a truncated 5th wave Primary degree top, diverging with several other indices - a Bearish omen one would expect at an historic centuries-long top. We'll be looking for a decline to below August 2004's 1,060 level, the prior degree wave 4, to confirm a major top is in and the labeling presented herein is correct. Failure to take out that bottom coupled with a rally to a new all-time high would confirm the extended fifth wave scenario and a Bullish 2005.

The shorter-term view of the S&P 500 shown above (courtesy of indicates that a small Rising Bearish Wedge for Minor degree wave 5 completed inside a larger Rising Bearish Wedge for Intermediate degree wave 5 that also completed Monday January 3rd, 2005. Since then we have seen prices decline impulsively in a Micro degree 1-2-3-4 move. Micro 5 is partially complete, so next is another lower thrust for Micro degree wave 5 down to complete Minuette degree i down. If this is in fact the major top we've discussed, prices should continue to work their way lower from here in stair-step fashion. Both the RSI and MACD have formed Bearish directional divergences with prices. The RSI has plenty of room to decline further, and the MACD is headed lower with increasing momentum.

After hitting an all-time historic high on Thursday, December 30th, 2004, the Dow Transportation Average has plummeted 187.18 points, 4.89 percent in merely six trading days. The new top created a Dow Theory Primary non-confirmation with the Dow Industrials who hit their all-time high five years ago next Friday. How's that for a non-confirmation. And it isn't like the Dow Industrials are knocking on the door or anything either, finding themselves 1,119 points, or 9.5 percent below that baby. Dow Theory non-confirmations are never good, at best make the statement that something is seriously wrong with the rally, and usually have very Bearish implications - crash implications.

The rapid plummet doesn't surprise us as we've been pointing out the Parabolic Spike pattern for several weeks now. Parabolic Spikes do not have soft landings. They portend precipitous nearvertical declines to at least the area the ascension began. A Rising Bearish Wedge also warned that the party was about over. Momentum is down hard as this index leads the other major averages lower. As far south as prices have come, neither the MACD nor the RSI are oversold, and the MACD hasn't even gone negative yet.

This is not data mining. The Analogs we follow are chosen for a very important reason. We compare the current great Bear market with prior great (secular) Bear markets to watch for common price behavior that will clue us that investor psychology is similar and thus the future course of prices may be predictable. Look at this Analog of 1972-73 with 2004-05. It is nothing short of incredible. We're talking a day for day analog here. Both periods had Presidential reelection campaigns with Republican incumbents winning reelection, with markets rallying like crazy for a few short months. Then in 1973 when everything was looking rosy, with no apparent warning, right after the first of the new year, a massive stock market crash occurred, lasting half the year. Astonishingly, the price patterns at the start of 2005 and 1972 are identical - tick for tick! How? Common investor psychology.

The top chart on the next page shows the SPX to VIX sentiment ratio as of January 7th, 2005. This contrary indicator set an all-time Bullish record a few weeks ago and has since plummeted to 87.93, still in the crash warning zone. Interestingly, it has formed a peak pattern identical to the peak pattern signaling the top in equity prices back in 2000. We've mentioned before that the pattern of rising crash level readings for nearly a year without a crash - unusual since over the prior four years readings above 68 generated crashes - is repeating the pattern of 1998/1999. That pattern proved ominous, marking a major top in equities that led to two years of huge declines. We believe this is happening again.

The second chart shows that the 10 Day Average Call/Put Ratio has fallen from 1.40, and that the sell signal it generated has proven dependable once again as equity prices have turned lower. The current reading of 1.23 is neutral, meaning the trend remains down.

The Economy:

We learned that Consumers hit the post-Christmas shopping hard as sales were up 0.2 percent for the week ended January 1st, according to the International Council for Shopping Centers and UBS in a joint report reported by Reuters on That certainly is good news for China. Apparently this year's holiday spending was heavy on the plastic, as VISA and MasterCard reported record usage. Buy now pay later. Does that also mean buy less later? If so, it will fit with the coming recession scenario.

Looks like economic activity is up the past month on several fronts. The Institute for Supply Management's Non-manufacturing (Services) Index rose from 61.3 in November to 63.1 in December. Above 50 indicates growth. They also reported that Manufacturing Activity rose from 57.8 in October to 58.6 in November. Factory Orders rose 1.2 percent in November according to the Commerce Department. Civilian transportation orders boosted the figure. However, Durable Goods Orders, while up 1.6 percent in November, were actually down 0.8 percent if you exclude transportation, according to the Commerce Department.

Moving onto real estate, Construction Spending was down 0.4 percent in November. Excluding government projects, it fell 0.6 percent. Residential was down 1.2 percent and nonresidential was down 1.2 percent, according to the Commerce Department. While Existing Home Sales rose 2.7 percent in November versus October, setting a record high according to the National Association of Realtors, New Home Sales plummeted 12 percent, the largest percentage drop in a decade, this coming on the heels of the Commerce Department's announcement that Housing Starts experienced the largest one-month decline in 11 years, raising fears of a Real Estate Bubble Bust.

Jobs. The Labor Department reported that the economy - in their estimates - created 157,000 new Non-farm Payroll Jobs in December. That just about covers population growth for one month, which means there was no net new job creation in December to reduce the number of previously displaced workers. Jobless Claims for the week ended January 1st, 2005 surged 43,000 to 364,000, the largest one-week increase in nearly 3 years. Job Advertisements are down in December, according to And according to search firm Challenger, Gray and Christmas, December marked the highest month for Job Cut Announcements in a year, reporting that businesses announced 109,045. Ouch.

But the stock market rose in December, so all is well with the world as Consumers basked in the glory of it all per the University of Michigan's final December Consumer Sentiment Index reading of 97.1 - which is still far below the 103.8 reading of a year ago.

Money Supply, the Dollar, & Gold:

Well it looks like the Federal Reserve has identified the current period as susceptible to a declining equity market because once again they have allowed M-3 to take off, up a whopping $56.6 billion in just the past week, a 31.3 percent annualized increase in money supply - not the sort of growth rate the Fed wants if what they say is true, that their top concern is rising inflation risk.

Maybe it's an anomaly, as one week does not make a trend, but . . .they boosted M-3 the last time equity markets were in high-probability crash mode, back in April/May 2004, and they were successful in minimizing the damage. As we've been pointing out, right now is another of those high-risk equity market crash periods. M-3 is up $97.5 billion since November 15th, and is up $129.8 billion since October 11th, but the bulk of the increase just occurred this past week. Nobody will admit this of course, but this is no coincidence. The Fed sees the dour technical picture and is pressed into action. Will they be successful in stopping this next crash like they were back in mid-2004? We shall see. What is more precarious this time around is that they are raising short-term interest rates at the same time they stealthily increase money supply. So far the Dollar hasn't sniffed out the increase in M-3, nor has Gold. It may be too early. They seem to be more focused on rising interest rates as a support for the Dollar. That could change with a few more weeks of money supply pumping. Stay tuned on this one.

Picking tops and bottoms is always challenging, especially at the conclusion of a long-term trend. This is where we find ourselves with the U.S. trade-weighted Dollar. Primary degree wave (1) down is nearing conclusion. The question is, did it reach a bottom at the end of December and the rally over the past week is the start of the countertrend Primary degree (2) up? Or, are we seeing the final topping action of Minor degree wave 4, meaning there is one more sharp decline left in the Dollar before a major bottom is in? We've labeled the chart below taking the position that this week's rally is the completion of Minor degree 4 on the basis that the Elliott Wave count would be more proportional to Minor degree waves 1 though 3 from last May. Also, the Dollar has liked to touch its upper and lower long-term trend-channel boundary lines at directional turns, so we believe the Dollar will seek its lower boundary before turning up. The corrective Primary degree wave (2) up may not retrace that much of (1) should the Fed hit the liquidity spigot hard like we saw this week. Rising short-term interest rates are conducive to a rising trade-weighted U.S. Dollar, but not so if accompanied by a stealth increase in M-3. So, perhaps (2) up will end up being a flat, an up and down sideways sequence before the next major leg down in the dollar resumes, Primary degree wave (3) later this year.

Gold has tracked as expected since our last analysis in issue no. 109 where we pointed out a short-term Bearish pattern, the upside-down Flag where choppy back and forth price action (the flag) angles away from the primary direction of the flagpole - which was down. These patterns are continuation patterns, and resolve in the same direction as the move that created the flagpole - so we noted that we can expect a breakout down, which we have in fact seen this first week of the New Year. The downside target from the Flag pattern is 417-ish, calculated by taking the measure of the flagpole (December 2nd's 456.8 intraday high minus December 10th's 432.0 intraday low) and subtracting it from the point of the next breakout down, around 441, which gets us to 417ish. We are almost there now. This decline should fulfill minor degree Elliott Wave 4 down, to be followed by a strong final thrust higher, Elliott Wave 5 of 5 of (1) up. The Ascending Bullish Triangle suggests the upward thrust could hit 500 over the next six months. Note that the patterns allow for all targeted price action to take place inside Gold's long-term rising trend-channel. The RSI is approaching oversold territory which fits with our call for Gold to pop higher soon.

The Gold Bugs Index ($HUI) charted on the next page has followed the path we expected from its mid-November top as outlined back in issue no. 97, November 5th, 2004, crashing 47.88 points (19.3 percent) from its 248.18 high on November 17th to January 6th's micro degree wave 5 intraday low of 200.30. The HUI is in the last leg of an Elliott Wave minor degree consolidation - wave C that should take prices down below 180 before turning back up in earnest. So far the HUI is finishing up a Minuette degree wave i, the first of five waves of C down. The RSI has predictably plummeted from a rare Head & Shoulders top formation to oversold levels, the place where Minuette degree wave ii up will grab the baton for the next short-term path. The MACD also fell sharply from a Head & Shoulders top formation and momentum is now clearly down. Neither the RSI nor the MACD are near the levels seen at the last significant bottom, back in May 2004. We would expect that once Minor degree C down is finished.

Silver is working its way lower from a Bearish Flag pattern similar to Gold's. Again, the breakout move south from the "flag" portion of the pattern should be equal to the length of the flagpole, about 1.60. This gives us a downside target of around 5.30. However, the Elliott wave count suggests only one more thrust lower is due before a reversal, so Silver may not get there on the current move.

Bonds have surprised many, rising throughout the latter half of 2004. The long-term Head & Shoulders top is still in play, and unless prices blast past the top of the Head, above 121.45, the pattern will remain in force. It is a massive creature with ominous repercussions should the highly reliable pattern be confirmed. To confirm, prices would have to drop decisively below the neckline, below 100. If that were to occur, the minimum downside target would be 79-ish. We're talking a massive, disruptive increase in long-term interest rates that would certainly spell disaster in housing, the collapse of real estate, and very likely strangle the banking system as collateral values plummet below loan extensions. What could cause this? A collapse of the U.S. Dollar and/or hyperinflation as a result of excessive liquidity pumping by central banks presumably motivated by the necessity to support collapsing equity markets or derivatives implosions. Increasing trade, federal budget, and current account deficits also could push bond prices lower. Should foreign holders dump, U.S. Bonds would tank. Why would foreigners dump our Bonds? The second chart on the next page tells us why. In terms of the valuedepleting U.S. Dollar, Bonds have held their own. But in terms of the Euro, U.S. Bonds have crashed. Foreign holders of U.S. Bonds have seen the value of their holdings decline over 30 percent in a little over two years due to currency exchange risk. If the Dollar looks like it is going even lower, look for them to prudently dump our Bonds.

That's the intermediate-term scenario. Shorter term, it looks as if Bonds have a bit further to run, as impulse Minor degree wave c of 2 up shown on the next page counts only as four waves complete, needing a Minuette degree fifth "v" up. That could push prices to the 115 area before Bonds turn lower in earnest. The choppy action we've seen over the past few weeks is a Minuette degree iv. Both the RSI and the MACD sit in neutral territory. What Bonds are telling us right now is that they don't see robust economic growth for 2005. Something is wrong with the recovery. Bonds smell deflationary forces or even recession. An equity event possibly.

Bottom Line: The technical evidence is compelling, we are either at an historic equity market top that is about to decline long and hard for years to come, or equities are going to stage one last rally throughout most of 2005 until reaching the Grand Supercycle top later this year, setting the stage for a monstrous decline into 2006 and beyond. For four years, the Federal Reserve has fought the Bear and succeeded in postponing the worst. Can they push this top further out into the future once again by soaking 2005 with massive liquidity infusions? Looks like they've already started. We shall watch with fascination as these two heavyweights climb back into the ring, and will report the slugfest blow by blow. Caution remains warranted.

"For God so loved the world, that He gave
His only begotten Son, that whoever believes in Him
Should not perish, but have eternal life.
For God did not send the Son into the world
To judge the world, but that the world
Should be saved through Him."

John 3:16, 17

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Key Economic Statistics
Date VIX Dec. U.S. $ Euro CRB Gold Silver Crude Oil 1 Week Avg. M-3
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 9259.9 b
7/30/04 15.27 90.12 120.10 267.00 391.7 6.56 43.80 9272.3 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 9320.5 b
10/01/04 12.75 87.77 124.07 284.75 421.2 6.94 50.12 9336.5 b
10/08/04 15.08 87.55 124.13 287.60 424.5 7.29 53.31 9355.6 b
10/15/04 15.04 87.20 124.73 286.45 420.1 7.11 54.93 9320.3 b
10/22/04 15.28 85.97 126.46 287.00 425.6 7.33 55.17 9341.9 b
10/29/04 16.27 84.98 128.85 284.75 429.4 7.30 51.76 9359.0 b
11/05/04 13.84 83.89 129.46 283.00 434.3 7.50 49.61 9363.7 b
11/12/04 13.33 83.71 129.85 283.50 438.8 7.62 47.32 9361.7 b
11/19/04 13.50 83.32 130.13 287.25 447.0 7.60 48.44 9352.6 b
11/26/04 12.78 81.81 132.93 288.75 449.5 7.59 49.44 9366.9 b
12/03/04 12.96 80.98 134.53 284.75 456.0 7.99 42.54 9382.7 b
12/10/04 12.66 82.59 132.36 276.25 435.4 6.74 40.71 9383.3 b
12/17/04 11.95 82.20 132.90 285.25 442.9 6.80 46.28 9379.3 b
12/22/04 11.45 82.01 134.06 282.50 441.4 6.93 44.24 9450.1 b
1/07/05 13.49 83.72 130.62 279.25 419.5 6.44 45.43 -

Note: VIX, Dollar, & Oil up. CRB, Gold, & Silver down.


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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