A Beautiful Picture

By: Hector Herrera | Tue, Jan 21, 2014
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Dow Jones Broadening Top

I title the chart above "A Beautiful Picture" because for those of us that love the financial markets it is indeed spectacular. A picture is worth a thousand words!

First of all, I want to clarify that charts don't predict the future of the financial markets as many technicians claim. What charts do tell you, along with sentiment indicators, is how most of the players in the markets are positioned. Knowing that will help you make better financial decisions. Charts also provide an inside look into the emotions of market participants. In the sense that when the balance has overwhelmingly shifted to one side, for example, most participants are too bullish or too bearish on the markets, it creates investing opportunities for the astute investor who is paying attention.

If you listen to the main street financial media you hear most talking heads claiming that the economy is great and that we are just at the beginning of a new bull market, not only in stocks but also in real estate. They are making all these claims because they see the price of paper financial assets go up. But, they fail to report the weak fundamentals of the real economy. In some cases conditions not seen since the great depression era of the early 1930s.

Now, lets get back to the chart. This is a price and volume monthly chart of the Dow Jones Industrial average from 1960 to the present. For the past few months I have read many articles on the Internet from market analysts comparing the current thirteen-year market consolidation since the 2000 top to the present, to the consolidation that took place in the Dow Jones Industrials from 1966 to the early1980s. Since that consolidation resolved to the upside resulting in a huge bull market, they are concluding that the current consolidation is similar and will resolve in a similar fashion. What they fail to realize or objectively analyze is that both consolidations are totally different and each one is painting a different picture in regards to the conditions of the market at each particular juncture and therefore suggesting totally different outcomes.

The consolidation between 1966-1982 is in a side channel that contains prices tight and orderly, aside from the two down spikes that I labeled false breakouts, one in 1970 and the other one late in1974. Looking back both of these two downward moves were bullish because the price immediately turned back in to the channel and continued its tight consolidation. This is usually an accumulation pattern, which therefore is bullish if prices break the top of the channel like it happened in 1982.

The current pattern that started in 2000, on the other hand, is nothing like the former. The first thing you notice is that prices do not move in a tight and orderly fashion across the pattern. On the contrary, as prices move to the right of the pattern volatility increases, this is not bullish behavior. The first thing I look for in a bullish consolidation pattern is for volatility to contract from left to right and the total opposite is happening here.

This pattern most closely resembles what most market technicians call a Broadening Top. The first clue as explained above is the increased volatility as time progresses. Second, the price/volume pattern is very clear as top #1 and top #2 are formed while volume is increasing. But, top #3 is forming on declining volume as you can see on the chart. Broadening formations are only found at market tops because they are the product of unrealistic market expectations on the part of bullish investors. The minimal technical target for this pattern is a drop in the Dow Jones Industrials to the bottom of the descending channel that is around 6000. If the bottom of this channel is broken to the downside a second target of 3000 can also be projected. This would imply a loss in the Dow Jones Industrials of 64% to 80% from present levels.

I know what most of you are thinking right now, this is impossible, and that the FED will never let the market fall that hard. Well, that is exactly the kind of mindset that needs to be on the majority of investor's heads for these patterns to work. The objective of the market is always to move in the opposite direction from what the majority of participants expect, with the least amount of investors aboard. That explains why 90% of investors consistently lose money in the markets over time.

Now back to the chart. The second major difference from the consolidation of 1966 - 1982 and the one we are now in is Interest Rates. On April 2, 1980, the U.S. prime rate reached a high at 20%. That coincided with the last time the Dow Jones Industrials touched the bottom of their consolidation channel. In other words, the bottom in stocks coincided with the absolute high on interest rates. As most of you know declining interest rates are bullish for stocks therefore a huge bull market in equities was born as interest rates started a multi-decade decline. Let's fast forward to the present time. While the Dow has been forming the last leg of the current topping pattern, interest rates bottomed making a low on the third quarter of 2012, and since then the yield on the 10-year treasury has been on a solid uptrend. In addition to that, the Federal Reserve has maintained ZIRP in effect since 2009. ZIRP is the FED maintaining a 0% nominal interest rate. This tool is usually used by the central banks to promote growth in the economy after a financial crisis like the one we had in 2007-2009. But, this policy is slowly removed as the economy recovers and the prices of financial assets stabilize. The odd thing that no one on the main street financial media seems to comment about is that we are suppose to be in this amazing recovery with financial assets hitting all time highs. Then why hasn't the FED started to raise interest rates gradually? The answer is simple, they know this is a phony recovery and the moment they start to raise the nominal interest rate the house of cards will start to collapse. Think about this for a moment, at top #1 on the chart the Federal Funds Rate was around 5.8%. At top #2 on the chart, the Federal Funds Rate was at 5.3%. Finally, at top #3 on the chart the Federal Funds Rate is at 0.25%. For those of you who still don't grasp the danger of the situation, it's actually very simple; at tops #1 and #2 after the stock market crashes one of the tools the FED used was reducing interest rates to help normalize the financial system and the markets. On the other hand, at top #3, the Federal Fund Rate is already near 0%, therefore the FED does not have this tool available to combat another market crash at this time. This makes a third market crash even more dangerous than the previous two.

Now let's examine the Shiller PE Ratio. At every meaningful stock market bottom in the last 100 years this ratio has moved below 10. This has not happened yet, that's why the bulls that are calling the 2009 low a generational bottom are wishful thinkers. In fact, in 1982 the Shiller PE Ratio was at 6 when the stock market bottomed while at the 2009 low it was at 15. This ratio was not in the single digits for the 2009 low to be a long term standing bottom. Today, this ratio stands at 26.25. Let's compare this number with previous important market highs. Before the market crash of 1929 this ratio was at 30 and before the market crash of 2007 the ratio was at 28. As you can see by this measure alone the stock market is overvalued at these levels and is most likely at a top rather than ready to start a new bull run.

Now let's look at a number of other facts that are present at this time and that were present at other major market tops:

  1. Margin debt is at record all time highs even higher than at the 2000 and 2007 market tops!

  2. Stocks are rising based on the "Greatest Fool Theory." As a new round of incredible market valuations for stocks with barely any earnings or no earnings at all emerge.

    NFLX P/E Ratio 282
    AMZN P/E Ratio 1452! That is not a miss print.
    FB P/E Ratio 146
    DDD P/E Ratio 207
    P Market Cap = 6.3 B EPS last Q = - 0.30
    TWTR Market Cap = 31 B EPS last Q = - 0.20

    Note: As a rule of thumb you want to buy stocks with a P/E Ratio no higher than 2x the P/E Ratio of the SP-500. As of the writing of this letter the P/E Ratio on the SP-500 was 19.52.

  3. Historic optimism: as the ratio between cash in money-market funds and more speculative stock market funds is at the lowest level since the 1 Q 2001! What this mean is most institutional money is all in. Chart courtesy of Elliot Wave International.
    www.elliotwave.com

Fund owners Cash.Stock Ratio Chart

  1. And finally, I would like to end with this amazing chart courtesy of Hussman Funds, www.hussmanfunds.com. John Hussman superimposed French economist Didier Sornette's pre-crash pattern over a current chart of the SP-500 since 2010. The similarities of the two are striking.

Anatomy of a Textbook Pre-Crash Bulbble Chart


Summary:

As I explained at the beginning of this article, charts don't have any powers of predicting the future, but we can use the information they provide through price/volume patterns to help us find high probability investing opportunities. In this case, at the very minimum, the chart on the top of page is telling us to be carefull and prepare a defensive plan if we don't have one yet. There is a 50/50 chance that the Dow Jones Industrial average can lose over 60% of its value in the next couple of years. The overwhelmingly one-sided bullish sentiment among investors and the extreme readings of many other market indicators certainly support this case. Let me ask you a question; If history is of any guide, would you be looking to back up the truck and load up with stocks at top #3 on the chart or should you be looking to implement a plan to protect your retirement and investment accounts? After you saw what happened at top #1 and #2 I really hope that you know the answer to this question.

Finally, in baseball terms, for those of you who are more aggressive investors the market is throwing you a fastball right down Broadway and all you need to do is pick up the biggest bat and take a swing at it.... Yes you may strikeout, but the chance of hitting it out of the ballpark is a bit better because at top #3 you have an asymmetrical bet where you can define your risk at an acceptable low level in order to make a huge amount of money. In other words, at this particular point the market is offering you a positive edge by taking a short position in the Dow Jones industrials. In the world of investing that is all you can ask for. I would attempt this only if you are an experienced investor or trader because timing a top is one of the hardest things to do. Greed and the fear of missing out is a powerful emotion that is going to keep naïve money coming in to the market up to the last moment.

"Two things are infinite: the universe and human stupidity; and I am not sure about the universe." ~ Albert Einstein

 


 

Hector Herrera

Author: Hector Herrera

Hector Herrera
http://www.systemarket.net/

Hector Herrera
http://www.systemarket.net/

Systemarket is a financial blog that provides alternative stock market investing ideas through ETFs and growth stocks. Our methodology is based on trend-following and momentum strategies. The ideas offered are not to be taken as financial or trading advice but as the first step of research before investing.

Questions or comments. Please contact me at info@systemarket.net

Copyright © 2014 Hector Herrera

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