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March 14, 2003

S&P 500 Waterfall Imminent
by Adam Hamilton

The massive 4" thick Webster's dictionary holding down my desk defines the word waterfall as, "a steep fall or flow of water in a watercourse from a height, as over a precipice".

Waterfalls in nature are certainly an awesome sight to behold. I am sure virtually everyone reading this has shared my awe in visiting a waterfall and drinking in the intense sensory stimulation. From the immense thundering sound that resonates deep within your very chest, to the cool foggy mists, to the wondrous spectacle of countless tons of water freefalling and then furiously smashing into a pool below, waterfalls truly stir our souls.

In the financial markets, the word waterfall plays on the visceral experience of observing the real thing in nature in order to explain a distinct bear-market phenomenon.

A financial waterfall is a relentless decline in a market for weeks in a row, almost always carving out new interim lows when it finally ends. In a financial waterfall selling pressure builds and builds, powerfully driving an index lower and lower. Eventually the selling pressure reaches a temporary climax in a short-term capitulation panic and then a textbook V-bounce is born from the ashes.

The term waterfall is so useful not only because of its raw descriptive power, but because it ensures that the crucial distinction between an all-out crash and a much slower decline is emphasized. While classical crashes are catastrophic 10%+ daily losses for a day or two, waterfalls are relentless declines that run their full courses over a month or two, about 20x slower than a true crash.

In market history the only times true crashes erupt is shortly after major long-term bubble tops are reached. Waterfalls, on the other hand, happen most often deep within the bowels of major secular bear markets. Waterfalls are the final stage in major downlegs before a temporary fear-laden V-bounce is carved.

As the title of this essay suggests, I do believe that the S&P 500 is in for another waterfall decline, for many technical and fundamental reasons outlined below. Waterfalls are emotional times for the financial markets so it is far better and vastly more profitable to know about a potential waterfall ahead of time rather than failing to recognize it until too late, after it's over.

Another potential S&P 500 waterfall means this flagship American index could relentlessly fall for a month or more. This would carry it well below its recent October 9th closing low of 777 and ultimately carve out a totally new interim bottom. This next waterfall will form the left leg of the long-awaited V-bounce in the index.

The incredibly dangerous emotions of greed and fear are the arch-nemeses of all speculation, and a coming S&P 500 waterfall will be hazardous for both the longs and shorts. Hence it warrants some discussion and psychological planning in order to successfully weather it intact.

For the longs, an S&P 500 waterfall is a nightmare scenario. It is like a month of trading days in a row of financial torture exquisitely crafted by the Great Bear to sow uncontrolled terror deep in their hearts. If they succumb to fear they will panic and sell near the V-bounce, at the worst possible moment, and hemorrhage a lot of valuable capital in the melee.

For the shorts, an S&P 500 waterfall seems like a dream come true at first. Unfortunately the waterfall deftly lays devious emotional traps that can slaughter the shorts too. Towards the end of the waterfall as the V-bounce nears and a major new bear rally prepares to spring forth out of the short-term fear ashes, greed utterly consumes many shorts. They fall into the foolish trap of believing that the first late-bust crash in history is near so their greed seduces them into not selling near the interim bottom. They too lose a lot of money by succumbing to greed at the V-bounce.

For speculators on all sides of the game, the imminent S&P 500 waterfall and its implications bear careful consideration and psychological preparation. Speculators must strive to be emotionally neutral through this awesome event, neither growing too scared nor lusting too greedily after profits.

Our first chart this week, and indeed this whole essay, was inspired by a fantastic graph a speculator friend of mine, Robert Fisher, graciously shared with me a few days ago. Mr. Fisher is an active private speculator who has lately been focusing his attention on researching moving averages as tools to execute superior trades.

Mr. Fisher noted that in the last few bust years the 50-day moving average (50dma) of the S&P 500 has consistently flashed an outstanding warning signal for impending waterfall declines. This incredibly bearish development just reared up again and speculators should carefully heed its ominous tidings.

In this graph the S&P 500 index itself is rendered in blue and its 50dma in white. As the secular S&P 500 bear market has unfolded in recent years, each time its 50dma nosed over and headed south, a vicious waterfall-type event followed in the near-term future, within a couple months. The most recent three of these very bearish short signals are flagged with solid-white arrows.

Mr. Fisher's excellent observations went much deeper however. He showed me that there is a subtle secondary signal that the 50dma flashes slightly after the very beginning of each waterfall. It is not as easy to see but after you examine the graph a bit it will really stick out at you, kind of like those computer-generated 3D illusion books that look like visual noise at first but if you stare hard enough eventually a picture materializes.

Mr. Fisher noted that each time the S&P 500's 50dma makes a new all-bust low following a major bear rally, it is all over. Within days or weeks after such a new all-bust 50dma low, an ugly new S&P waterfall continues accelerating down a steep slope carving the left-hand leg of the famous V-bounces. The dotted-white arrows above mark these new all-bust lows in the 50dma.

This fascinating phenomenon happened in every waterfall above, which are labeled in blue. The 50dma tops and then turns south shortly after a major bear-market rally fails. Then, a month or two later, the 50dma stealthily makes a new all-bust low and the waterfall accelerates.

A new 50dma all-bust low after a major bear-market rally begins failing is a rock-solid short signal, an unambiguous warning to get out of Dodge in terms of long positions or face horrific losses.

Following the latest October 9th V-bounce labeled as "Rally 3" above, the S&P 500's 50dma achieved an all-bust low of 867 in mid-November. Then the 50dma dutifully turned higher on the spectacular bear rally and peaked at 908 by mid-January. Then, as is evident in the graph, the S&P 500 index itself began to fall rather rapidly in recent weeks, unceremoniously dragging its 50dma lower.

As anticipated, this latest major bear-market rally is rapidly imploding before our very eyes. And yes, all the graphs in this essay and this whole analysis fully considers Thursday's impressive short-covering rally in the indices on the good tidings of a potential war delay by Washington.

Last Friday, March 7th, Mr. Fisher's imminent waterfall signal was triggered, and bullish and bearish speculators ought to take careful note of this provocative development. On March 7th the S&P 500's 50dma closed at a new all-bust low of 866. By Thursday March 13th of this week, after the sharp one-day anti-war stock-market relief rally, the S&P 500's 50dma closed under 860, another fresh new all-bust low. And so it begins!

Each time this signal has been flashed in the bust to date, it has warned of an imminent waterfall decline approaching. I suspect the signal will prove valid yet again today. You fellow shorts, rejoice but don't get greedy and be ready to cover near the V-bounce. You remaining longs, get ready for some excruciating pain if you insist on staying long through this waterfall.

This coming S&P 500 waterfall will blast through the old October 9th low of 777 as if it didn't exist. The next potential V-bounce will probably materialize somewhere around 667, a potential short-term target for which we discussed the logic and rationale behind recently in our popular Zeal Intelligence newsletter for our subscribers.

Interestingly, an S&P 500 level of 667ish sometime in the next 6-8 weeks would bounce right off the heavy lower support line drawn above just like the past V-bounces have. It is always encouraging to see short-term targets computed by totally different methodologies line up nicely!

Now that you have had the opportunity to observe Mr. Fisher's powerful waterfall-imminent warning signal, like me you probably know a huge number of folks who are still ragingly bullish this very day. The awesome mini-bear rally on Thursday the 13th certainly stoked these fires! The bulls are out in force and they seem to think that the destruction and waste of war will somehow magically unleash a fantastic new bull market in US equities.

Personally my tolerance for this perma-bullish drivel is wearing rather thin. Monday March 10th was the three-year anniversary since the NASDAQ bubble topped, and if investors and speculators can't take the time to learn how post-bubble bear markets work in three long, hard years, then they probably fully deserve to be gutted by the Great Bear.

While the perma-bulls have already chosen to lobotomize themselves by ignoring the facts as their fortunes are flushed away by this ravenous Great Bear, it is important that speculators understand the inherent goofiness in the perma-bulls' perpetually hyper-optimistic market predictions. The endless Wall Street hype has already cost so many so much, yet like undiscerning sheep people are sadly still swayed by it.

The perma-bulls are now claiming that the S&P 500 is carving out a super-bullish triple bottom around 800, and you can see what they are talking about in the graph above. Yet, upon careful examination this theory doesn't seem to hold much water. In the rest of this essay I will discuss the strong technical and fundamental case against this wishful thinking.

As all speculators are forced to learn sooner or later, major interim bottoms only occur on great fear, a short-term capitulation panic marking the low point of V-bounces. If you look at the red VIX line in the graph above, you will note that a huge VIX spike above surrounding technical terrain was conspicuously Missing In Action this week.

The VIX, a great gauge of general fear, is recording no extreme fear at all today! This week's S&P 500 slump showed no fear, meaning that odds are vastly in favor of the hypothesis that it is not a valid interim bottom.

A real, solid interim bottom will occur on a monstrous VIX 50ish or even 50+ spike that will leave no ambiguity whatsoever. The perma-bulls' arguments for a triple S&P 500 bottom near 800 launching a fabulous new bull market are specious and easy to dismiss at this point in the game. Technically there has been no solid "third bottom" yet!

The bulls also amazingly claim that recent short-term technical action is bullish, something that utterly blows my mind. As this next graph shows, recent S&P 500 behavior is anything but bullish. This is an indexed graph, indexing the three latest major bear-market rallies circled in yellow on the graph above. It converts each rally into common terms so they are perfectly comparable.

While this unique methodology is thoroughly explained in "Bear-Market Rally Autopsy 2", it is easy to quickly grasp. Each major S&P 500 bear rally is converted into a common scale from 0 to 100, with 0 marking the preceding V-bounce and 100 marking each bear rally's ultimate top. The X-axis shows the number of trading days before and after each bear-rally top, which is classified as day 0.

In perfectly comparable indexed terms, the dismal failure of the latest bear-market rally in the S&P 500, the blue one above, is phenomenally bearish. Not only is the recent post-rally downtrend in the S&P 500 sloped steeply downward in a laser-sharp line, but the index has already witnessed two bearish technical failures below this important support.

85% of the ground gained from the latest V-bounce low of 777 has already been lost. The S&P 500 is once again trading within spitting distance of these important levels and it won't take much fear to push it through.

Once the S&P 500 closes below 777 for a few days, a blizzard of sell orders will hit as confidence crumbles. In addition, many speculators set stop-losses right under recent lows in order to protect themselves. As these stops are triggered the waterfall will accelerate dramatically, feeding on itself and breeding even more frantic selling. 777 truly is the Moment of Truth when popular bullish fairy tales boldly heralding the end of the Great Bear will face their ultimate acid test.

If I was long this market today like the bulls, the chart above would deeply disturb me. If everything is so wonderful in the US equity markets as the perma-bulls claim, why does the current decay curve in the flagship US equity index line up exactly with past S&P 500 behavior right before previous waterfall declines to new lows? Why is the trend down, with lower lows and lower highs, rather than the other way around? If the markets really believed that war was somehow positive wouldn't they anticipate this and rally ahead of the fighting?

This week, three long and painful years after the NASDAQ bubble topped, it defies belief that so many investors and speculators still don't understand the central issue behind bubbles and busts. Things like the coming Iraq war, economic releases, news, and single-day movements are totally irrelevant. They are merely useless distracting noise.

The immensely powerful driving force behind bubbles and busts is valuation. If stocks get way overvalued in a spectacular bubble then they are going to inevitably be ground down to way undervalued levels in the bust that follows. This is the way markets have always worked in history and the way they will probably always work in the future.

Until the US equity markets are officially undervalued relative to multi-century-old historical average valuations in terms of price-to-earnings ratios and dividend yields, the remaining perma-bulls' unbridled optimism will be proven premature. Our final graph builds on this crucial central market truth which was discussed in great detail in "Long Valuation Waves", "Valuation Wave Reversion", and "Dividend Valuation Waves".

History plainly teaches that until the US equity markets are undervalued, any chance of a long-term secular bull once again emerging is purely wishful thinking. As the P/Es and dividend yields at various stages in the S&P 500's bust-to-date clearly show, the Great Bear is simply working to eliminate the gross speculative excesses of the bubble.

The S&P 500, the biggest and most important stock index on Earth, was trading at a breathtaking 55x earnings and only yielding 1% near its bubble top! Several years later, after immense losses of capital and incredible financial pain, the index is still trading at 21x earnings and only yielding 2%. To the best of my knowledge a major secular bull market has never launched from general valuations anywhere near this high in all of financial-market history!

All of the major long-term bottoms in US equities in the last 70 years or so have occurred at an average P/E ratio under 8x earnings and an average dividend yield over 8%. 8x and 8%! To get to such historically low and immensely bullish valuations today, the S&P 500 will have to plunge far, far lower than anything we have witnessed to date.

If the combined earnings power of all 500 elite S&P 500 companies today is used as a baseline, the flagship index would have to grind down to 325 before it would be trading at 8x earnings, the historical super-bullish long-term bottoming level! 325!?!

If the combined dividend payments of all 500 elite S&P 500 companies today are used as a baseline, the flagship index would have to grind down to 210 before it would be yielding 8%, the historical super-bullish long-term bottoming level! 210!?! Yikes.

Now I do doubt the S&P 500 will plunge quite this low in the coming years because earnings and dividends generally rise slightly over time slowly addressing the rampant overvaluation problem, but I have no doubts based on my many thousands of hours of financial-market research that the ultimate S&P 500 bear-market bottom is far lower than the October 9th 777 levels! There is simply no way the index bottomed above 25x earnings while yielding under 2%! Preposterous.

Based on history, anyone who thinks a long-term bottom has been reached before the S&P 500 trades under about 10x earnings and before it yields around 6%+ is ignoring the core valuation problem. To borrow a famous 1990s Democratic campaign slogan, the ultimate issue driving the financial markets today is not the war, not economic reports, not the news, but "It's the valuations stupid!"

Whenever you hear the perma-bulls, who have been catastrophically wrong for three years in a row now, brazenly proclaim that another "ultimate bottom" has been reached, you ought to check on valuations to see if they even have a realistic hope of being right. If you want to stay on top of current valuation levels as all investors and speculators should, we painstakingly calculate and track these valuation numbers every month in our acclaimed Zeal Intelligence newsletter for our subscribers.

The S&P 500 won't carve out a long-term bottom, and a new secular bull market won't begin galloping, until the flagship index once again trades well under fair value (14x earnings and a 4.6% dividend yield). This unpleasant aftermath is the price we all have to pay for the euphoria and absurdly high valuations reached in the bubble. Sadly it is like winter after summer, inevitable.

With valuations still far too high, the probability that the October 9th 777 low will hold in this downleg is pretty darned close to zero. As Robert Fisher's excellent 50dma signal showed, an S&P 500 waterfall decline is almost certainly imminent.

For one final perspective shooting the perma-bulls' pet idea of a triple S&P 500 bottom near 800 out of the water, please note the white volume data in the graph above. Any major interim bottom is marked by a large volume spike above surrounding levels, a temporary short-term capitulation panic on high volume. The S&P 500 lows of this week did not correspond with a high-volume spike, betraying that they are almost certainly not real interim lows and merely daily market noise.

All signs today point to an imminent S&P 500 waterfall decline. Get out if you remain long and get ready for some serious action if you are already playing the short side!

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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