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WALL OF LEGITIMATE WORRY

The major indices are showing technical weakness. In the meantime, the crowd has been lulled asleep by the last 2 years where it would have been premature to take bearish positions against the stock market. Seemingly every time the market moved toward an intermediate term important technical support level or key moving average, a sharp rally provided the market with a “save.” The market has also been relatively resilient from bad news and there has been no shortage of it. This has served to put many traders asleep. The action of the market itself seems to be the most meaningful cause of the market action. This is known as momentum.

With the market’s upward bias, seasonality and wives tales have been a good play from the bullish side and poor for bearish use. Examples follow. Remember the success of playing the year-end rallies but the failure of a New Year swoon in ‘06? “Sell in May and go away”? Bearish wives tale, will not work. “Three (interest rate hikes) steps and a stumble”? Bearish rule. Forget it – Won’t work. Santa Claus rally? Bullish. Works every time!

News has also had a bullish effect on the stock market over the last 2 years. Good news has been good news for the stock market, and bad news with the lack of a significant market drop following it has served as a catalyst for several rallies. Think London bombings.

After more than 2 years of this, the crowd has been conditioned to a bullish bias in evaluating the stock market. And while it is entirely possible that the bullish bias could be a successful strategy in the near term future, it would be wise to consider that this time it may be different.

So what is different this time? I will outline some of the factors contributing to the case for a short term end of this momentum driven market and a resumption of the secular bear market.

1. Technical Analysis. Never has the public been so involved in the technical aspects of the stock market. If the Nasdaq bubble has taught the public anything, it is the apparent usefulness of technical analysis. While the wild speculation in technology stocks of the 1990’s was driven largely on absurd profit projections, today’s wild speculation is largely technically driven. Moving averages and momentum are household words as illustrated by many commercials focusing on technical tools. If you listen to main stream Bloomberg radio for a half-hour, you are likely to hear a commercial for a school where you can “change your life” by learning to trade. Similarly, a Sunday channel surf around the basic cable is likely to reveal a tape set that can be purchased to teach you how to trade options for profit and fun. Although these examples are on the “lunatic fringe,” it does point to technical analysis as a growing and popular tool. Some professionals appear to be increasingly emphasizing technical analysis in their decision making process and investing in a manner that is not characteristic with their fundamental views. Think Cisco. While this is now a good way to make a point or two here or there in this trading range environment, are the true risks being considered appropriately? One of key components of technical analysis is the stop loss to limit the amount of money one can lose in a single position.

While it is perfectly logical to think that losses can be limited by a stop loss or similar strategy, when a large crowd employs the same strategy at the same time, it cannot work unless there is a similarly large crowd on the other side of the strategy. Up to this time, there have been folks to step in and buy the dips based on technical analysis. These folks on the buy side are looking at moving averages, support lines and stepping up on the dips (so far). Yet once the technical case for buying dips is gone, no one will buy. It is my belief that we are a single 10% market down day from experiencing something that is really ugly – a panic selling episode. And while there are some who are conjecturing that this will not happen because of organized support (think PPT), nothing such as this lasts forever. If the market is being supported by some form of organized support, this will only last until it benefits the organized supporter. This time period is definitely not forever and it may be not for long. Once key technical support levels are taken out with their reason to buy gone, the technicians will run for the door and sell. If this happens, good luck with your stop losses.

Assuming such organized support exists, if these supporters of the market wish to diversify into stocks, they will not want to do it at these high prices. Similarly if they want to diversify in real estate, it will be at bargain prices which are much lower than today’s. It may be timely to note that margin debt in stocks is at a high level, and we all know about the high level of leverage in real estate. In short, the market is vulnerable to a change in heart by those who are now providing its organized support. They can hurt the overleveraged owners of stocks and real estate by pulling out of their supporting positions and forcing a panic sale. It may not “feel” like this can happen, yet it can.

2. Technical Analysis – Leading Indices. The following chart is a long term weekly chart of the small capitalization Russell 2000 index. The 5-wave pattern in red, complete with throw over, is the proposed ending diagonal pattern discussed in a previous article. It suggests a dramatic reversal in the making.

The 6-month candlestick chart of the Russell 2000 shows a broken trendline. Not a decisive break as the technically watched 50-day moving average served as support on Wednesday. Is the “dramatic reversal coming?

A similar pattern may be seen with the Nasdaq composite. If the lower blue trendline is broken to the downside, the primary reason for buying the index will be removed.

Technical Analysis – Leading Sectors

Some formerly leading sectors are showing technical weakness. Consider the semi-conductors sector. While several indices have made or are threatening to make new highs, this sector is still well off of its January 2004 high. Semi-conductors tend to be a more cyclical sector. Is the action in the sector suggesting an economic slowdown?

Another key sector is the biotechnology sector. A speculative favorite. Thus far, biotechnology is far from its fall high.

Finally there is the internet sector as represented by the internet holders – a basket of internet stocks ex Google. The ETF is technically weak, and it is difficult (but not impossible) to believe that the market can head higher with internets and biotech lagging.

Today’s Market

I don’t know if I have made the case for “this time it is different” with respect to whether a major change in secular trend (from up to down) in the stock market is now in the works. If there is any single reason to suggest that this is the case, it would be the completion of the 5-wave ending diagonal with throw over in the Russell Small Cap 2000 index which would suggest, in the words of Frost and Prechter, “a dramatic reversal” ahead. Returning to the 6-month daily chart of the Russell, it is clear that we have a break in uptrend.

We are now back into the inside of the two trendlines that define the diagonal pattern. Provided that a sharp rally to reclaim the trendline doesn’t occur over the next few days, it is likely that the Russell 2000 will revisit the lower trendline of the diagonal. If that breaks downside, we’ll likely visit the 510 area, and if that crumbles the Russell’s uptrend is probably history. Of course from the bull market’s beginning to the present, moving averages and support levels have held, so it would not be wise to assume that “this time it is different.” Yet, it would also not be wise to be comfortable with the continuation of this trend. It cannot last forever, and there is no telling when the holders of our debt will decide to become long term holders of stocks (at much reduced prices), or diversify into the residential real estate market.

Here are some other key charts which are important to examine from the context of their importance to the general stock market, which time will not allow me to discuss at length.

Nasdaq 100 shares – On support whereby a bounce is the correct trade (unless “this time it is different”).

Mid Caps – A leading index with key technical level at 760.

Cisco – a return to the previous trading range would be bearish for the overall market.

Homebuilders – Head and shoulders pattern not yet completed.

General Electric – Bubble stock of the late 1990’s owns the major financial press outlet.

Google – RSI breaks into new low ground while prices sit on top of support. The heart of today’s market cannot be cut out. If there is organized support for the market, it will find its way to Google.

This time it may be different – the wall of worry may be legitimate.

Martin Goldberg

Copyright © 2006 All rights reserved. Martin F. Goldberg, MS, P.E. Market Analyst Expert Page Commentary Archive Email

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