The very popular notion of the Fed taking a ‘one-and-done’ approach to managing the economy and inflation may have bit the dust once and for all after the FOMC news Tuesday. The verbiage left open a major hole in bullish investors’ theory that inflation is not a continuing threat to the market by saying effectively ‘one-and-maybe-more-to-come’ which is anathema to bulls expecting to run well beyond new highs. If stocks are the longest duration assets in the financial markets as we believe, then they will react the most dramatically to rates increasing from low levels. This is what we have come to think of as the ‘Japanese P/E effect’ of the late 1980s. When inflation and rates are low, P/Es surge like Internet stocks, pushing valuations geometrically higher. This virtuous circle of events flowing from Volker’s taming of inflation in 1980 led to the long bull runs since in our opinion. That is why ceasing new long bond issuance was so helpful to the recovery 3 yrs ago.

Once the inflation Djinni is out of the bottle, as gold and bond market vigilantes would argue has occurred over the last few weeks, then the inverse of the ‘Japanese P/E effect’ will occur to the great discomfort of shareholders watching years worth of profits evaporate. We cannot yet say with confidence that inflation and vigilantes are prowling in earnest, but the early signs are suggesting it may become so sooner than many would wish. The key for us comes from the bond market, a counter-intuitive observation from an equity market analyst, but what drives rates has historically driven both earnings and stock valuations. The mystery of Japanese P/Es in the late 1980s when old-world stocks sported 50-75x multiples despite single-digit growth rates, was for us partially explained by the unwinding of that bubble. Once rates returned to positives following the wildly popular Japanese warrants that were attached to debt at the time and briefly became a $70-$100b market, then P/Es began the march back down to much more reasonable levels comparable to those in other countries.

In the context of the current market, we suspect that the Fed’s shift from cheerleader to cheerless inflation fighter as the Institution’s charter requires, then something has to give. Under Greenspan the Fed could help the economy and the markets by printing money, especially after 9/11 when gold last bottomed. But with the rise of inflation, at least the variety that bond market vigilantes believe in, comes the difficult situation where the Fed must choose between the economy, price stability and stock market health. The key change as we interpret it may be that the Fed cannot have it coming and going as before, financed as it was by printing presses. Now the Fed risks losing its hard won credibility if it fails to address adequately the inflation threats as seen by the fiscal conservatives who demand protection from price spirals in the yields of the vast quantities of bonds that they purchase. The same view point now appears attractive to foreign investors in the US, but particularly in US bonds. They have bitten the bullet with regard to a falling dollar, a result of deficit spending, and sacrificed returns for much of the decade already. Accordingly they are now increasingly demanding compensation for further investment and tacitly threatening to exit if they are not satisfied, a serious risk to the financial markets.

Commodities’ explosive run up in prices lately could be seen as confirming cycle work that shows the final stage of a recovery to often experience a blow-off in metals and foodstuffs. The fact that copper is masquerading as an Internet stock in Y2k should give pause to the LT bulls, suggesting as it does that speculation has taken over from good, solid fundamental supply/demand calculus and is completing the price spiral with a frenzy of euphoria. In our experience this is not the stuff of a dawning bull market but rather the dramatic end of one. The push up to 25 yr records in gold prices suggests that the glowing metal has migrated from jewelry to inflation hedge to speculative feeding frenzy. Well, at least it has strong momentum suggesting another leg to test the highs whereas other new highs look much less robust to us. As rates run higher, we would expect.

So why then would the Fed’s minor change in stance have the impact of precipitating a wave of dollar-asset selling? For us the answer lies in the market’s expectations. If ‘One-and-Done’ was the mantra and was disappointed by a Fed that is being forced to fight instead of create inflation, then the result would be a blast of selling by foreigners and interest sensitive players, like growth stock holders and long bond owners. The impact will be to broaden the selloff, as signs of economic slowdown concur with continuing pricing pressures, the worst case scenario for bulls: stagflation. We can't tell if this will happen, but do think the conditions are ripe for a correction that could extend into a bear market if the right mix of events is present. Pricing discontinuities could also fallout from the mix under pressure from an exogenous shock. We can't tell what because it has to be a surprise to the marketplace. But the list of candidates is long and robust. For now we await price confirmation below SPX 1290, but note that during the writing of this note the ST confirming level of 1314 has been breached suggesting further downside is likely in the coming days to weeks.

The market pattern is that of a terminal wedge now breaking down from its throw over. It is a topping pattern that has proven to be complex and surprisingly slow to develop. Since the Fed’s change in stance, the market has reacted with early signs of a trend change. Today may well cement that change with a fast breakaway move such as is being seen in Asia and Europe following the reversal on Thursday in US markets. The initial support on SPX broke at 1317 and again at 1314, breaking both sides of a wedge that made up the throw over for larger topping structures spanning weeks to years. The impact of the breakdown could be immense, but for now we are trying to stick to one level at a time. The small throw over wedge targets at least 1280 but could go much further. Below the 4/20 wedge we have been describing is another wedge dating to 1/11/06with support at 1290. Below that comes the 3/5/05 wedge and another at 3/8/04, one with support at 1245 which could be the critical one and the other at 1212. What could make this pattern so dynamic is that even the smallest wedge can easily reach the lowest support, possibly setting up a major correction or bear market. But again we need to act only on one level at a time in order to maintain good risk management and not get too far ahead of ourselves.

Rates are setting up a potential breakdown of major proportions. It is not yet clear and we hesitate to even show the chart but now that the breakdown has run well below what was support and now is resistance perhaps it won't change anything to illustrate it. The importance could be very high since the bond market often precedes the stock market in forecasting ability. The breakdown of a major trend that has been successfully tested perhaps 5-6x is not something to be taken lightly! It could signal a change in trend that began in the early 1980s, back when beer was much more valuable than pennies. Things have changed and today rising rates are like the icebergs that threatened the titanic; if long rates go much higher, it could undue whole industries and push the economy toward recession. With a double top in the Dow and what appears to be failing internals that suggest another test or breakout is unlikely, the odds of a recession go higher. If consumer confidence tanks then the odds ratchet that much further. It is a dangerous time for the market when leverage is so remarkably high, yet most investors don’t even think of it as being much of a threat. Derivatives could become a dirty word soon.

RTW

SPX broke down key supports to confirm the initial two layers of terminal wedges
making up a likely top

The Daily shows that 1290 will be the next level of confirmation making the 1/11 wedge operative

Weekly charts show the SPX at key resistance dating back to May 5 yrs ago – note divergent RSI!

Liquidity turned negative 1/20/06 – Perhaps the Fed wants a correction?

A sell signal is now operative in the ST below SPX 1317

This chart looks awful! With VAP plunging and Momentum even worse…

Word is that Confidence will tank today – we don’t doubt it and it could have an impact on stocks

Daily S/D is now on a Sell but needs price confirmation below 1290

As bad as the Hourly VAP chart looks, this isn’t much better – VAP is rolling and RSI is very weak!

Weekly is distorted by Y2K – but a sell is starting and goes operative below 1245

Momentum has lagged badly over the last rally suggesting a deeper correction ahead

Certifications and Disclosures

© 2006 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
ICAP Equity Research
Jersey City, NJ
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