Closing Prices	Support	Resistance		Yield %
Nasdaq	2272.70	2125	2250	S&P 500 EPS yield	6.51%
S&P 500	1261.48	1245	1316	30 Yr. Bond yield	5.13%
Dow Jones Indus	11148.73	11125	11750	Greenspan index cheap by 28%	127.9%
Crude Oil	71.30	68.00	75.50	ST yield	4.71%
Gold (spot)	648.00	600	690	Yen/dollar	112.68

The gains of 2006 are rapidly slipping away with SPX now up only .66% from up 6.3% at the highs just 2 weeks ago. The speed of the decline has been striking especially considering the prolonged sideways movement over the last 2+ years. More importantly for us is the action along key support lines for several senior averages like the Long bond and Nasdaq. The Terminal Wedge topping pattern we discussed in prior notes has confirmed on the initial support failures and now is closing in on the lower supports in many indices, suggesting deeper declines ahead. So in this environment we wonder just what the market is telling us about the future considering its longstanding track record of accurately discounting future events. 

The charts are getting uglier in a variety of markets. The bond market has led the way and is falling further below the key Bullish Support Line (BSL) that has repeatedly served as the level that called in heavy buying and then rewarded such activity with big gains in the ST. The fact that the BSL has failed implies that something potentially very important may have changed in the marketplace. On the arithmetic chart bonds are right on key support, so the next move could be telling. Interest rates have manifold impacts upon the market and so are the single most significant indicator for us. With housing and construction representing the vast majority of jobs creation, higher rates will with high probability slow both building activity and cut jobs across the country. Higher rates also play into the demand side of housing with mortgages falling at the peak of the seasonal cycle, a telling statistic of trouble in consumer finances in our opinion. The trend in mortgage applications is showing signs of strain as well with a break in the pattern spanning the last two years. Rates further affect stock prices by compressing P/Es as we have observed in the past, but not on a one-to-one relationship as one might expect. The P/E effect of rising rates and inflation tends to be geometric at low relative levels, taking valuation multiples down several times as much as rates rise off the bottom. 

Consumer demand takes a hit as well from higher rates through the inverse wealth effect and on the mountain of debt now being carried by households across the US. One statistic tells it all in our opinion: last week we saw a study on TV that showed 29% of all mortgages written in the last 12-months are now under water! That must send chills down the backs of banks all around the country as they contemplate repossessions by the truckload. It should send similar chills to anyone thinking about selling a home, particularly anyone who must sell, because distressed sellers tend to sharply depress prices and none more than banks dumping repossessed houses as quickly as they get them. It suggests that the virtuous cycle of wealth effect and multiplier effects are now reversing, taking down demand at the same time that prices are compressed making a downward spiral possible. The bigger problem is that it probably will follow the same line of acceleration that occurred on the upside in early 2003 when everything was working in favor of higher prices. 

No discussion of interest rates would be complete without a look at Money Supply statistics (see chart below). The liquidity pumps have been used like never before since just before Y2k and have played a central role in shaping the markets over that period and likely well beyond. The Fed has eased off the accelerator at a time that makes sense for inflation hawks that are ever more stridently demanding action to slow what they see as a new cycle of rising prices already well established and threatening to turn much nastier in the coming year. The timing also comes at a bad moment for the stock market and potentially for the economy. Normally the Fed would gun the liquidity pumps and make the problems go away. But something important has changed in that the opposite seems to be occurring; the Fed is sitting idle as the market takes a pounding. That alone is remarkable since 5 years have passed without a similar event taking place. 

Our informal indicators are pointing to a situation where the economy may be slowing more rapidly than realized by the Fed or the market. Over the last 10 years or so we have been regularly conducting informal surveys of the tone of economic activity from a variety of sources. In the last year or so they have been steady and robust, but over the last three weeks we have noticed a marked change suggesting that business activity may be slowing much more rapidly than expected. The validity of these indicators has been pretty good over prior cycles but it tells us more than anything to be alert going forward for subtle signs of change on the margins. No indicator will carry more weight for us after yields than the jobs numbers. If our thesis is correct, then the coming jobs reports will show substantially weaker jobs creation than expected. Should the jobs numbers turn negative, then the economy could be moving into the onset of a recession. The market tends to forecast it with a bear market about 4-6 months ahead of the NBER, but our jobs indicator appears to be much closer to coincident than lagging like other recession measures. We will posit that a recession has begun after two consecutive negative jobs reports.

The charts show a fascinating picture of what could turn out to be a failed recovery and double dip recession coming in the next 6-12 months. Taking into account deeply flawed indicators like the NBER recession gauge, it could be happening much sooner in reality. A study we conducted 6 years ago concluded that of the major bear markets around the world over the prior 40 years plus 1929, in all periods the market rebounded between 30%-65% over a similar duration as the initial decline and then rolled over into a second decline of roughly equal depth and duration. The charts are now pointing to a rising probability that the economy and financial markets are going to follow the historic precedent and slide into another decline. This outlook only weeks ago was considered the minority view, but is rapidly moving into the mainstream as events paint a surprising picture of developing crises that weight down buyers with a rising tide of troubles.

For us it may have started with Iceland’s and New Zealand’s currency crisis. Both governments had enjoyed a period of prosperity and were spending increasingly beyond their respective means. Eventually creditors objected and investors quickly moved to exit widespread carry trades that had become wildly popular among the hedge fund community worldwide. Next came the commodity blow-offs around the world as speculators ran wild pushing prices into the stratosphere. This is typically a good sell signal on the economy and in its final stages on the stock market. This time was no exception to the rule either. The liquidity cycle is quiescent at a crucial moment implying that the Fed will stand by as the market gets hit, the first time in recent memory that has happened and bound to be cold comfort to the bulls that have depended and gotten rich upon the expansive efforts of the Fed’s Money Supply policies. Interestingly the Arab markets tanked into the commodities blow-off. Then the fateful Fed meeting where the language changed ever so subtly as Helicopter Ben more by default than by commission apparently ended his support of the markets. For our lights it is about time! 

The prices paid indices have run so far that it is remarkable that inflation isn’t a great deal higher than we hear about. Then again by our math inflation is a great deal higher than the Fed or the government tells us that it is. Last year at this time we ran CPI numbers but added back in housing costs, reversed chain weighting and removed technology hedonic adjustments. The result was startling: CPI went from 3% to 5.5%! The impact of many of Greenspan’s changes to CPI over his long tenure in the Fed was to distort inflation measures by taking out key elements that have lately been major contributors to what should be a much higher reading. Interestingly the market appears to be ready to pay attention to what it blithely ignored only weeks ago! Again, its about time! The long bond is poised to breakout to multiyear yield highs that would likely set off a major bear market and perhaps an accompanying recession. Time will tell.

The Fannie Mae (FNM:$50-NR) crisis is a particularly scary one for most informed investors. It represents the largest repository of mortgage debt in the US and only supports it with a tiny 2% of total loans in hard capital. If FNM’s hedging program slips even a little bit due to rising rates or defaults by borrowers, then its capital will be the only bulwark against a much greater crisis enveloping the financial and housing markets. With nearly 5.5% of mortgages already 180 days late (remember this is your home and is the last place a sane person would fail to pay up if at all possible), the risks of any bad news that increases consumer distress like higher interest rates or higher fuel prices will likely set off a wave of failures where people simply walk away from their obligations. That in turn would cause rapid selling of repossessed homes by the banks to repay mortgage debt as far as it goes. Bids would rapidly reflect the distressed selling and with such high proportions of mortgage holders already underwater, the banks and FNM would be next in line to take the hit to capital. Once the crisis gains traction, derivatives players could be wiped out by the same forces that pushed LTCM to the brink: no one wants to step in front of a locomotive at full speed, even if the ‘models’ say they should! That reticence would likely take away the necessary bids required to keep the system afloat. When living in a world of extreme leverage, it doesn’t take much to foment a crisis of capital. With the government up to its ears in debt and deficits, its ability to help is limited. Prime the pumps in a very public way and inflation expectations explode higher. That in the end is the most likely outcome in any crisis because all the moves leading up to it are predictable and therefore the markets will discount them as far as possible. 

The market pattern is rapidly devolving into a confirmation of a major breakdown of support. Nasdaq is at the forefront with a break of its Bullish Support Line (BSL) going back to 3/12/03 lows. This is significant because if our wave count is correct, then all that has transpired since that low is the final 3-waves up of a corrective bounce that followed the great Y2k bear market. Once that BSL is broken, the bullish 5 wave pattern is likely completed. That our LT study of bear markets around the globe called for a reversal at almost exactly the point that the senior averages topped and turned lower further supports the thesis that a new bear market and recession is soon to follow. On a log chart Nasdaq broke down but the 8/04 lows which we count as the lower edge of a multi-year wedge top still lies below the current price, providing one last support line at 2125 before a deeper, more damaging bear gains traction. 

The Dow is now below both wedge top supports on a daily but hits the weekly, multi-year wedge support around 10500. It is the strongest of the senior averages while Nasdaq is the weakest, a curious result given small and mid cap indices’ new highs recently. The Russell 2000 broke down its daily wedge as well but doesn’t hit the LT wedge support until 670. Perhaps the most interesting dissonant data point is the NDX, the Nasdaq 100 largest companies, which is now fully through all of its wedge supports and arguably starting its major bear run lower. With so many cross currents of large cap and small cap stocks behaving differently depending upon which industries they reside in makes for some of the confusion investors are now confronted with in the marketplace today. 

The SPX is not much better in terms of pattern readability over the last 3 years. The false breakdown in October ’05 throws off our demarcation of wedge supports. If we ignore the violation then the key support line hits at 1245, which is also the prior new high from 3/05. If we include the violation dip then the support hits around 1220, but changes the pattern. Our experiences point to higher degrees of order as the most probable pathway to catch big turning points. With multiple supports arising at 1245, that level becomes our key confirmation point for the larger scale pattern supports. With its sustained breakdown our weekly Supply/Demand sell signal becomes operative and targets considerably lower prices before the deluge is completed. 

For now the market looks like it has entered a high momentum, high volume down leg that is only partially complete. With the BSL supports failing on important markets like long bonds and Nasdaq, the implications are for further failures across the stock markets around the globe. One of the lessons of the ’98 LTCM crisis is that all markets tend to correlate to one in major corrections and panics. That means investors cannot find a place to hide within the market. Cash is king in a crisis, but with rising inflation not even currency is safe! Gold may be better but doesn’t pay interest. FX crises are likely to be precipitated along with a bear market in the US, exacerbating the selling internationally as the Fed is forced to defend the dollar at the expense of the economy and the stock market. This is the perfect storm that takes away the gains (and perhaps much of the capital) gotten by its virtuous twin that so powerfully rallied the markets in over the last 3 years. For us the best way to play is to hedge longs or play short, buy gold on dips and avoid swaps or derivatives. 

The good news is that free market economies are the best in the world at solving problems quickly and efficiently. Consider the S&L crisis compared to the Japanese land crisis of 1990. The free market economy solved the problem rapidly and with minimum of costs to the system. The planned economies take decades to work out the issues at best. Likewise free enterprise is the best system in the world to innovate us out of trouble again and again. This is the lesson of history. So bear markets and recessions are actually healthy events like winter to the 4 seasons. Rather than fight them and incur huge costs that ultimately fail to change the pattern, it might be better to work with the system and let it do what it does best. The one hope for bulls to avoid a serious sell off is a major buying flurry at the key lower wedge supports at SPX 1245, DOW 10500 and Nasdaq 2125. At this point we are doubtful but one never knows. Better to remain flexible and make money both ways!

But either way be careful: its dangerous out there! 

Certifications and Disclosures

© 2006 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
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