Since the highs on 5/8, the SPX declined about 6.1% while the Dow slid (5.5%) and the Nas gave up (9.0%). The rebound from 5/24 lows made for retracements of 50% on most avgs, though SPX is a bit sloppy and Dow measures from a lower point to .618. The bounce has created a structure that measures close to 100% on SPX where the initial A leg up in late May is about the same magnitude of the 2^nd rally leg that began after Memorial Day. Interestingly this measurement of the A and C legs of an ABC corrective bounce also puts SPX at 1294 give or take, which is the trendline resistance from the big wedge patterns forming from January and 3/4/05. The trend line resistance has been tested in most senior avgs and represents an important bearish confirmation should prices not be able to sustain penetration them. For SPX the lower edge of the wedge from either January or March and the April lows hits at about 1294, while the Dow is around 11290 and Nas is roughly at 2220. It may prove significant that RSI seems to be lagging on the June rally to date, particularly on software stocks we follow. This could be signaling that the C-leg up is done or very close to it. So far the decline and bounce have behaved in an orderly fashion lending support to the bearish view that market declines have just started.

The counter argument for stocks is that the economy is doing well and the Fed is about to pause, which would leave monetary policy on hold while accommodation still is occurring, though to a lesser degree. The weak jobs data Friday points to the pause from the bull’s perspective. The charts also could support another blow-off top in the market with only a modest degree of stretching. The idea would be that the SPX has formed a rising or diagonal wedge from the 8/05 highs and now is rallying up to throw over resistance at 1350 or so. This pattern could happen, but in our discipline it is too ‘square’ in its formation to be a good wedge. The measurement of 8/3/05 to 10/14/05 is almost the same as the 5/8 to 5/24 decline running afoul for us of the classic definition of a wedge pattern that is comprised of two converging lines: for this pattern to converge, one must wait a very long time invalidating it in our opinion from being a wedge with all its predictive power. We mention it because if the rally from 5/24 continues higher, it would violate the bearish picture above the key trendline resistance into the 1300’s and at least shift the top to the right, but could form something else entirely that is not currently clear from the charts. 

Instead of viewing the jobs report as good news, our interpretation suggests that it is indeed quite negative news on the economy, pointing to the effects of higher interest rates on construction jobs as well as on the consumer in terms of demand. The Fed funds futures have been an excellent forecaster of Fed actions and Friday remained above 50% in favor of another hike on 6/29, but down from 68% prior to the news. The risk of another rate hike for us comes from inflation data that has been consistently showing increasing pressures on input prices and lately of wages too. We hear increasing numbers of stories from companies we follow of mgmt being forced to raise wages to avoid worker defections. The key point as we interpret the larger economic picture as it relates to the market is that jobs are in a potentially serious slowdown that is possibly beyond the reach of the Fed in the present climate of inflationary concerns. Looking back over decades, our recession indicator has been quite effective in catching the early onset of actual recessions and the bear markets that precede them. If our thesis is correct that the  US  is sliding into a recession then jobs will continue to weaken, turning negative for the 1^st time since early 2001.

The key to most bullish stances that we have evaluated seems to be a belief that rates will shortly decline. Without this opinion, much of the bull case looks a lot less compelling to us. The LT pattern of the bond market shows a very serious breach of longstanding support that has not been repaired even after many weeks of trading. This implies that liquidity is no longer available at easy terms as demonstrated first in Iceland and New Zealand but increasingly in  Japan as the carry trade shifts in reaction to sudden losses as currencies drop out from under traders’ feet. The risk to the currencies may be closely tied to global liquidity making the key indicators to watch the Japanese short rates and US long rates, forming a global yield curve that could have major implications for global stock market directions. The march to higher rates seems about to resume by our work. With the Money Supply holding at relatively slow growth rates for many weeks now, the upward pressure on yields seems to be a function of disaffected fiscal conservatives (the bond market vigilantes) no longer playing along with high rates of gov’t spending, forcing yields to adequately compensate for inflationary threats that they (and we) perceive but that the Fed does not believe is a meaningful threat. That the vigilantes have parted company both with the Administration and with the Fed is a very interesting and significant signal for us as we watch the market.

There are a number of issues that follow from the rise in interest rates. We note them here due to the powerful impact that rising rates have upon our analysis of the stock market and implicitly of the developments in the economy. Consumers are among the most fragile players in the interest rate drama, but the keystone will likely be FNM and its kin the GSE’s or gov’t sponsored entities carrying the implicit guarantee of a bailout. The GSEs hold a veritable ocean of mortgage debt and rely upon derivatives to hedge rate exposure to the shorter term funding of the huge portfolios holding much of the mortgage pool outstanding. The risks to rising rates hurt consumers for obvious reasons, but the twin taxes of fuel costs and debt carrying costs due to higher rates have a duration component as well. The longer gas costs over $2 and rates rise above recent lows, the more domestic spending that represents about 70% of the US economy slows down. So far there has only been limited evidence of consumer spending slowdowns among retailers, but as rates rise higher so too will the pressure on households to cut spending.

Other pressures on consumer spending follow from the use of home equity as an ATM. Recently the media showed a startling statistic that of the mortgages written in the last year, approximately worth $3 trillion, upwards of 29% have no equity in their homes. For almost a third of recent mortgages to be underwater suggests that potentially well over $1 trillion worth of homes could come to market as homeowners turn in the keys to banks and walk away from their failed investments. Recent spirals in rental costs demonstrate that the long lasting exodus from renting in favor of owning homes is now reversing and probably gets much bigger before it stabilizes. We made a big point at the time that the Fed had changed CPI, taking out the homeownership costs and using rental costs as a LT proxy, thereby distorting the inflation readings for a number of years as rental costs fell with rising home buying. Now that the tide has turned, the Fed may have to revamp its statistics once again or face the music because CPI will now begin to rise faster than many expect due to this very important change made by Greenspan in 1998-99 timeframe. With CPI running higher on rental costs, so too will rates to compensate for rising inflation threats to retirees, raising costs to gov’t programs like Social Security, Veterans Benefits and Medicare. Also with rising CPI comes upward pressure on the bond market yields, hastening the day that the stock market has to deal with P/E compression in which rates are tied intimately into valuation models for stocks. The flood of mortgage resets and expiring teaser rates from 2 years ago will only exacerbate weak retail sales, as consumers can no longer rely on home equity to qualify for refinancing and have to cut spending instead.

Long bond yields are ST correcting a larger buy signal

Interest rates are very strong as RSI (green) shows – suggests higher yields coming soon

As we look forward in the context of the market pattern, the quiet period ahead of 2Q06 earnings season is about a week away and will quell much of what can be said about stocks in the US on calendar fiscal years. This ‘quiet zone’ is a potential issue as data points trickle in about how the qtr went for companies because there is a 3 week period into the end of pre-announcement season where little good news can come out on stocks, but plenty of potential bad news can still come out. Pre-season is officially the 15^th of June to the 10^th of July for 2Q earnings, but the final days of June into the 6^th trading day after the qtr end is what matters for most tech stocks. This period is often the time when bad news comes out, leaving investors hanging until regular earnings season kicks in from the 15^th to the 31^st of July more or less. During this ‘quiet zone’ the market has a coincident pattern that could easily turn into a major problem for investors with what we describe as a wave-2/ wave-3 transition that could set off the next down leg in the market decline.

The market pattern has come down in a typical bear leg, and then bounced in a fairly standard corrective bounce formation. If the market now turns lower and accelerates, then the odds will swing heavily in favor of another bear leg of similar duration and perhaps even greater magnitude. This structural formation also coincides with other technical issues that provide support and may emphasize the turning point and down leg that could follow. With major wedge support lines that broke down with the May decline in stock prices, what used to be support has now turned into resistance making it more difficult for bulls to push prices higher or even to sustain them as new selling pressure comes into the market. If prices in fact do turn down now and selling pressure accelerates the speed of the decline, then it will provide confirmation on a number of fronts for our bearish forecast for a bear market and recession in 2H06.

Our Supply/Demand models show stocks in a Sell configuration with a significant bearish divergence between Volume-Adjusted Price and its Momentum as measured by Wilder RSI. The sell may be easing a bit as Supply slows its ascent; this is part of the potential bull case for another blow-off top should the Fed aggressively ease into weaker jobs and consumer spending data should it show up soon as we expect. The Momentum of this pattern is very weak pointing to further declines ahead, however, and we have found that with this model the RSI is surprisingly useful and accurate when used in conjunction with S/D charts. The daily models show a pattern that is now quite coiled and poised to move in one direction or the other with a great deal of force. Looking back to a study we conducted around Y2k timeframe, when S/D chart configurations approach this level either a ‘crash’ or a powerful rally shortly follows in the grand majority of cases evaluated. This configuration led to the big October ’98 rally, the October ’00 bear as well as the October ’02 rally for example. How this time works out is not clear and may be affected by Fed action or inaction in a substantial way making technical analysis much more difficult. The Hourly model shows SPX to be shifting from a fairly meaningful rally mode into a new Sell signal. What makes the Hourly difficult to interpret, is a surprisingly powerful Momentum reading on SPX. Normally Sell signals are accompanied by weak or divergent Momentum, but this time it is coming off a big surge that suggested higher prices in the latter days of May. The Momentum indicator is now divergent again which may mean that SPX is ready again to decline.

By the same token, we see signs of rates rising again perhaps after a bit more corrective consolidation. The euro appears poised to experience a substantial decline relative to the dollar, yet the yen looks ready to go the opposite way, rallying further versus the buck. This could hurt multinational earnings and sales, pressuring the market further. It seems that every way you look, there are troubles threatening the market!

RTW

SPX has likely begun its 3^rd wave down targeting 1232 or so ST

SPX would confirm the weekly Sell signal by sustaining prices below 1245

 ‘C’ Wave down could follow the Y2k ‘A’ wave bear market down in duration and in magnitude

Liquidity isn’t flowing to help the market – for the 1^st time since ’03 lows – a major policy change!

An hourly sell signal started Monday afternoon – on Bernanke comments

VAP rolled over but RSI really took a hit – Tuesday could suffer from this kind of pattern

This chart is scarier to us than today’s date!

The day before the Crash of ’87 looked like this…

Daily S/D is at ‘Crash’ levels – in the past the market either rallies or falls hard from here! 

Momentum didn’t buy into this rally attempt at all – now VAP is turning negative and so is RSI!

Prices Paid are accelerating higher
 Inflation is getting worse not staying contained – rates may have to follow!

Bonds have now violated a support line going back to before Greenspan’s time!

Weekly sell signal becomes operative below SPX 1245

Momentum is telling us that the market will fall further – likely confirming the next bear leg lower

Housing hasn’t fallen this hard since the 1990 recession!

Copper is a good proxy for economic activity – This chart says further downside is coming soon!

Certifications and Disclosures

© 2006 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
ICAP Enterprise Software
Jersey City, NJ
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