The search for the end of a corrective bounce that began on 6/14 has been a difficult and frustrating experience given the many possible turning points that failed to deliver in the last few weeks. The moment has come again where logic and discipline dictate a potential turning point. The notion is predicated upon a reaction to the down leg starting on 7/3 highs that should cover between 50-65% of lost ground, but on weak volume and momentum to correct the speed and shifting sentiment from the downdraft before it. With sentiment back up to almost 50% bulls from a low of 32% a few weeks ago, the timing appears to be right for a return to the bear market from May highs.

The rally from 7/18 lows measures just above the typical 62% that Fibonacci followers look for, a common occurrence lately as traders adjust to profit from predictable actions of technicians at work. Adjusting for a deep pullback in mid-July gets SPX back to almost .618, the key retracement level. The same is true for the Dow and Nasdaq. Also of interest is the measure from the 18^th low and the next dip on the 21^st. For SPX the distance up on the initial move and the next rally up measure .618, a likely level to stop the advance particularly with low volume and weaker momentum than should be the case in a healthy rally. This is true for many senior averages as well. Finally our timing model picked the 18^th as a turn date and caught the lows within a few hours; the next turns are expected on 7/30 and 8/12.

The New High/Low models are showing a significant uptick in Lows combined with oscillators turning down again after a questionable bounce. The Supply/Demand models also show a continuing Sell signal on weekly timeframes as well as on daily, but hasn’t yet turned back down though momentum remains quite weak through the rally phase. Hourly models show a likely turn into a ST sell signal as of mid-morning. While room to maneuver remains in these models, the suggestion is that more downside is likely in the near future as market internals deteriorate into earnings season. 

Part of the difficulty of counting the corrective rally from 6/14 and 7/18 lows comes from the unusually large corrective waves starting on 5/24 and again on 7/18, which traveled to retracement limits over a long period of time. The extended time required to build these corrective waves then points to short and fast corrections in the next stage of the decline due to the principal of alternation between waves 2 and 4 in Elliot Wave Theory (EWT). The significance of the count as we can best determine today is that 3ii or the 2^nd wave (up) of the larger 3^rd wave (down) from the May highs is now increasingly likely to have finished, setting up the next down leg 3iii which normally is the highest momentum movement in the larger pattern and often the nastiest as well. In more comprehensible terms, the 2^nd period of declines from the highs is probably now ready to continue lower to its conclusion perhaps down to SPX 1170 sometime around 8/10-8/12. 

Why would the market choose to turn down now? We think it directly relates to both Fed policy statements and earnings reports that together suggest that the economy could be slowing more rapidly than expected and inflation continues to swell. Nothing in the text of the Fed tells us that tightening will halt, especially in the context of increasing price pressure showing up in both the  Richmond and Philly Fed. Along with misses from a major e-commerce facilitator and a top Mfg company today, the implication is that the economy is continuing to slow further and that inflation is not reacting to the weaker demand. This situation is all too similar to the mid-70’s stagflation era. The risks of recession and pricing power erosion from inflation are growing in our analysis. As inflation rises and growth slows, the Fed may not have the luxury of choosing to help the economy as it focuses on controlling inflation. In the past when a choice had to be made it came down in favor of the economy and the market and at the expense of inflation. In the current environment we suspect that the decision to stop inflationary gains over the economy and the market will be enforced whether the Fed wants to go along or not. The bond market vigilantes are lurking and conservative politicians are serving notice to the President that inflation has to be dealt with or rates will rise to accomplish the same goal but with a lot less concern about how the markets react to the contracting liquidity and credit than the Fed would. This is the hard landing scenario.

As we have noted in the past Sarbox may be causing a significant shift in the way companies report disappointing results. In the past the bad news would almost always hit in the pre-announcement season ahead of regular earnings. Then a few weeks later the reports would be almost entirely good news or inline results. What is occurring with increasing frequency of late is that companies are reporting substantial misses and guidance cuts during regular earnings. For investors that are not tuned into these changes the news can have a nasty effect of catching portfolio managers by surprise and therefore increasing the odds of an emotional reaction to dump the stock. Hence as we have repeatedly seen stocks that miss by a wide margin during regular earnings season are taken out and shot by upset shareholders. Accordingly we expect to hear more bad news in the days ahead as the bulk of companies report 2Q earnings. Caution may be in order.

A recent report in the NY Times talked about over $400 billion worth of mortgages written over the last 3 years are coming up for resets of teaser rates that are typically well below market levels for interest rates. The effect could be to drive household expenses sharply higher to the extent that mortgage holders do not double down by refinancing with another hybrid form of mortgage that allows their payments to remain relatively low. Our concern is that with housing prices falling recently many home owners may no longer qualify based on income for the mortgages that were written with the benefit of home equity balances. That would mean consumers would have little choice but to sell their homes or embark on a serious austerity plan that would impact spending across the economy. If they choose to sell their homes or if they have no choice, then even a relatively small percentage of home owners selling in distress will take out the natural bid in the marketplace, forcing prices down across the entire housing stock and potentially setting off another round of forced sales. 

Because of the use of derivatives in the mortgage market and the easy availability of hybrid mortgages that significantly reduce the monthly payments but at a high cost down the road, typical real estate behaviors may no longer be operative. Normal behavior in a pullback from recent high housing prices would be a slowdown in volume as sellers become reticent to cut prices down enough to clear the market. This hoping for better prices in the face of evidence to the contrary slows the declines in price because sellers often would elect not to sell until they get their price. In today’s marketplace this option to continue holding the home and paying the mortgage may no longer be viable for consumers with hybrid mortgages and low income to loan statistics made possible by such features as no amortization or teaser rate resets. Once the piper comes to be paid, home owners that cannot refinance will have to pay up by 100% to 200% depending on the type of mortgage employed, cutting retail spending and slowing economic activity. Or they may be forced to sell at the market price. If the amount of home equity falls below the loan amount, a possibility that has become increasingly likely with a 20%+ decline in housing prices, home owners may elect in large numbers to hand the keys back to the bank. The big problem arising from this scenario is that banks are notorious for dumping repos at whatever bid they can get, further hitting home prices.

With a market pattern that could arguably target SPX 600 over a 1.5-2 yr horizon, the underlying fundamentals would have to be significantly negative. With what we believe will be unusual liquidity in a down market in housing due to hybrids and derivatives on the CMO side, the real estate marketplace could become subject to the kind of cycle of margin calls forcing prices down and setting off the next round of margin sales, ultimately creating the potential for crash conditions. The Fed is already behind the curve in our opinion because of Greenspan’s choice of PCE indicator, the use of Core vs. Nominal inflation measures and the many distortions introduced over his term to CPI; all result in understating inflation and therefore overstating real economic growth. Accordingly the Fed has overshot its own tightening cycle substantially because it thought that the economy was zooming along at 3% growth when in reality it was skirting a recession at only 0.5% thanks to the omission of housing costs, hedonic adjustments and chain weighting to inflation indices taking off roughly 2.5% of the readings that would have been visible with the tried and true methods of measuring inflation in the pre-Greenspan era. The result could be that a major recession is coming, one that will take considerably longer to work out than the usual 9-months.

So far the jobs numbers have only slowed modestly but the trend lower is pronounced. One of these months the market will with high likelihood get a big surprise as jobs come in only a fraction of expectations and perhaps even negative. The best recession gauge we have found is jobs performance. When the jobs numbers turn negative a recession onset is the odds on bet. With construction companies posting big downturns in orders and record inventories, it is only a matter of time before the jobs number reflects the weakening of the economy. Since construction makes up a major part of Mfg labor and the total number of Mfg jobs has fallen by something like 95% of early ‘70s levels, the impact will be considerable. With falling retail spending, jobs will start to fall out of the biggest employer of service jobs: the retailing industry. All this could be occurring in the near future or it could be delayed much as the market correction was delayed by as much as a year or more by gov’t spending that propped up the economy far longer than it could have sustained only on organic growth. Since the deficits are so large, the gov’t will have to cut spending just when it most needs to increase deficits to protect the economy from a hard landing. Unfortunately the cushion inherited from prior administrations no longer is available to us.

The bear case certainly sounds scary enough. The market patterns support such a draconian view of the world. The huge increase in household debt levels from a generation ago threatens the continued ability to sustain lifestyle in the US . Derivatives could unhinge the financial system by bringing confidence in our institutions including the Fed into question. Inflation may soon be recognized as being far worse than the public has been led to believe by politicians and a gov’t with serious conflicts of interest. Huge debts to foreign lenders can be paid back in sharply devalued dollars, but the collateral damage will probably include retirees’ savings, consumer purchase power and systemic confidence which is the underpinnings of the entire financial infrastructure of the   US and of the global economy. If we were inventing a scenario that would explain what the charts say is possible, a bear market decline that cuts the market in half over 2 yrs, the current environment would certainly provide enough risks and problems to do the job, perhaps several times over. 

Still the lesson since the turn of the century has been that economic and market cycles can take a lot longer than anyone expects or as John Maynard Keynes so aptly said about 60 yrs ago: the ability of the market to remain irrational is far greater than the ability of the investor to remain solvent. We recognize that the bear view is only one opinion and that other possible outcomes could turn out to be operative. Accordingly we will strive to monitor conditions and respond to changes in the market picture should the most likely case shift in probability over time. For now the message is to prepare for a tough market but not to panic. The opportunities to make money are increasing, not the reverse! 

RTW

SPX may have completed a corrective wave-2 bounce - Momentum is failing here

SPX has retraced at 62% of lost ground – a logical turning point on bad econ news

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

Liquidity is only slightly better than in the last market decline – the Fed isn’t rescuing stocks this time around!

The Hourly is just about to issuing a Sell signal 

VAP is turning down and Moment is topping after a big run – a trend change in the ST?

Daily S/D is coming off a corrective bounce

VAP is rolling over - Momentum didn’t rise enough for more than a ST corrective bounce

Mfg is slowing but prices continue to rise – stagflation again after 30 yrs?

Bonds have now retested resistance at 108+ and now are testing the recent lows!

On an arithmetic chart yields have broken out above a 13 yr resistance zone!

Notice how Copper has divergent momentum on the double top – economy slowing ?

Weekly Sell signal becomes operative once again below 1240 on SPX

Momentum has stayed weak and VAP as well – suggests more downside ahead…

Smaller caps may be about to turn down in a deeper correction soon

Additional Information Available Upon Request      

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