The rally that just wouldn't quit may have run into falling housing prices! After two full months, the market was still trying to reach higher as of last Friday. But important signs of deterioration in the market internals may presage a turning point. Driven by better than feared economic and inflation news the shorts had to cover and the market pro’s took them to task by pushing prices higher on thin volume. When trading closes at the highs on unusually weak volume, short squeezes are often the cause. This is when the market makes a short term high and tests it three times then the stage is set for a down leg to commence. Expiration is over removing another bullish motivator as long positions are flattened by market makers propping up price levels for maximum pain to options holders. The market looks poised to take the next few steps lower based on chart patterns and internal measures.

The SPX chart pattern indicates that a corrective ABC rally may have reached its conclusion. While there is never certainty that the market will turn now, odds can be handicapped in order to improve risk/reward parameters and optimize trading profits. The patterns now argue for a logical point of bifurcation. Starting with the low in mid-June the SPX rallied in an ABC pattern. The measures of both time and price work out by our technical discipline to indicate a completed formation. The A-leg (up) now matches the C-leg (up) in terms of price movement, suggesting that the next direction the market takes will be down. The normal retracement limits have been breached which creates an uncomfortable dilemma for us. Using techniques to adjust for traditional Elliott Wave Theory (EWT), the SPX has violated the bear market move from May. Traditional EWT allows the market to retrace all the way up to the highs without changing the count. For us the retracement violation means that we would begin our bear market count from Friday’s high rather than from the May high as the start of the bear market should it in fact occur. For the moment the bear case is on hold; it must resolve to the downside before we can again expect significantly lower price levels over the next year or so. 

With the bear case temporarily on hold, the potential for a bull run to test the May highs is considerably higher than before the technical violation last week. Should buyers come into the market in a big way, it is possible that SPX runs further. We are seeing, however, a number of signs suggesting that the market is more likely to fall going forward than to rally to May highs. The fact that volume has been unusually weak, especially on Thursday/Friday of last week erodes confidence in the market’s will to continue the run up. Momentum echo’s this view with significant deterioration in market internals, showing weaker and weaker strength behind the recent market gains. Interestingly the breakdown of volatility measures normally points to a sustained rally, but in the current environment the fact that New Highs are so weak while New Lows are drying up quickly may alter the balance between bull and bear forces. Typically New Highs spike higher into a rally and Lows drop off at the same time; this time around SPX rallied with only a very weak pickup in Highs coupled with a fairly sharp drop off of Lows. Exogenous events may also play a larger role than usual with Iran’s stance on inspections of its nuclear facilities and pending announcement relating to nuclear capabilities threatening global confidence. Likewise the ceasefire in the Mid-East represents a tenuous basis for bullish conditions to flourish in our experience. 

The key to market levels is likely to be a function of Supply rather than Demand for stocks. Our Supply/Demand models indicate increased odds of a resumption of longer term sell signals. The S/D charts show a developing new sell signal on hourly time frames. The daily models also show marked deterioration in Demand for stocks recently. The weekly model is striking in its degree of momentum weakness indicating that more downside is likely soon. We find it curious that the Momentum price/volume consistently lags the Volume-Adjusted Price, or VAP, in recent weeks whereas in bullish times Momentum leads VAP (see the red vs. green lines on second charts after Supply/Demand below). Our interpretation is that rallies are losing steam over the summer and will set up a deeper selloff as a result. Similarly A/D Oscillators are pushing up against overbought readings while recent highs were made on a falling A/D line, suggesting risks of weakness are running higher than opportunity for upside gains. 

Inflation fears are lurking just under the surface of the market’s collective mind. That is why when Fed-Head Moscow spoke recently it turned the market on a dime and reversed the rally on significantly higher speed and momentum. After today’s soggy housing news, the market again fell hard on increasing momentum and volume. Should the selling continue, the odds of a change in trend would rise precipitously. The bond market, which is central to our view of the stock market, also flipped on Moscow’s speech and again more strongly on the housing news, staunching the hemorrhaging on yield charts. Interestingly this reversal comes almost at the last possible moment before the patterns would have been violated. TYX has been retesting key support in a long term chart formation that targets 6%+; but should rates fall below Tuesday’s lows, odds would substantially increase that a widely expected bond market rally will indeed come to pass. Given how liquid and enormous the bond market is today, little credence can be given to the notion of ‘painting’ the tape. We attribute the change to a reawakening of the inflation fears that have been so quiescent of late that the bulls convinced themselves that inflation no longer matters. Au contraire! 

For us the evidence is compelling that inflation is anything but quiescent; perhaps incandescent is more appropriate based on 5 yrs of Prices Paid indices with CAGRs of 25%-35% plus the combined impact of rising fuel costs and a falling dollar. The notion that only ‘Core’ inflation gauges matter to investors, we would agree – but only to the extent that forces impacting prices do not last longer than roughly 6-12 months at the outside – ‘transitory’ factors lasting longer than 12-months must revert to ‘Core’ status. To do anything less is to fall victim to denial, that most damaging condition that is antithetical to the gathering of profits. That the market just woke up from a nice dream where inflation was history only makes reality that much more disturbing given the magnitude of money invested recently. The risks of P/E compression due to higher interest rates are only subsumed by the impact of a cyclical downturn to corporate profits brought on by leverage and slowing consumer spending. 

One example of the insidious nature of inflationary expectations can be seen in the Richmond Fed Survey released Tuesday morning. The index level fell from 10 to 3 indicating significantly weaker business activity covering almost 10% of the US economy. But even worse is the Prices Paid component, which rose to 3.28% from 3.14% in the prior month. Considering that shipments fell from an index level of 13 to (8) in the August reporting period, the implications are that despite slowing economic activity inflation remains a growing threat, one that is still accelerating despite GDP growth that is markedly slowing. Much of the bull case is predicated upon the idea that inflation is peaking and needs only another period or so to show that the Fed’s tightening policy is yielding favorable results. But instead of demonstrating that inflation is ‘contained’, it appears increasingly likely from current data points that expectations of price rises are building rather than diminishing as widely believed by the marketplace. Therein lies the potential for a serious disruption in the markets, as rapid adjustments are required to bring market exposure back into line with actual conditions.

For us one of the principal risks to the stock market is the possibility that distortions in inflation measures have created a false perception of economic and market conditions that may prove to be untenable in the context of equity valuations once the true state of affairs becomes undeniably clear. To have accepted as valid the notion of paying $175k/PC when the true price is $400 (Hedonic adjustments in GDP) or of excluding housing costs from the calculus of CPI as it has been done for generations especially when home ownership is up to 70% of households or of substituting steak for spam with the result of recording net lower inflation because a dollar buys more spam than steak (Chain weighting assumptions in GDP) may seem ludicrous in time, once the mystique is replaced with reality. Then we will look back and say, ‘how could any clear minded person have believed that ‘Core’ inflation is the only kind that matters when nominal CPI is running at over 4% and oil has been over $40 for 3 yrs running?’ Our fear is that just like we now perceive ‘portfolio insurance’ as hokum, so too will we come to see that ‘Core inflation’ and ‘Nominal inflation’ cannot be separated – however convenient it might be – as both represent prices that are higher than they were in prior periods. Inflationary expectations can be an incredibly insidious disease; only exceeded by self-deception in its ability to destroy capital.

The pending announcement by Iran regarding its nuclear capabilities leaves us with a bad feeling. The classic ploy would be to stall, much as Israel has done with its ceasefire, until the essential operations have been completed. Then present a fate accompli to the world. Realistically what can developed countries do if Iran announces that it has a nuke? Nothing! Just like what happened when India and Pakistan made their declarations of membership in one of the most prestigious and exclusive clubs in the world. And what would stop other would-be members in the nuke club? Nothing much if they can stall long enough! The impact on the markets would be in our opinion stunningly negative. Hopefully Iran will instead choose to come to heel but what disturbs us is the market’s configuration that would seem to forecast a deep and destructive bear market that hits almost at any time. We like investors everywhere hope not, since our fortunes are tied to the Street like everyone else’s, but denial is not a useful defense and to us forewarned is forearmed.

RTW

A small H&S pattern may have confirmed in major indices today

SPX rebound since June lows measures A to C at 100% suggesting a completed corrective bounce

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

Should consumers pull in their horns, retailers could face a sharp drop in sales

Money Supply remains range bound so the dollar will be a better indicator while this is the case

Dollar weakness reflects inflation that the CPI with its 23 changes isn’t tracking – when it tanks due to deficits the market will get hurt!

The Hourly is signaling a new Sell signal 

Moment is so much weaker than VAP – looks like a trend change lower is likely 

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

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

Bonds are retesting the LT support – now resistance 

Long rates may have survived a test of the spring breakout higher – if so then the target becomes 6%+

Copper momentum is deteriorating – suggests global economy is slowing faster than thought

Smaller caps are poised to turn down again

Weekly is still on a ST buy signal 

Momentum is so far below VAP compared to prior rallies that a return to the LT sell signal is likely soon

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