The large caps ran to slightly higher levels, notching marginal new highs in many indices. Only the Dow and NYA seem to be in suspense. The significance of this action is to throw many a forecast and wave count to the winds. The key question that confronts investors is fairly arcane yet crucially important to determining the next direction of the market. The essence of the question is whether the action since 10/02 lows to the present is a 5 wave affair or a complex structure that is a corrective 3. The resolution will directly bear on (pardon the pun) the next major move in the market. If the pattern is a 5 then we can expect only modest corrective pullbacks, though from the highs this may seem to shorter term players like a bear market of some ferocity. A structure of 3’s would point to a destructive bear market that would at least test the lows but could run considerably deeper over the next couple of years. Whatever the count, the rally’s power has surprised us of late.

The pattern that developed off the ’02 lows could be counted as a bullish 5 into early December where it terminated in a wedge. After a long retracement the SPX then bottomed in March of ’03 and started its run to yesterday’s highs. We have struggled for years to interpret to our satisfaction the pattern count up from those lows. Whether they were complex 3’s or an expanded flat or a legitimate bullish 5 wave affair was just not clear, but due to the magnitude of each outcome it is of paramount importance in the years to follow. To be fair it could still be interpreted as any of these options, though they all agree that the pattern looks about done. What we think may have occurred, however, is that the slight new high on 9/26 finished a 5^th wave up instead of what looked devilishly tempting to the bears, like a bearish wave-1 (May declines) and a full retracement (wave-2) back up. That means the rally from ’02 lows may have only just be ending! 

The implications to analysts of a full 5 wave bull run by Elliott rules has to be a wave-1 or wave-A and therefore would not conducive to a bear market decline to new lows like alternate interpretations. Instead it could be part of a much longer A (up) of a corrective ABC recovery following the Y2k bear. The devil in the detail for this scenario is that the destructive bear would logically follow the elongated ABC corrective bounce from Y2k declines with a full bear market to new lows or nearly so. Another surprising possibility is that the market may have completed its first 5 wave rally in a larger bull market. If so then the Y2b bear would of necessity have completed entirely by the ’02 or ’03 lows. A new bull would pull back, but not much further than 50% of the run before starting yet another 5 wave rally higher! This scenario seems totally at odds with the economic picture as we see it. To justify a full bull market we would need something like the Internet boom to provide huge amounts of fuel required to bring it off. There are other possibilities but the one thing that seems fairly clear is that at the end of this run, SPX will decline in just about any case we can come up with. The depth, however, is in question.

The puzzle deepens with foreign large cap indices showing much the same patterns as the senior US avgs. The German Dax looks strikingly similar to our markets in the nearer term structures. We think the possibility of global correlation between stock markets supports our reading that US stocks are finishing a bullish structure and are ready to give up some ground. The fact that both domestic and foreign indices measure wave-1 and wave-5 at 100% makes us increasingly confident that an important top is being reached at present. We can see similar topping patterns in a great many software stocks that we cover as well, though the final stages could still show a little more upside before succumbing.

The finish to the structures dating back to 9/5 highs came in the form of a terminating wedge with 5 points in the shape of an upward pointing slice of pizza. The high on 9/5 was the 1^st, the low on the 11th was 2^nd, the high on 9/21 was the 3^rd and the low on 9/25 was the 4^th in the formation. The 5^th point came as an ABC up to the high yesterday which threw over the top of the terminating wedge. Interestingly there have been other structures leading up to this thrust that also fit wedge structure and could be building a nested pattern that often occurs at extremes. The powerful push that created the throwover also took a great many tech stocks to recovery highs and took the form of a blowoff top. Remarkably the spike in volume and price enticed the remaining bulls to throw caution to the wind only a week ahead of earnings pre-season! 

The Durables report showed a striking slowdown in gov’t spending. The recent Philly and Dallas Fed surveys only made it worse with similar sharp reversal of economic activity. These radical ST shifts have been echoed in the housing data as well. The Fed surveys’ impact was exacerbated by the Prices Paid components which fell only modestly despite the abrupt drop in business activity from healthy levels to those approaching recessionary readings. This could be stagflation if the inflation numbers don’t follow business activity lower, and quickly. The bulls will have to reconsider their wildly optimistic stance into pre-announcement season where the bad news flows and guidance can be cut sharply even into the seasonally strong 4Q period when most bulls were counting on it to power the next leg higher. The next data points will be PCE Friday. Next week has ISM and jobs data. Should that most insensitive of all inflation gauges show that prices continue to rise, the Fed will be at a minimum delayed in its plans to ease in early ’07 but might even force FOMC to hike one more time to the great distress of consumers, businesses and bullish investors. 

Interest rates are close to resolving a critically important issue that could well determine the direction of stocks both here and abroad. The long bond yield is caught in a maelstrom of activity, breaking down only to then recover and break again. The cross currents are extremely powerful, reflecting two warring motivations: the desire to fly to quality after the commodities bust versus the fear of inflation, especially stagflation. The currencies may tell the tale soon if erosion of returns forces int’l players to get out of dollar-based securities. The flight from dollar based assets has not yet gained traction and the long bond yields may signal changes. With our serious concerns about the effects of the ‘03/05 refinancing boom, the outcome that makes the most sense is for long rates to move sharply higher, exacerbating economic weakness and consumer distress as well as compressing P/Es, but fear is the most primal and powerful of emotions so this conflict may take more time to come to a lasting resolution. 

The bond market has rallied in a powerful move that broke threw a potential wedge bottom and is heading straight for longer term trend support around TYX 4.75%. The former support, now resistance, at 5.05% will be all the more intense since the breakout in May/June failed on its retest. The fear factor is great enough to subsume the flight from inflationary pressures. We find it fascinating that the long bond price chart is only just running into resistance at 112-12, and with a bearish divergence building in RSI. Should it hold the long bond could bounce off 4.67% support, a trend line coming from June/December 05 lows. The yen has broken down against the buck and is retesting trend resistance. The euro isn’t as clear sitting on support. History suggests that Japanese investors will repatriate assets if domestic markets improve. 

With the SPX blowing off above wedge resistance in a dramatic throwover, stock upgrades are flourishing all of a sudden, setting up the conditions for a potential bear trap. When SPX falls below the shortest term wedge around 1335 and more convincingly below 1320, early confirmation of a reversal would fall into place. The next step would be for the market to fall below 1291 support, the minimum pattern target for the wedge. Consumption data could confirm our contention that the consumer is hitting the wall due to sharply higher mortgage payments as adjustable rate loans reset from teaser rates around 2% to market rates close to 6%. That payment hike will squeeze household finances far beyond any benefit from lower gasoline prices, perhaps by a factor of 6-10x leaving little choice for consumers but to clamp down on spending and potentially to walk away from homes that won't sell. The weak durables numbers point to slower home spending, but consumer sentiment is running rampant with peak readings back in place. Investor sentiment is getting lofty as well. Perhaps only a new high on the Dow is required before the bulls run out of steam. A failure there would be bearish indeed.

RTW

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