No one seems to know exactly how, but from one day to the next, summer ends and fall begins: you can feel it in the air. If the current set of measurements on SPX are correct, we should be noticing the difference at almost any time. The market has run a bit higher than we anticipated with the .618 retracement of the Y2k bear market having measured to around SPX 1260. But what may have been short squeezes powered the market higher until the weaker hands had withdrawn. Now it looks increasingly likely that .764 will be the retracement that provides the resistance robust enough to stop the market rally. The fact that oil appears to be forming an important bottom along with interest rates may signal the sea-change that brings on the next trend direction and with it at least a significant correction, but potentially a great deal more.

The Dow hit its new highs while Nasdaq has only retraced .313 of its bear market, which is remarkably weak by any measure. The fact that large caps were the locus of strength suggests that a flight to quality or perhaps a new ‘nifty fifty’ scenario has transpired over the last couple of years. Mid caps hit highs in May but now are retracing just about the same .764 as SPX since the top. The same is true of small caps, implying that the forces that could make new highs across the board unreachable may have already begun to act upon smaller companies. Their large cap brethren may not be far behind, with only their huge scale economies and marketplace leverage driving the longer staying power. With profit margins failing to make new highs for the 1^st time since ’94 or so, it suggests that unless 3Q06 promises to show higher levels of earnings needed to surpass the 8.74% peak in SPX, the market may not be able to find sufficient fundamental growth to sustain recent price gains. With inflation data coming out this week, the turning point may be upon us.

The motivators for higher oil prices may be incrementally higher demand, but OPEC just lowered their aggregate global demand forecast implying that the issue is supply. The emergency meeting of the oil Cartel will likely provide loud voices for slowing production in order to diminish over supplies and to drive prices back up to the deliriously profitable levels of the spring and summer. Oil indices are close to highs and oil stocks are robust as well, but we notice a significant divergence in momentum, which could complicate the situation over time. Trying to connect the dots in order to understand the picture that charts represent is a difficult task, one that is subject to surprises. As of now we suspect that the global economy and the US in particular are weakening quicker and further than desirable, threatening to end the expansion on any Fed miscalculations. We have opined that the distortions in CPI brought about by changes instituted by Greenspan understate inflation by 2%-3%, with much the same data going into the GDP deflator calculus, and could precipitate an overly restrictive monetary policy stance. The effect would be to tighten more than necessary because the key indicators used recently like PCE represent inflation long after its initial resurgence and so will report its retrenchment commensurately later than would be needed to make a soft landing possible. Oil prices could be telling us that demand is greater than we realize, but that the combined tax of fuel and interest rates will stall the consumer and therefore the economy. The effect might be the same, yet arrived at through a different set of conditions. At least we will know soon.

Consumers are losing their much-needed relief from high fuel costs. The reality is that conservation is difficult at best and requires considerable time to fully implement, making fuel costs stay stubbornly high despite a lowered standard of living. Interest rates further exacerbate this situation by driving away refinancing that could save many households from substantial financial duress. After the last 3 years of massive refinancing activity, the majority of mortgages based on floating rates or hybrid structures are coming up for resets. If unallayed, this will drive costs a great deal higher for affected consumers. While fuel costs are highly visible and very annoying, the decision to continue driving or heating is realistically not up for much debate. As prices climb higher, consumers are forced to find the money from other sources. Compared to mortgage resets, fuel costs represent a small fraction of total annual costs for households. Accordingly we suspect that Xmas will be the first time in memory that parents are compelled to cut back on spending in order to stay afloat. The more realistic of the hybrid mortgage holders will choose to sell their homes event at sharply reduced profits because they recognize the need to stay liquid and to live within their means to avoid serious financial problems. The less prudent will find their mortgages in default and their homes subject to foreclosure. The forced sale of millions of homes may set off something akin to a margin call across the real estate marketplace taking prices down sharply and thus setting off another round of forced liquidations. This cycle could be a key contributor to what we are concerned will be a coming recession. 

Retail Sales data show a marked downtrend since early summer and when charted with food and energy, the drop has been precipitous. With inflation being propped up in the PPI by tight wage markets around the country, an uptick in Core PPI or CPI could foment a major surprise in the market: a rate hike just when consensus thinking was betting rate cuts would begin early in ’07 to facilitate a soft landing. With all the noise made by the talking (Fed) heads lately, it should come as no surprise that a rate hike is being seriously considered. Still the market can look at strikingly negative data and placidly ignore it while pushing the Dow to another record close. As long as bears are active in the market right now, the vicious short squeeze that has taken the market higher going back to 9/11/06 when short interest grew to outsized proportions and invited raids by professional traders and bulls. Once the buying pressure is largely completed, the firepower to sustain the upside in the market will be tested by the few bears with remaining ammunition. If they succeed in moving the market lower, then we can expect several waves of panicked selling to replace the short squeeze, giving the bulls a taste of the same medicine that cured many bears of any desire to test the market’s mettle. We think that on the heels of an oil rally starting out of a nice wedge reversal pattern and rates moving into another bullish wave higher, the market may finally be at a point where buyers can no longer support it, setting off a correction but one that could easily turn into much more.

The market pattern is one of an extended retracement rally from the ’02 lows, one that usually stops at 50% or 62% of the lost ground. This time, however, the market has run substantially further and made it to the 76.4% retracement level, which represents the last major resistance zone before new highs. Our count of the wave structure is one of a corrective nature with 3’s rather than bullish 5’s, but these counts can be misleading until they are complete which keeps the uncertainty high until just before the trend terminates and reverses. Our discipline will not turn bullish until a fast move has taken the market back through supports in the near term and on heavy volume and confirming momentum. It is this way we try to avoid whipsaws like May/June proved to be for many in the marketplace. So far the pattern reads to us as a corrective 3-3-5 formation that is typical of retracement rallies. It is reasonable, however, to count this bull-run as a bullish 5 wave affair and may be necessary should the market surprise us and make new highs across the entire market capitalization of stocks. That is in our opinion of the (dare we say defects) idiosyncrasies of Elliot Wave analysis. 

One way to adjust this flaw is to follow only overlapping and non-overlapping structures, ignoring classical wave counts. 

This technique was pioneered by a friend and mentor who passed away earlier in the year, but has proven to be quite effective over the period of the bullrun from ’02. Key to this approach are fast breakaway moves that occur because both bulls and bears have been drawn into positions and then squeezed hard, in effect taking them out of the market temporarily. Once the market is fully balanced between bulls and bears, usually at a point of a critical paradox shift such as the current debate regarding inflation and the strength of the economy, even the tiniest bit of action or news can sway the masses into a huge, widespread reaction. With both bulls and bears on the same side of the equation, in this case with bears badly burned and out of the market while bulls are fully committed, then a shift in the paradigm causes both groups to begin selling in earnest to reposition to minimize losses as the market takes off in a new direction. In our experience these turning points are as plain as sunrise on a clear day, but the buildup to the event can be treacherous and expensive. In the bear reversals it is much tougher yet given the market’s almost religious convictions about optimism and bullishness. 

As of now we are closely watching the market for confirming signs of change. It seems increasingly likely that change is in the air. But the key confirmation will come only on a fast breakaway move lower on high volume and with confirming momentum. Then SPX will knife through supports without looking back, evidence that longs are panicked and together with bears are desperately selling to reposition in time for the big move lower. That doubly concentrated selling power is what drives the breakaway move and easily overwhelms any opposition. This is where the ‘freight train’ analogies come into the Street’s lexicon: you can't fight the tape because everyone is selling at a fever pitch. Back on 3/12/03 we saw exactly that kind of action in the market, but now a similar pattern is evident in oil rather than stocks! We think the SPX is about to move in concert with oil and rates but in the opposite direction. Since the market has put up such a strong rally for the last couple of months a corrective pullback would be likely in any event so the real test will be the character of the downside. Bulls have run the table for so long that they will complacently give back some ground without a fight, until they realized that something else is happening, perhaps 5-10% down from the highs. Only then will they become worried and then fearful, the necessary ingredients for a bottom in stocks. It is for these reasons that we expect a deep decline in stock prices rather than a shallow corrective pause before a run to new highs. 

The alternate count for the market is a bullish 5 wave pattern from ‘02 lows that would make the entire Y2k bear market complete and representative of a larger magnitude wave-4 correction that then leads to a bullish large scale wave-5 rally to all time highs in a bull market run that will just keep running and running higher. The count using 5’s from the ’02 low puts the structure at the end of a wave-1 bullish movement, one that is now due for a correction in a wave-2 pullback. The next bull move would be a wave-3 action that would probably be quite powerful. After another correction, which by Elliot rules needs to alternate with the wave-2 decline in size and duration, the final wave-5 rally takes the market to its ultimate heights for the entire movement going back to the large scale wave-1 beginning that could date back to ’94 or even ’82 lows. This is another reason why we believe that a bear market in the near future would prove to be a deeper than normal drop in stock prices. The key differentiator between the corrective count of 3’s from ’02 lows and the bullish wave-2 pullback before higher highs to come will be both the structure of the decline and its speed/momentum. 

There is plenty of evidence for bears to make a compelling case for considerable downside in the market from here. But there is sufficient doubt and uncertainty so as to leave ample room for the bulls to argue convincingly for further upside yet to come from stocks. The narrowing trading range and increasingly tiny incremental price gains suggest to us that the market is well balanced between bullish and bearish camps: setting the stage for a decisive inflection point to occur. Now for the fascinating example of how market economies and free markets react to changing data on profits and economic conditions, a key attribute to the success of capitalism over the last 250 years. Close observation will reveal the mechanisms behind investor emotions during changing outlooks for business, stocks and the attendant risks. 

RTW

Multiple Wedge patterns are all coming to a major resolution very soon 

Our ABC corrective rally count shows a potentially complete structure

The entire bull run measures at A = C at .618% - a logical end point and close to a .764 retracement as well…

Retail Sales show a significant decline that breaks uptrend supports – turning point ahead?

Money Supply still isn’t moving! –Gspan would have poured on the liquidity injections months ago…

Industrial Production is slowing sharply and risks falling into recession ! 

The Hourly is turning into a Sell

VAP couldn’t make a higher high – VAP is now falling sharply – a turning point ?

Futures show a bullish terminal wedge that broke out around noon on 10/16

Daily S/D is coming off a corrective bounce

RSI failed to make a higher high as with prior VAP peaks – a big down day could turn this indicator bearish

A decisive failure at key resistance – inflation is scaring the bond market ! 

Interest rates are going higher – pressuring consumers and slowing business activity…

The dollar is rallying powerfully on renewed fear of geopolitical risks

Below 123 there is little support if any!

Weekly may be close to a turn – just need the breakaway move

For a new high on VAP, Momentum is strikingly weak suggesting a failure in the market soon.

Certifications and Disclosures

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

CONTACT INFORMATION
Richard T. Williams, CFA, CMT
ICAP Enterprise Software
Jersey City, NJ
Email