The SPX made a textbook perfect wedge pattern with throwover and reversal; so have the Dow, Nasdaq, Russell, Mid-cap and NDX. The significance of a breakdown just before a major holiday, made all the more important due to Black Friday results coming out today, could be to mark a turning point in the market. Our Sell signal became operative upon the fast breakaway move Friday on heavy volume and high momentum. This caveat has been critical to performance this year by avoiding many of the potential sell signals that never came to fruition. These ‘unrequited’ sells constitute ‘noise’ but each one has to be considered carefully in its own context. The bottom line is that the market finally seemed to turn on our required fast breakaway movement with strong volume and momentum. The fast break so far is becoming in need of a corrective bounce, but shows many characteristics in common with larger declines of the past. A Black Friday below expectations may have been the key.

The question that remains to be answered is the same one upon which bulls have predicated their faith and confidence as they fully committed to the long side: will the consumer be able to spend more this year than last, making for a profitable Xmas spending season that drives 30%-50% of retailers’ annual profits. Xmas has become the ‘do or die’ situation for capitalistic economies. What we find to be telling is that many toy retailers have already cut prices sharply, suggesting that even if demand ultimately comes in at better levels it will still be a negative Xmas for most players. Word from Black Friday was that consumers took the ‘bait’, buying flat screens and other ‘hot’ items, but then left the stores without buying anything else. This behavior changes a great deal in terms of the selling environment. In a period of time where consumers are stressed by lower real spendable income, for a variety of reasons from weak jobs to inflation to higher fuel and mortgage costs to falling housing prices, any price cuts will quickly become ‘permanent’ in the minds of households. With so many consumers already suffering from inadequate income to cover necessary expenses, the only hope for anything close to a ‘normal’ Xmas will be to buy at exceptionally low prices and to cut corners wherever possible. To the extent that our view of the consumer is correct, we can expect to experience an almost unprecedented surge in crime as well as road rage as frustrated and desperate consumers struggle to avoid disappointing their kids.

Another classic indicator of pending recessions is inventory build-up. In the old days before Supply Chain Mgmt (SCM) companies would build inventories when demand slowed unexpectedly or suddenly. The costs of carrying excess inventories would then tax the bottom line significantly at just the point the firms could least afford to carry it. Layoffs would then follow and price cuts, which hurt profits even more taking the stocks down hard. Now days the inventory is seen as a tax or an insurance policy against problems in the Just-in-Time deliveries (JIT). For years during the start of the recovery from the ’01 recession experts debated why the inventory levels in corporate America remained at or below normal recessionary lows. Our view was that SCM had substantially changed the equation making inventories obsolete and largely unnecessary in modern factories where JIT was employed with great success. The cost savings were enormous and contributed to the peak profit margins now enjoyed by many firms in the market today. For inventories to suddenly spike upward to recessionary highs would be unthinkable in the new era of SCM, but in fact it has happened. The reasons are not totally clear, but we think that an unexpected drop in demand is the most likely reason. For us the spike in inventories suggests that the economy is undergoing a major transition that has not yet become disseminated: that another recession is about to begin. The timing as always is virtually impossible to get right, but we would posit that it is near. The fact that the ’01 affair was so mild indicates that this one could be deeper than usual.

Any forecast of recession is likely to precipitate a reaction that most indicators show that the economy is doing fine as the Fed keeps telling us. We wonder if perhaps the Fed has been drinking its own Kool-Aid. The use of PCE as an inflation measure along with the repeatedly debased traditional CPI and Deflators presents a picture of an economy virtually inflation-free; yet any household can plainly point out that prices have risen consistently and significantly over the last 5 years. Just look at the cost of watermelons or Thanksgiving dinner: our estimate of inflation comes in around 2%-3% above current CPI, so instead of 2.7% it could be 4.7%-5.2%. This estimate squares with the experience of households across the nation. Accordingly if the Fed actually believes its own debased inflation gauges then it would be late to identify pricing spirals and then be commensurately late in acting to stop them from ‘taking root’. We believe this is exactly what is happening with the Fed-heads regularly prescribing further rate hikes to stem the tide of inflationary expectations, yet the policy of pausing remains in effect. Soon the dollar will begin to slide as investors abroad come to agree with the notion that inflation is higher than acknowledged. If the GDP is only 1.1% with a great deal of help from cheats like not accounting for debt service (hence the switch from GNP) and debased deflators, instead of positive growth as reported it could well be running at (.9%) to (1.9%), clearly recessionary levels. The fact that NBER believes the recession ended in ’01 becomes debatable if traditional inflation measures were once again employed, perhaps carrying the recession into summer of ’03 and the recovery since a muted affair with substandard jobs creation. Reality and the numbers just don’t add up, leaving investors and the public with a sense of disconnect with their government.

While the market has managed to shrug off a series of seriously negative data and then rallied to new highs on subsequent data that to us looks at best neutral, something like a surprisingly weak Xmas could set off a rout in stock prices as complacency is replaced with fear. On the more likely side of the equation, we would not put it past the marketplace to simply ignore a negative report of early Xmas buying in favor of waiting until the days before the event claiming that last minute buying has been increasing over the last few years. Still the trends in economic data are clearly alarming to our eyes and business trends are equally disconcerting making stocks look a great deal more expensive and vulnerable than investors currently believe. A recession is uniformly bad for stocks so anything that brings us closer to an onset would be cause for concern, something that apparently escapes the grand majority of investors. It is too early to say much based on the trend break in the market so far, but we cannot find an adequate explanation of what is happening in the economy and in corporate growth and earnings that can better fit than a recession in the making which would show up initially as a new bear market. Jobs have been the best indicator over the last 50-100 yrs; with the significantly sub-par growth during this recovery, jobs are still sliding towards the zero line which would signal a recessionary onset despite even mystery revisions that even the BLS cannot explain that put almost 1m ‘new’ jobs into the roles. The trends seem clear: recession is coming whether we like it or not. Since the market anticipates 6-9 months ahead of the event, a bear market would then be the early warning and confirmation of our analysis of trends.

The market’s string of new highs has complicated our interpretation of LT trends and patterns as pointing to a major topping process that could be resolving in the near future. Right now fits the bill in a variety of ways. The bears are so beaten down as to hesitate to even discuss the situation much less act on it. This behavior acts to deprive bulls and market pros of the buying power they need to alternately resurrect weak markets or to fleece the bears by squeezing them into covering shorts. The recent pattern of wedges embedded in other wedges was last seen in the run up to May highs. Prior to that it occurred in the buildup into the March ’04 highs. The meaning of such patterns may be that market pros are frustrating bears by setting off repeated short covering rallies and then profiting from the bulls by stalling out buying after each breakout. It also functions to complete multiple layers of wave structures that constitute Elliott patterns. In each case it served as notice that a reversal was imminent; then as now it appears to be setting up a larger pullback or even bear market. Similarly investor sentiment has lately run up to excessively optimistic levels from fairly negative views. Some argue that because the absolute level remains below prior tops the market can run higher. To us the trends in sentiment signal a lower high and now the breakdown that leads to a market selloff.

The potential bottom in oil and long interest rates also could signal a correction looming in the near future. The basis behind a rally in oil could be the tactic permission by the US to build a nuclear arsenal in the Mid-East. Once OPEC grows teeth it can price oil at whatever level it desires regardless of economic impacts around the world. This would be especially important if reserves have been overstated and are now showing signs of running dry in the all too near future. Cold weather could also play havoc with fuel costs. A failure to rally could show consumer demand failing so it gets complicated very quickly trying to read rationales behind the charts. Rates may be clearer with inflation chief among the reasons for higher rates, but also fear emanating from Mid-East turmoil and somewhat tighter Fed policies. The impacts are substantially easier to gauge with consumers and marginal businesses suffering from higher rates particularly when home prices are down, income is weaker and mortgages are resetting from low teaser rates.

The count as we see it now puts the SPX at the end of the 5^th of the 5^th for so many orders of magnitude that it staggers us. Still risks remain that the market could run even higher on a ‘perfect landing’ scenario, but we have trouble envisioning it with such pressing problems seemingly everywhere. A ST terminal wedge threw over and reversed Friday after retesting supports (now resistance). Should SPX continue to move sharply lower and with requisite pace, the top could indeed be in and perhaps a new bear market could be in the making. Next key support at SPX 1325.

RTW

SPX has thrown over and reversed – and with the required fast breakaway mov !!

A 5th wave rally count shows a potentially complete structure

The bull run measures at 76.4% retracement – It also puts the 5^th/5^th at 100% of 1^st/5^th leg up

Durables have fallen to the 3^rd lowest level in 50 yrs – only once has it hit these levels
and not precipitated a recession

Prices still high despite big drop in GDP growth - from 3.5% in 1Q to 1.1% in 3Q – Inflation still threatens!

Confidence turns negative just as recessions have hit in the past – suggests onset coming in near future…

The Hourly Sell signal is at the extremes so a bounce could happen

VAP is trying to bounce – RSI is a bit better but still weak – Momentum will be key here

Crude is approaching key support – a bounce here is likely off $56-$57 level near term

Daily S/D sell signal confirms upon sustained prices below SPX 1390

RSI has made a lower high while VAP reached new highs for 52-wks – downside may be fairly large

A marked divergence shows on SPX’s rally through November – lower highs and lows may spell trouble

Rates have reached the ‘fish or cut bait’ point – below 4.599% the yield rally is dead…

The dollar is in danger of a freefall on deficits and a weaker consumer

The LT support for housing doesn’t come into play for another 50%+ decline – suggests more downside ahead!

Weekly S/D lurks at 4-yr extremes – appears to be turning negative – confirmation below SPX 1390

For a new high on VAP, RSI is still weak and now turning down – a lower high is a negative signal

Money Supply is threatening to breakout to higher levels after the election

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