The bears, few that remain, got a major gut check at the door coming in to the office after a nice, long holiday. The time off was just about enough to forget about the lost year that was 2006 after such a promising May/June correction failed to follow through. Then the morning futures showed a major uptick coming on the heels of bullish international action during out holidays. It seemed as if the steamroller was fully gassed up and ready to roll some more when something very interesting happened: with the revisions included, the ADP data on jobs came in almost 200k Lower than expected. This is as readers may recall, the same index that incorrectly called jobs up 300k about 3 months ago and is a recent entrant in the economic statistics indicator space. That raised a lot of worrisome questions in the bond and currencies markets where bears were saying that a sharp drop in jobs would be a compelling signal of the onset of a recession (ourselves included). Oil prices broke down key technical support levels hinting at weakness in demand. When the ISM data followed shortly after the opening surge higher, it showed much better than expected results for both inflation and economic growth. The Construction Spending data was better as well. So given that backdrop, we would have expected a major rally higher; what we got instead were key reversals!

The trends for the ISM and Construction Spending continue to show the extremely bearish indications that have led us to call for a recession in the near future. Even the 3-month uptick in Construction was potentially only a retest of an important LT trend line breakdown from the fall. While inflation looked somewhat better, falling faster than the economy for a change in terms of prices paid, the overall trends suggest that much more trouble may be encountered in the near future. We have opined that housing has another leg down in the next 3-4 months as price reporting lags catch up with investors’ perceptions, killing any housing price or stock recoveries with ready sellers to pounce on any rallies as soon as they appear. The implications of the trend data out today coupled with the reversal of prices intra-day could easily point to a major trend change that we have been watching for over the last few months. 

The SPX had formed a series of embedded wedge patterns running back to late November as well as the latest sub-structure that began on 12/22 that required at least a higher high if not a meaningful throwover of resistance from the upper edge of the larger pattern. That throw over appears to have occurred at the open of trade for 2007. Over the next few trading hours, the market fell back inside both the 11/22 and the 12/22 wedges; once the Fed minutes hit the tape the lower edge of the 12/22 pattern was also breached, in a confirming movement for the entire formation. The larger wedge from 11/22 has its key support at SPX 1410, below which would provide critical confirmation of further downside in the near term. Of course all of the supports and resistance levels require sustained prices in order to be operative. Otherwise a failure to sustain breakdowns today in the senior averages would set up potential rallies to follow but that remains to be seen at this point. Of the larger US averages, the Dow shows the best wedge development with very clear formations from 11/22 and 12/22 starting points at the highs for each wedge, though a number of smaller wedges have also been subsumed by these bigger patterns. The implications, subject to our requisite breakaway selloff on confirming volume and momentum, would be that the bull market dating back to 3/03 or 10/02 if not longer would finally be complete. 

The bond market has been telling of late, providing the early warnings that we have observed in several major turning points over the years. Yields have broken out and run higher despite heavy resistance at a number of levels after a failed rally attempt last spring. Oil prices have fallen hard suggesting something has changed globally in the demand picture. The significance could be that inflation is more serious than realized, that the economy could be weaker than anticipated, that consumers are in a more tenuous financial position than acknowledged or that the dollar is at risk of a sea change in attitude by foreign central banks as they migrate toward euros and away from greenbacks. We have long maintained that any substantive shift away from US dollars by Central bankers around the world would have a most profoundly negative impact on the market as well as on the economy due to the ingenious design of the International Monetary System at the time of the Bretton-Woods agreement after WW-II. 

The essence of the situation is that the US gets to print many, many more dollars than could otherwise be the case without inflating its currency and suffering the consequences of purchase power erosion. This delightful outcome was wrought by the geniuses who gave us the post WW-II monetary system that has ensured US hegemony over all Western economies since that time. With the introduction of inflation in the mid-1960’s due to the Vietnamese war, the gold standard was eliminated in order to sustain the Bretton-Woods system in the context of US desire to inflate its currency to covertly finance the war effort. Should this monetary system become defunct, the US would likely feel the impact in terms of a sharply higher inflation rate coupled with a sharp drop in the dollar against other currencies. Further economic repercussions would follow, though exactly what would happen may not be clear given the scope of time that has passed and the lack of understanding regarding this critically important US institution. As long as we can hold on to Bretton-Woods, the US economy benefits enormously but as it erodes, primarily due to inflationary effects on our foreign investors in the dollar and dollar-denominated securities such as stocks and bonds, those benefits will potentially take on a geometric rather than just arithmetic shape to the reaction.

With Housing prices at risk for another down leg that could do serious damage to the economy and consumers’ ability to spend at typical levels, jobs become ever more important to the sustainability of the expansion, and by extension, the bull market. Friday will bring us the Non-Farm Payroll numbers and after the ADP variety, this could be cause for anxiety by investors. With word we have received from software vendors providing solutions to the Retailing industry, jobs that normally would have come about due to seasonal sales surrounding Xmas may not this time show up! That surprising conclusion is predicated upon the notion that new capabilities in SCM, ERP and CRM software make it possible for Retailers to eliminate the need, and expense associated with, seasonal help. If true as we believe it will prove to be, the jobs numbers this year may show a sharp drop from the more typical numbers in prior years, setting up a major surprise from investors. It could also tip the LT jobs trends below the crucial ‘zero line’ where our research has shown that actual recessions almost always follow sustained breaches below this level over the last 50+ years. Since NBER recessions are visible only after 2 consecutive negative quarters of GDP growth, this measure isn’t much use to investors. Our approach is potentially much more rewarding: we have been able to spot each ‘actual’ recession within only a month or so from its onset over back testing dating to the 1950s with only one error. That was the mid-80’s growth recession that threw off a number of related indicators as well. If jobs numbers continue to decline, our recession model will give a rare signal of a pending recession onset.

The market normally signals a coming recession by breaking down into a bear market 4-6 months ahead of the actual onset. This history has instances of concurrent bear market and recessionary onsets suggesting that we may not get much warning this time. With the greatly increased speed of the financial markets and global liquidity transactions there might not be much time for players to reposition before the markets react and take out any available bids. In the days of 1/8ths and 1/4s Wall Street could afford to provide crucial liquidity for institutional investors to liquidate large blocks of stock immediately, but in the age of not even pennies but mills of pennies, there is little incentive to provide capital in highly risky transactions any more. The emergence of auction-based electronic trading platforms could suffer from a hidden, yet critical flaw: they have no liquidity creation function like the NYSE and the Nasdaq did with Street firms taking on risk to earn a higher rate of return from customers willing to pay in order to get blocks done quickly in adverse market environments. Today there may simply be no more bids which could cause markets to gap lower on virtually no trading.

The SPX and Dow patterns point to a potential top and then a deep correction spanning years. The confirmations need to come in the form of multiple days of overwhelming volume on heavy selling, setting up the panic move that is required to signal a major trend shift. The current patterns are right as is the timing of pre-announcement season that begins after the close. The economic conditions are ripe and Xmas spending remains a significant question upon which a very great deal depends. The technical picture shows early signs of a potentially serious sell signal with New High/Low models, Oscillators and Volatility measures as well as Supply/Demand charts all show preliminary sell signals that require further development to become operative. With jobs numbers in doubt and LT trends signaling substantial issues emerging, the stage could well be set for a spectacular market revaluation lower to account for economic conditions that may have diverged sharply from the perception of investors pushing stock valuations to record highs of late. Should the next few days experience a sharp selloff on heavy volume and confirming momentum, we will raise our confidence that the bull market is rapidly coming to a close or is already finished. Still we would hasten to point out, the trading opportunities that would logically follow such a top and reversal scenario could be ‘once in a decade’ kinds of chances for alert and flexible investor to make money.

RTW

The Dow reversed yesterday’s sharp rally – potentially completing a series of embedded wedges

The Dow fits the bill for a nearly perfect 5^th wave structure, complete with wedge top, throwover and breakdown !

SPX has retraced 84.5% of the Y2k decline – almost exactly what a wave-1 to wave-2 relationship should be 

ADP jobs data showed a surprisingly large gap vs. consensus – could the lack of seasonal jobs cause a big miss on Friday?

LT data show a potentially important trend break in jobs creation – below the zero line indicates a recession

Construction shows another potentially key trend breakdown

Mfg shows an economy perilously close to recession – history shows a reading below 50 leads to recession

Mfg Prices have come down along with business activity – but may not be low enough to allow the Fed to stimulate again

Hourly Sell signal from New Years Eve is potentially getting extended.

VAP is falling hard but RSI is strong enough to force a bounce – perhaps the breakaway will have to wait

The inventory of homes for sale indicates lower prices ahead – 90-day pricing lag may be obscuring deeper declines.

Daily S/D is hinting at a Sell signal – SPX 1410 and 1326 are key support levels going forward

VAP is heading lower – RSI is weaker but at a potentially important level for a bounce

This is a potentially serious chart – Market breadth is sharply falling while prices ran higher!

Rates are retesting a breakout higher – note that momentum confirms the breakout so higher yields are likely 

The dollar below 80 to us means serious trouble – Foreign investors have decreasing incentive to hold US

Oil is coming rapidly to its Bullish Support Line – a key support level at $56

Weekly S/D needs only a fast move lower to become operative below SPX 1390

VAP is peaking but Momentum has lagged and indicated significant weakness – a correction is indicated

Money Supply is now turning back down after holding over 7% since the fall

Certifications and Disclosures

© 2007 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
ICAP Enterprise Software
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