The dollar has bounced back after falling down below its strongest support at DXY 80.25 suggesting that the next two (last two) support levels at 79.80 and 78.20 will be safe at least for a while. Neither of these levels have the depth of support that earlier zones boasted. The dollar plunged through heavy support like it was largely irrelevant. From our perspective a falling dollar drives inflation and therefore higher rates. As rates rise delinquencies and defaults in consumer mortgages will accelerate. Unfortunately the relationship won’t likely be 1:1, but rather a geometric acceleration so that 50 bpts higher rates could for example double defaults making the looming housing/consumer crisis build faster and faster. The Street is coming to realize that sub-prime problems may translate into the broader bond market and into consumer spending behavior. We couldn’t agree more! The problem is that with 10-12% vacancy rates in many mid-sized cities around the nation, any meaningful increase in defaults will drive housing prices lower, exactly what consumers living on the edge can't tolerate. Without the ability to refinance out of teaser rate ARMs, resets which are happening at the highest rate now that summer is turning into fall will accelerate the number of distressed sellers driving home prices even lower. This speeds the cycle and pushes even stable households into financial trouble that results in austerity (read recession). But what makes the marketplace so challenging to profit from is that prices don’t just follow a straight line. Hence the bounce potential.

This indicator spikes up on corrections – when it reverses a big rally can follow – but only if it stays down

The marketplace is beginning to ‘get it’ in terms of the risks to stocks and bonds going forward. As the sub-prime crisis bleeds into the CDO market and then driving a change in risk perceptions behind the entire rate structure that effects stocks, bonds and business profits. With every mortgage insurer going bust and every hedge fund denying redemptions, the picture and investors’ fears grow clearer. What makes profiting from such emerging trends so difficult is that stock prices behave like a rock tied to a rubber band: when the market mind starts to appreciate new risks the rock falls, stretching the rubber band until it reaches its limits. Then the rock (market prices) rebound to some degree, usually a Fibonacci ratio of the decline before returning to the downside. While we cannot rule out further bearish declines ahead, there is an interesting and potentially profitable trading opportunity that appears to be upon us. The market is testing its multi-year support line at SPX 1450, extending from the lows in 7/06 and 3/07. If this trend support holds then the market will bounce in what has become known on the Street as a ‘Dead Cat Bounce’. Typically a dead cat recovers between 38% and 65% of lost ground. More than 65% recovery suggests that this bounce is something more than a bearish corrective movement and that our supposed wave count is somehow wrong. At present the count appears to conform best to a 5-wave (bearish) decline that is in its 4^th leg (up) to targets between SPX 1485 and 1512 with the midpoint at 1500. Above 1500 the count is wrong.

This chart is looking worse and worse – forecasting a major correction or even price discontinuities ahead, but with a bounce 1st

The alternate wave count calls for a return to new highs in a fairly rapid and surprising rally. This outcome is so unlikely that it fits the bill for the market’s persistent ability to disappoint the maximum number of investors. It would likely be born of a Fed rate cut or some other surprising event that would ease investor fears for a time. Since earnings are over and Back-to-School is the next important event in consumer spending until Xmas is upon us, that will be an area of close focus for us to gauge the impact of Mtg payment resets that are peaking now through September, representing about 50% of all ARMs sold since ’02 receiving rate hikes of 100%-300% of monthly payments. Also around 50% of the class of ’02 that was hit with initial resets this time last year, which precipitated the sub-prime mess early this year will receive their 2^nd reset from approximately 2.75%-3% up to market rates that today are 6%-7%, effectively doubling costs again for those mortgage holders unable to refinance out of the Option ARMs purchased at 1% teaser rates for the initial 3 years and then ratcheting up to market rates over the next couple of years in 2.75% to 3% increments. This is the Double-Down thesis we put out earlier this year. It calls for another down leg in housing and Mtg defaults which will probably cause consumer spending to fall sufficiently to push the economy into recession, if in fact it is not already there! Since we will not know the truth for several more months, there is ample time for bulls to reassert themselves and do some bottom fishing that has been so well rewarded over the Greenspan era. The larger question is what Helicopter Ben will do next.

After whatever bounce potential in the market unfolds, we anticipate further negative economic data leading to the realization that the sub-prime problem has morphed into a bursting housing bubble driven by leverage from easy money coming from carry trades at remarkably low costs to borrowers. As the truth dawns on investors, the result will be an increasingly urgent desire to protect capital even at the expense of returns. In other words, rates will run higher at the same time that credit availability will trough making any leveraged transaction difficult if not impossible for any but the most liquid investors. In short: if you need to borrow, you won’t be able to get any. The implications of a full blown credit crunch akin to the ’79-81 era would be to severely correct any market dependent upon leverage and big inflows to sustain price. Put another way, in our experience everything will decline and decline sharply and cash will become king once again as it did at the trough of each economic cycle. But this time dollar denominated cash will erode at an increasing rate as inflation ramps up to repay huge gov’t debts.

There is a widespread belief in the markets that after a prolonged period of higher than normal returns in financial assets that any correction will return to the LT trendline and then rebound. Any serious study that we have made into market history demonstrates that this outcome is simply a fantasy of complacent investors. The historic pattern has been to correct hard and fast, taking the market prices all the way back down to the very LT trend lines which typically means a 50%-90% correction. Once the flow of easy money is crimped then every market that benefited from surging liquidity will have to return to trough valuation levels along the lines of the ’02 bottom when stocks traded for net cash or less. Many stocks bottomed at that time around 0.5x book value. We pounded the table in early October ’02 on stocks that were trading at discounts to net cash, and found investors too wary in most cases to care! That is the outcome of a true bear market environment, one that we have only partially seen in the Y2k declines. The data shows as best we can interpret it that Y2k was only the first half of a major cyclical bear market that will carry the market back to its LT supports last seen in ’91 after a full recession.

The Durable Goods report tells us that a peak may have been hit – in the past each peak has lead to a recession shortly after…

The events that will play a pivotal role in determining whether the market pattern is a prelude to a major bear market or the final stages of a bullish blow-off will be Back-to-School sending, Mtg defaults and the dollar in our opinion. In effect it all comes back to housing because with sup-par jobs growth over the span of the ’01 recovery, much of it in lower income strata, the refinancing game was the only meaningful way for consumers to improve their lifestyles. Once the liquidity boom derived from an unusually large carry trade created by the US and G8 policies pumped up dollar based assets, bubbles began to appear first in stocks and later in housing prices. In order for the dollar to hold its own carrying an enormous debt load, much of which was piled on in the last 6 yrs, corporate earnings have to remain strong enough to support the dollar asset sellers including distressed mortgage holders coming out of the sup-prime mess. Pundits tell us that high single digit earnings growth is sufficient to hold the market steady, but we question the logic. Once peak profits have been notched and subsequent results started to fall, only a major force of the magnitude of the multi-trillion dollar carry trade, has the power required to even sustain prices. The Fed can alter the timeframe, but not the outcome itself of shifting economic cycles. Helicopter Ben won his spurs by writing a well-respected treatise on avoiding depressions. His solution was to print money and, if necessary, drop it from helicopters. If so, look out below the dollar or any dollar based asset. 

The one saving grace of the US economy is that the consumer seems to consistently surprise forecasters by a willingness to go further and further out on the limb of insolvency than anyone expects. Perhaps given the more modest slide in recent months for each of the indicators mentioned above could mean that recession will not happen imminently, but a steep dive in the stock market has signaled the start of a recession in virtually every case we have studied over the years. This is why we are watching the dollar and interest rates so closely: if the dollar falls further or if rates continue to rise, it will create a gathering storm of selling pressure. The emerging credit crunch where banks are loath to lend money even to fully qualified borrowers due to the damage to their balance sheets already incurred. This is the same situation that developed ahead of the ’90-91 recession for many of the same reasons as that scenario. This time around, however, the potential damage is national rather than regional and thus could be much larger and more serious than anything seen in recent times. Only lower interest rates coupled with weaker inflation and a solid economy might avert the problem.

A startling statistic just out is that 35 major deals have been held up by a lack of funding from investors who no longer are willing to put up capital that was easily available only 2-3 weeks ago. The spread of defaults stemming from the sub-prime mess has joined the stronger yen to choke off carry trade financing to a degree. The fact that virtually every bank reporting earnings had to take charges for loan loss reserves is likely to be another key driver for the liquidity crisis in the making that has gripped M&A players. In just a couple of weeks the world has materially changed in terms of risk perception and therefore availability of capital to fund the large number of new deals pending. The media has been touting how low corporate defaults have been, carefully glossing over consumer default rates that have acted recently like Internet stocks in ’99, trying to argue that CapEx spending will offset consumer spending to sustain the recovery. We beg to differ: the trends in the last few years in IT spending has been to closely follow C-level executive sentiment which in turn follows headline news such as the Sub-prime crisis and the sudden dearth of financing for private equity deals at lofty valuations. The extent of fear coursing through the market is in our opinion reaching a possible ST peak on the back of higher defaults, weaker housing, the failing hedge funds and fear of further revelations of sub-prime problems across other sectors.

The stock market is showing extended sell signals across all timeframes of our Supply/Demand models as well as in other indicators like our award-winning New High/Low models and Oscillators, suggesting that SPX may be poised to bounce at least in the ST if not longer. Recent lows in stock prices have created significant positive divergences in RSI readings, adding weight to the signal thrown up by the daily and hourly S/D models. The Daily model is fully at what we call ‘crash levels’ which has resulted in the past in either major rallies unfolding or significant plunges in the market. With data still supporting bullish views of the economy and earnings, we find it hard to believe that the market will fall in a straight line lower without a meaningful bounce at least if not more significant upside. SPX could rebound to 1516 without substantially changing the price pattern and with so much newfound fear in the marketplace it hints at a turning point at least in the ST. The Hourly model is now swinging back to a less negative reading from its sell signals from early last month. With ST Oscillators showing peak oversold readings it makes for a logical play to try the upside for as long as it lasts. There is a pattern interpretation that could take SPX to new highs if only briefly, pointing to an enticing environment for bulls to squeeze the now fat bears out of their winning positions. 

If the dead cat bounce fails to sustain itself of shows a decidedly lackluster tone, then we would quickly reconsider our stance given the weight of bearish data present in the market today. But until then let the rally caps come out of the closet and buy for the love of buying! But with tight stops as always…

 RTW

DXY is showing a completed wedge with positive RSI – despite negative fundamentals a bounce could follow soon

SPX has positive divergences on the lower lows – a bounce is likely here…

SPX trend support hits at 1450 today – a likely rallying point for bulls

The uptrend support at SPX 1450 is a juicy point for bulls to squeeze the bears out of positions

Hourly S/D is extended on a sell signal – a bounce could follow soon

VAP is trying to bottom – RSI made a higher low suggesting buying pressure is building up now

S/D is giving a crash reading – suggesting either a big rally or a melt-down just ahead

VAP is working on a bottom – Momentum may have fallen too far and too hard to sustain in our view …

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© 2007 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
Senior Software Analyst
Summit Analytic Partners
Jersey City, NJ
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