The market has declined as expected in a 5-wave pattern that probably completed Friday. SPX has fallen by 11.9% while Nasdaq slid 12.4% over the last few weeks. The proximate cause appears to have been sub-prime defaults that frightened investors into revaluing risk assumptions. The pervasiveness of CDOs in the marketplace have gone an important step further in a potential bear market by bringing into question both the extent and the viability of the entire asset class. The reassessment of risk, particularly the heightened perception of uncertainty surrounding the market value of mortgages, has effectively motivated lenders to halt credit lending of virtually any type regardless of the underlying collateral. Because of the financial alchemy that made it possible for sub-prime mortgages to in part be reclassified as triple-A rated bonds by slicing and dicing CDO structures, the valuation of these loans soared well beyond economically defensible levels, setting the stage for a meltdown as investors rush to exit any CDO exposure. The levels of fear in the marketplace have reached significant levels such that Canada announced that it was effectively guaranteeing commercial paper in order to facilitate liquidity that is required for business as usual. That the step was highly unusual is noteworthy and indicates how pernicious the credit crunch is becoming to consumer and businesses alike. Accordingly SPX bounced off a completion of its initial down wave, setting the stage for a relatively short, sharp rally. Friday’s Discount cut could fire that rally even more.

Money Supply (MZM) Model Chart

Source: Bloomberg Charts and Summit Analytic Partners Technical Research

The Fed elected not to pump up the market - a significant departure from Gspan – the Discount Cut today however is not…

The sharp declines in Tokyo may have played into the Fed’s decision to cut the Discount rate after a 5% plus drop overnight. The risks of further trouble in the markets may have tipped the balance. We have long anticipated that the Fed would feel compelled to act in favor of the market but also suspected that the Money Supply would be the vehicle of choice. Instead the Fed appears to be acting to offset the credit drought caused by banks and lenders virtually halting lending operations in the face of sub-prime defaults. In effect the levels of global liquidity have come crashing down, threatening the viability of economic activity everywhere. This is why Canada moved to guarantee commercial paper transactions and why we think the Fed cut the Discount rate. Without available credit most transactions in the financial markets would halt and businesses would be forced to sharply curtail normal operations due to a cash squeeze. This is a normal, predictable reaction to the dawning awareness that global leverage went too far predicated upon fundamentals that were not wholly sound. The key outcome will be whether the economy falls into recession as a result of liquidity contractions. 

After a brief bounce the nasty slide in global liquidity may have further to fall

The big risk looking forward from our perspective is the impact of widespread bond rating cuts as rating agencies feel pressure to make good after the debacle called sup-prime. So far we have only seen perhaps 1-2% of bonds at risk being downgraded. The credit structure used to float CDOs built on mortgages of all quality descriptions took the early payments and classified them as AAA credit. The next tranche was rated somewhat lower but still investment grade. Finally the later tranches were rated back to the underlying quality of credit. The problem is that the ‘Liar Loans’, as no doc loans are commonly called, cut across sub-prime, Alt-A and prime loans according to officials from Fannie Mae suggesting that default rates well beyond historic norms will plague the better quality mortgages just as it has on sub-prime. Once the reality that the tranche structure by itself cannot improve credit quality of a lousy piece of mortgage paper, we believe the credit rating agencies will be compelled to cut ratings across the board for CDOs built on questionable paper. The result could be another down leg to the housing, credit and bond markets precipitated by institutional investors being restricted from owning debt below investment grade. The need to report 3Q holdings in compliance with investment guidelines may become the motivator for another wave of selling pressure in the financial markets.

When we look at the SPX structure for clues to the coming market direction several possibilities result. Working from the ’02 lows we can (unfortunately) count either bullish 5-wave patterns or bearish 3s. The bullish count puts the SPX in its 4th wave (down) of what will likely be a LT 5-waved rally. That suggests the current corrective bounce spurred on by the Discount rate cut either be a ST corrective bounce in the larger 4^th wave down or could be the start of the 5^th wave to new highs. The upside target would be roughly 1605 depending on where the bottom forms. We can count a full 5-wave decline as complete as of late Thursday. The Discount cut likely cements these lows as a bottom at least in the near term. The final rally leg would probably follow a 5-wave form into a wedge or H&S topping pattern. Still failures of the 5^th are not unheard of and need to be watched.

The dollar hit resistance in what could be a very bullish wedge reversal pattern – but must sustain or risk a big drop ahead!

The middle case of our three potential SPX counts from October ’02 lows argues for a B-wave bounce in what would be a larger ABC correction may have completed leaving the markets in the C-wave down to complete. The C (down) leg would likely be a 5-wave affair of which we may have finished the 1^st. The timing of this structure would fit well with 3Q pre-announcement season starting at the end of September. Our channel checks indicate that credit issues are beginning to affect corporate operations forcing mgmt to conserve cash. The most obvious way to save cash in the ST is to cut IT spending. We anticipate that 3Q will show that this situation has become operative across enterprise customers. The extent to which it impacts business will be reflected in both results and more directly in 4Q guidance. The normal budget flush is due to push the market up for the typical 4Q rally attempt. This time could be different if credit availability curtails business activity not to mention consumer spending constraints.

The last potential count as we see it calls for a bearish 5-wave structure to unfold. This outlook also fits well with the macro environment where untenable levels of leverage have become pervasive in the global economy. As this situation unwinds all the markets experiencing unusual upside over the last few years will likely have to return to their LT trend support lines which are in most cases a long, long way down from the recent highs. The targets for such a bear count would be into the 500-600 zone for SPX but could fall even further. The outcome behind this projection would almost certainly be a recession and a significant loss of confidence in the financial system.

For now we see a corrective bounce unfolding in the next few days. The pace will likely be frantic as shorts scramble to cover in the face of aggressive buying. This frenzy will exhaust itself over a few days and then subside into a period of drift on low volume. Then the selling pressure will likely reassert itself once again for the 3^rd wave down. The key aspects of the bounce will be what the dollar does. If it continues to rally then the big multi-year wedge reversal pattern could carry the dollar into the mid-to-high 80s. Otherwise a failure to sustain prices would signal that the wedge is more of a DOTF (dilemma of the 4^th wave) which is a false rally followed by a sharp sell off. Rates look to be moving higher on a longer term trend. Oil could weaken if consumer demand falters due to the Double-Down of resets on mortgages hitting in record numbers through September. We estimate that 70% of the reset ARMs will ratchet higher over this summer, creating a powerful downdraft for consumer spending. 

The big question will be whether this rally is a 5 or a 3: if the former then the bullish count is operative. Otherwise a 3 wave affair will signal further corrections to likely follow soon.

RTW

SPX has positive divergences on the lower lows – further upside is likely here…

SPX trend resistance hits at 1460 today – a 50% retracement of lost ground and a likely rallying point for bears

The uptrend resistance at SPX 1465 is a logical point for bears to re-enter shorts – 1485 is also resistance at .618 of declines

Hourly S/D is becoming extended on a buy signal – a turning point could follow soon

VAP is consolidating after a bounce – RSI made a higher high suggesting buying pressure is still building

S/D is giving a ‘post crash’ buy signal – suggesting either a big rally or further melt-down just ahead

VAP is bottoming – Momentum made a higher low signaling buying power coming into SPX fa…

S/D could be approaching a ‘post crash’ buy signal – suggesting either a big rally or further melt-down just ahead

VAP is looking for a bottom – Momentum is turning up signaling buying power - but must be maintained !

Philly Fed shows a bounce in activity, but nothing yet that is clearly good news

Work Week tells us that if orders don’t rebound robustly then layoffs will follow soon

Inventories tell us that much of the uptick in bus activity has not been sold through – presaging trouble ahead

Housing Permits show a major bear market in progress akin to ‘89-‘90 and ‘79-‘80

Additional Information Available Upon Request

Certifications and Disclosures

© 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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