We fully expected the Fed to ease and ease aggressively; the market was surprised by the generosity if not by the willingness of the Fed to pursue a policy directly at odds with its primary purpose for being: to fight inflation! Bernanke elected to goose the Money Supply in a big way two weeks ago and now has done the same thing from a rate perspective. The implications are the same whether by rates or by liquidity injection: inflation will now accelerate further and the pain required to tame it will grow geometrically higher. For some reason the public and the Congress seem to have forgotten that recessions are not bad things, they are necessary ones. If the earth never had winter, the growth of flora and fauna would quickly overwhelm the landscape making it impossible for anything to thrive over time. Thus the marketplace needs to be reined in before it can do permanent damage to the economy, excesses need to be wiped out and the discipline of pain reinstated for the health of the system. Capitalism is the best way to run an economy, but it cannot succeed if politicians interfere. 

The SPX is likely done - if this is an ABC correction 

The help to housing industry players that the 50bpt cut in rates for the Discount and Fed Funds rates will probably not prove to be sufficient to get the job done according to the builders interviewed on TV today. We would agree that more is likely to be needed if propping up the economy and the market is what the Fed desires to accomplish. Otherwise the inevitable recession will come, differing only in magnitude despite good money being thrown in after the bad. The fact that it is the Fed that is doing the throwing is truly unfortunate given its reason for being; the consequences of its neglect of its primary role of inflation fighting will likely come back to haunt Bernanke, making predecessor Greenspan’s worse fear increasingly probable that Congress will use the same power to create the Fed to undo it. Given the track record in recent times, we can only argue that the Fed be made truly independent so it can withstand whatever political heat it faces or to get rid of it as a major cause of inflationary pressures. The marketplace will adjudicate as it sees fit in the coming weeks. The impact of brokers missing numbers despite playing games with tax rates and other accounting sleight of hand will be assessed as 3Q earnings approach.

The rally has run further perhaps than our forecast would have called for but fits perfectly with a technical retracement

While the market has gotten about everything it could have wished for in the form of aggressive intervention by government at a crucial time, the bears may yet rule the game. The 3Q is coming to a close and brokerage stocks are now reporting negative surprises for those willing to look beyond the glossy headlines to see the carnage beneath. Pre-announcement season is only 2 weeks away and regular earnings another couple of weeks behind that. The implications are that despite the best outcome the bulls could have hoped for the calendar now poses a series of potentially negative events that could turn the tide. The fact that early reports have shown consistent slowing in sales and weakening of margins underlines the risks ahead for investors long the market. If the 3Q turns out to be weaker than expected or 4Q guidance less than anticipated, the implications will almost certainly mean lower valuation multiples and softer stock prices soon to follow. There is in our opinion an unusually high degree of estimate leverage in the software stocks we follow. Any diminution of growth rates would highlight the excessive valuations of the stocks and motivate sellers to exit or experience the harsh discipline of the marketplace. 

New Lows show a potentially important sell signal poised to become operative in the coming days

The jobs data last week carried important signals for the outlook of the economy and of the market. With negative jobs growth a longstanding signal of a recessionary onset will become operative. We have highlighted the games being played with jobs reports such as reservists being called up in almost unprecedented numbers since the days of Guadalcanal in WW-II, serving to increase employment by creating phantom jobs at a rate of 1-2 per reservist called up for duty. The impact could account for as much as 1.5m jobs. This amount could hold off a negative reading on the jobs report for quite some time, but ultimately not change the trajectory of the economy. The market signal of a recession normally comes 6-9 months ahead of the event, but this time may have been thwarted by book cooking, causing a late signal to occur much closer to the actual event. The track record of jobs calling recessions has been formidable indeed over the last 50+ years. We suspect that it will once again score a hit.

Jobs tend to correlate closely with the SPX – When jobs turn negative recessions occur and markets correct 

The dollar has now fallen to the chart lows if not further at DXY 78.67 suggesting that a heavy band of support has indeed failed with perilous consequences. After the Fed cuts we were mystified as to why the dollar didn’t sell off hard. Rates have rallied sharply as expected but the buck held on: until now that is! With a broken pattern of supports, foreign holders of dollar assets will now begin to sell in earnest. The inflow data shows that even China is selling now which makes it unanimous that dollar based assets are no longer cool to own. That sentiment will likely hasten the decline of the dollar and speed the systemic adjustments that are sure to follow. Stocks and bonds will take significant hits as foreign buyers exit, creating substantial selling pressure on all markets including the dollar. A downward spiral could ignite if domestic holders react to the falling prices precipitated by a falling dollar. Inflation will also ramp up faster now that the currency bulwark is no more, making the bond market selloff even more likely over time. Saudi Arabia also has evidently severed its dollar peg, something that China and others will feel enormous pressure to follow, will probably de-link oil and the dollar making an oil selloff more likely to us. If a weaker dollar exacerbates inflation then China which is currently raising rates and taxes to cool its economy will have a tough time easing right now and therefore making its own inflation problem that much worse. To us the data suggests that dollar-based markets will be facing real trouble soon.

The SPX has formed a pattern that fits well with a wave-2 corrective rally in the form of an ABC bounce. The initial A (up) ran from 8/16 lows to 9/4 highs while the C (up) began on 9/11 to the highs on Wednesday, measuring 100% of A = C. That measurement suggests that the entire pattern is now complete and will reverse lower in a more rapid decline that would develop into a more powerful wave-3 bear market leg. Many other indices around the world fit either a .618 A = C measurement or as a .618 retracement of lost ground from the highs, something that SPX also fulfills. The implications are for the bear market structure to reassert itself in a new, more powerful down leg or for some other pattern to become evident during the days to come. The history of the market has shown that when the degree of orderliness rapidly increases across measurements, pattern fulfillment and wave counts, the odds of a trend change grows rapidly higher. The good news is that the outcome will be apparent soon either way.

The Supply/Demand models are showing a fully extended Hourly pattern that signals a sell in most indices including the SPX. The ‘Crash’ levels approached in mid-August reversed in the predicted big rally which now is potentially reversing. Both Supply and Demand are showing signs of turning off extended readings. The Price/Volume indicator VAP shows a big surge in buying power but not enough to get SPX back up to the highs. The Momentum of the move is also suspect, falling below prior highs in VAP and its own highs contingent with SPX highs. This means a weakening market with potentially failing internals. Without the robust buying power needed to lift shares to new highs, the impetus shifts to the bear camp especially going into pre-announcement season. Hourly S/D is at extreme readings after the Fed rally and now is poised to turn down once again. VAP powered to an impressive high but Momentum failed to confirm it despite its own high reading. Weekly S/D came off its own ‘Crash’ levels in August and is still on a buy signal, yet not a robust one. VAP recovered but didn’t catch up with the expected levels of buying power. Momentum was even weaker suggesting a false rally or a bull trap in the making. Certainly with all the headline news favoring the bull camp it would tend to draw in the last investment and trading dollars to participate in the ‘easy money’ being made all across the Street. But this situation could quickly reverse, not in the least with Bernanke testifying today on the economy and recession risks. Any adjustments to popular perception will likely be addressed in his testimony today. Also with big software earnings reports out tonight, normally taken as a bell weather for IT spending, a clearer picture of selling conditions is likely to emerge.  

Other indicators of interest are the numerous Relative Strength (RSI) indications that show weakening stock rallies as prices hit highs but RSI fails to confirm. The trick to RSI is that it cannot tell time: a negative divergence only tells us that prices will fall in the future with high odds, not when it will begin. Still the fact that so many areas in the marketplace are showing negative divergences from oil to bonds to stocks to indices, makes us think that something unusual is at work in the system. With our Double Down thesis that mortgage resets are more than doubling this year over last as both the class of ’03 and now of ’04 get their reset payments that ratchet up sharply higher than during the low rate teaser period, housing will be a major motivator for potential trouble ahead. The one key indicator that has not signaled trouble is the New Low models which put the odds of a big sell off at significantly lower levels than the majority of those we follow closely. The key to the New Low models will be whether the next couple of days post meaningfully higher New 52-week lows and thus carry the indicator back up above breakdown levels where they are flirting at the moment. A full breakdown is consistent with a big rally, but a reversal off these lows will signal real problems emerging in the internals of the market. 

The current reports by transportation companies suggest that oil could run into trouble. The charts also show a negative divergence that could translate into a top and downturn in crude. The implications would be that demand is slowing, something consistent with economic issues in the US and perhaps abroad too. In all the horizon is threatening like we have not seen in decades. The probabilities of a crash are as high as we have seen them now that virtually every precondition is operative except a looming trade contraction from either a trade war or stumbling economies abroad. The risks of loss are well beyond any upside that we can see at the moment. The good news is that the picture will resolve quickly, giving market participants what will likely be a good signal as to which direction will next unfold. The profit potential now is as high as the risks in our opinion so stay sharp and good luck!

RTW

SPX has weaker RSI at the recent price high – signals weakness ahead in what could be a wave-3 decline

SPX is pushing trend resistance at a .618 retracement – with highs so near bulls may feel compelled to drive SPX higher ST 

The bull market may have completed in mid-July – and a bear market could well unfold from here

Hourly S/D is at extremes pointing to a new Sell signal soon

VAP is rolling over quickly – RSI too after both hit extreme readings 

S/D Daily is fully extended on  a ‘post crash’ buy signal – The rally was very weak and so downside potential is high

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

S/D is still on a Buy signal following the crash signal – but price confirmation is late in coming, if at all…

VAP made a lower low – Momentum never turned back up suggesting mounting weakness ahead

Claims are also signaling a recession onset in the near future

Inventories are sharply higher – this is before the current Mtg resets have become known!

Inflation on this measure looks almost tame – But the dollar and gold suggest otherwise !

The dollar has broken down from a bullish wedge – now 78 support is in serious jeopardy 

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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