In each cycle, the sequence of events where tops and bottoms are concerned rarely, in fact, never unfolds the same way. Yet in each cycle there is always a certain method to the madness, and where tops are concerned the slow, elongated process is the norm. It is the drawn out nature of tops that actually make them so hard to spot because tops and the act of ‘topping’ is always a process, usually described by the collective market action over a period of weeks and months, not days.
Back in 2007, I walked readers through the process of the grand market top, writing a whole series of articles that described the potential carnage and the ear marks of carnage yet to come. I wrote those articles well before those events began to be discussed in the mainstream, and before the markets began to move. In some of those articles, I described a global ‘top out parade’ where one asset after another began to peak and roll over on the downside. Mind you, each asset class took turns moving into its final peak, with a long staggered list pulling together in systematic fashion.
This “top out parade’ sequence was described in the articles listed above, and in others buried in the Financial Sense archives. The idea is that while no cycle ever matches, every cycle always rhymes. Already, in this cycle, we see that Homebuilders, Mortgage Brokers, the MSCI US REIT Index and possibly now, the Nuveen Index for Municipal Bonds, have recently put in what appear to be important peaks. Taking a more global view, the Nikkei 225 in Japan, the Kospi in South Korea, and the Chinese Shanghai Composite have all struggled in recent weeks, with the Shanghai most likely having seen its high for this cycle back in early August. The British Pound also appears to have left in place an important cyclical peak.
Above: the Nuveen Municipal Bond Index, a big break to the downside in the last few days.
Signs of things to come?
Of course, with so many indices still very close to their highs, it is early to be thinking “final high.” My best guess would be that in the weeks ahead markets will continue to become a lot more choppy with one market after another slowly rolling over on the downside -- the top will emerge as layers are peeled from the onion. My job in this column is to act as guide and highlight the various comings and goings for those who may be too busy in their daily lives to flip through an endless stream of charts.
At the moment, while I am cautious that the end of the advancing cycle is coming into view, I am not yet ‘flat out’ bearish. I expect the stock market to linger near the highs, with fewer and fewer participants holding up the major indices as distribution takes place. In reading many solid articles on the economy and based on my own perusal of the data, I see every likelihood that another series of major contractions will rock the global economy in 2010. I am confident a Double Dip recession is directly ahead, as without real improvement in the employment picture there can be no resumption of consumer spending, and without consumer spending, where is final demand going to come from?
At the moment everything resides on people having a paycheck to spend, and with companies cutting back and paychecks disappearing, precisely how is consumer confidence going to continue to hold up? As I see it, commodities are likely the first Achilles heal to bear close watching. In my view, the fact that the Baltic Freight Index is declining speaks volumes as to the real tepid state of affairs. This means that attention must be paid to the commodity complex, to areas such as Energy and Basic Materials. In the case of Basic Materials, stock piles are surging for many commodities implying the potential for downside price pressure should demand begin to wane. So far, among the base metals, Copper, Aluminum and Lead remain near enough to the highs to leave room for debate as to whether a cyclical peak has been seen. Zinc has just broken out to new highs for the cycle, so maybe the other will follow in short order. What would be more compelling evidence would be to see if Aluminum, Copper and Lead break down to new lower lows in the weeks ahead, and perhaps if Zinc does a downside reversal at the same time. That would show a more compelling case for a topping sequence in the Base Metals which is very marginal at the current time.
Another idea borrowed from past cycles is the idea of watching the related commodity type stocks -- as often equities will actually lead a turn in a given commodity space. To that end, in my work I track a handful of Base Metal Copper producers which seem to be in a potential rising wedge topping pattern. To date, the pattern has not reversed substantially to the downside, and for all we know it may not. Yet, if it does reverse to the downside, it could become an instructive early clue that a cyclical market top is starting to take shape. Already on a relative strength basis, the case is starting to build that Base Metal stocks may have already put on their best show for this cycle.
Above: GST Base Metals Index – in the latter stages of a rising wedge?
Above: Relative Strength Ratio of Base Metal Stocks versus S&P 500. Has this gauge already peaked? It is now below the 50 day average. (Thin line is 50 day average, thick line is 200 day average)
Energy is another key commodity that must be closely watched. If global demand is really starting to trail off, then price of Oil will roll over and reflect the onsetting weakness. In my work, I note that Oil is presently hovering just above the 50% retracement zone from last year's big decline, and just below the classic fibonacci .618 retracement. A .618 fibonacci retracement comes in over the next few days (weeks) in the low $80 area. At the same time, all of the price action seen in the last few weeks (since early June) appears to be taking the shape of a well formed (a,b,c,d,e) five wave triangle. Wave D to the upside could be peaking right now, and could be followed by a quick and very shallow dip back down to the high $60’s for a stubby Wave “E”. This would then almost certainly be followed by a rapid thrust up and into the low $80 area, at which point Oil will likely exhaust its multi-month advance and then begin to roll over to the downside in earnest. Once the top is in for Crude Oil, I believe it will be hard pressed to find a stable bid, and prices will erode radically in the months ahead. In my view, a move all the way back down to the low $30’s is well within prospect for 2010 if a double dip recession takes full control.
Above: Crude Oil with Elliott Labeling and important logarithmic fibonacci retracement zones.
Above: a better view of Crude Oil with Elliott Count, a fourth wave triangle could be finishing up in the next few days and could lead to a fifth wave, sharp but brief thrust to the upside with a final and very major peak in the low $80’s.
Above: Crude Oil with the Oil VIX Index (lower clip)
Another element common to most commodity markets right now is a pervasive degree of positive sentiment and a high level of complacency. Expected volatility levels have declined tremendously and right now, whether it is Gold or Oil, volatility estimates are ultra low. In my view this hints at downside surprises ahead. Of all the markets I follow, none is perhaps more dangerous at this time than the market for Junk Bonds. It is ironic that two years following the beginning of the great crash of 2007-08 the reach for yield is so striking that investors are willing to pay up for sub-par (in many cases, truly junk paper) just because they are desperate for yields. Credit quality on these bonds has deteriorated radically as today’s climate is nowhere near as positive as the climate that prevailed back in mid 2007. Yet today, yields are even lower. This predicament falls squarely on the doorstep of one Chairman Bernanke. Thank you, Mr. Chairman, for depriving the Senior Citizens and Savers of the United States from their interest income.
Thank you, Mr. Chairman, for generously handing that income stream money over to the large Money Center banks who need to rebuild their imploded balance sheets. Thank you for forcing investors who have no business doing so, to take unwarranted risks with their hard earned savings as yields on money markets are now so low that there for many is almost no choice but to seek out the high yields offered by low quality bonds. In my view this is poor, very poor policy making by the Fed which continues to compound one mistake upon another.
Above: the Euro (top clip), the Euro VIX Index (middle) and lower: the Euro with 20 day moving standard deviaton. Volatility is bound to pick up and that implies some dramatic movement dead ahead. At the moment the Dollar is derided and could be nearing an important low.
Above: GST Junk Bond Index has plateaued with momentum gauges now definitively rolling over... a good sized decline from here could start to argue the case that high yield bonds have made their peak.
That's all for now,