Market as a Glance

 5/26/2010: Dow 9974.45 | S&P 1067.95 | NASDAQ 2195.88 | Russell 2K 642.62 | NYSE 6631.36 | Value Line Arith 2336.95

Psychological: On edge. May 6, “Flash Crash” got traders stocking fallout shelters, but not as quickly as they were in fall 2008. VIX spiked to an intraday high of 48.20, a level consistent with its peaks of September 2002, September 2001, October 1998, and November 1997. Weekly CBOE put/call ratio for week ending May 21 climbed to 0.81, its highest level since the March 2009 bottom. There is blood in the street, but is it enough yet. Escalating tensions on the Korean peninsula, worst oil spill in U.S. history and an uncertain outcome of the financial reform bill are just a few of the hazards that could lead to further bloodshed.

Fundamental: Soft. Labor market remains very soft and weekly initial jobs claims continue to be choppy. Q1 GDP has just been revised lower, opposite of expectations. Deficits and debt maintenance are increasingly becoming a major issue for the smallest of municipalities to the federal government and even more in Europe. Potential spending cuts and higher taxes could further decelerate an already slowing economic recovery.

Technical: Oversold. Dow, S&P and NASDAQ dropped more than 10% plus from recent highs in just four weeks, quickly diving through their 50- and 200-day moving averages. Only NASDAQ has reclaimed its 200-day line. Dow and S&P are still trading below their respective 200-day averages. These previous support levels could be substantial overhead resistance on any oversold rally. Technology has been providing market leadership so any clear move higher by NASDAQ could sound the all clear on this correction. Without leadership, the next move could be down.

Monetary: Loosening. Policy had been trending towards tightening ever since the Fed completed its $300 billion treasury purchase program last fall. But, as currency markets and Libor rates began responding to the European debt mess, the Fed reinstituted currency swap lines, last implemented at the onset of the financial crisis, to provide liquidity and tame wild forex moves. A “flight to safety” into treasuries and other dollar dominated assets has pulled long-dated bonds and mortgage rates down. As a result, house refinancing applications have risen sharply as measured by the MBA Mortgage Applications Survey. Inflation is in check and rates are likely to remain historically low for the foreseeable future.

Seasonal: Bearish. June is the worst performing midterm election year month for the Dow and S&P since 1950. NASDAQ’s “Best Eight Months” and small-cap strength also end this month. NASDAQ’s Seasonal MACD Sell signal can occur anytime after June 1, but has triggered as late as July 27 in 1977.

We pounded the table pretty hard last month that a correction was imminent. It came fast and furious and volatility spiked as the market whipsawed, plunging 1000 Dow points intraday in the “flash crash” on May 6. A week later after failing to reclaim the losses of May 6, stocks began to slide again, suffering another massive one-day drop on May 20 and then making new intraday and closing lows this week.

On a closing basis from the April highs the Dow is down 11.0%, the S&P 500 -12.3% and NASDAQ -13.2%. Intraday the losses are -13.7%, 14.7%, and 15.6% respectively. Our two bear fund recommendations, Grizzly Short (GRZZX) and Federated Prudent Bear (BEARX), are up about 8%. Our two bond ETF recommendations, iShares Barclays 7-10 Year Treasury (IEF), up 4.3%, and iShares Barclays 3-7 Year Treasury (IEI), up 2.3%, are doing their job.

Despite the now well documented speed of light that the markets trade at nowadays, and the 24/7 news and information cycle, most standard market-moving data points still get released at the same time intervals they have for decades. Corporations report their income statements quarterly and government and industry groups release economic and business metrics on the same weekly, monthly, quarterly and other regular intervals as they have been for eons.

So we can look back to the secular bear market years of the 1970s for some guidance on a potential downside target range. This was the last time that the Dow experienced a bear market loss of greater than 40%. All previous instances of 40+% Dow declines occurred before the end of World War II. At the December 1974 bottom the Dow was down over 45% on a closing basis. Much like the 2009-2010 bull market, the Dow reclaimed the waterfall decline of 1974 in 1975, in short order.

Then after rallying about 80% from the low to the bull market high in 1976, it fell about 28% from September 1976 to the February 1978 low. This was in the upper end of the range of the previous bear market bottoms in 1970 and 1974. In the charts below we compare the 1970s to the present to illustrate the similarities and what could be a potential downside range should this correction turn in to a bear. These charts are presented with monthly open, high, low, close bars in order to fit 10 years of data.

Potential Downside Target Range

Similarities of the current market chart pattern to that of the 1970s are simply amazing. Economic and geopolitical conditions are not identical, but both eras suffered from stress on these fronts. The main technical chart difference is that the run from 2002 to 2007 was longer and stronger. We can’t be sure of the timing, but a retreat to the 8000-9000 range on the Dow seems quite possible.

Many technicians have recently jumped into the bear camp noting technical breakdowns and topping formations. If you look at a weekly chart of the Dow you can see a potential head-and-shoulders top pattern forming with the left shoulder in November-January and the top of the head in April. We are currently sitting on what could be the neckline. There is also the potential for a Dow Theory Sell Signal and a Three Peaks/Domed House top. We recently commented on these two patterns in blog posts on May 21 and 24.

But before we get caught up in our own forecast for a bear market decline of 20-30% in 2010, let’s remember a little Talmudic wisdom by way of one of our favorite Almanac quotations from media mogul John Malone: Moses Shapiro (of General Instrument) told me, “Son, this is Talmudic wisdom. Always ask the question ‘If not?’ Few people have good strategies for when their assumptions are wrong.” That’s the best business advice I ever got.

We have touted our forecast, but we do not want to be afraid to be wrong about the extent of the decline. We have been ahead the curve on calling for a correction using our historical and seasonal analysis in conjunction with technical and fundamental readings as they presented themselves. We were contrary with our top call and want to stay objective moving forward and let market internals and the pulse of the market guide us.

We have to remain open to the fact that the market is not likely to do as we expect and could just as easily be in the process of building support and rallying to new recovery highs. There is still, and will always be, strife in the world. Though heightened tensions on the Korean peninsula and elsewhere in the world, as well as political battles here in the States, concerns us, the European debt contagion is under control for the moment and there is hope for some progress on the Gulf oil spill.

Pulse of the Market

So as geopolitical crises and conflicts play out on several fronts it will be as important as ever to heed the readings from indicators and market internals. The Dow quickly blew through its 50-day moving average (black line) and 200-day MA (red line) (1) during the recent correction. The 200-day MA had not been pierced since last July and as we mentioned last month, this breach has ominous implications. These levels could prove formidable overheard resistance on any rally.

Buy and Sell MACD indicators are deeply negative and trending lower (2), indicating momentum and the market trend still have a downward bias. Our Best Six Months Seasonal MACD Sell signal that triggered on April 8 provided us with an excellent opportunity to take some profits and take some bearish positions in the portfolio. 



The streak of 10 up Mondays in a row ended abruptly on May 24 with a 1.2% Dow loss (3). But even though we had three down Fridays in a row, one bastion of internal strength is that we have not had a Down Friday/Down Monday in 31 weeks since October 26. NASDAQ tech stocks have lead this whole bull market higher and the correction lower (4). Tech is likely to take the lead again if this bull market is destined to resume.

Market breadth was hammered the past four weeks with the 3078 declining issues on May 7 (5), nearly matching the panic selling levels of October 10, 2008 and the greatest number since then. The advance-decline line often turns up before the indices, so keep a close watch on this metric. New lows reached triple digits for the first time since the March 2009 bottom (6).

Put/call in tandem with the VIX also spiked to the highest levels since the March 2009 bottom (7), though well short of the extreme bear market bottom level reached in November 2008 of over 1.00. Finally, the recent flight to the safety of the Treasuries has pulled AAA bond rates down as well (8). Negative readings abound, but these extremes may be signaling an end to the correction. 



Disclosure Note: At press time, Hirsch held a position in GRZZX and IEF.