Planet Yelnick

A Simple Explanation of the Great Recession and Why It Has Years To Go

From 1987 when Greenspan took over the Fed until 2009 when the US hit Peak Debt, the US private sector added $34T of debt while US GDP only went up by $9T. Rather than seeing this as a classic Ponzi Scheme, economists praised it as financial innovation. Steve Keen, an economist out of Australia, writes a trenchant essay on this topic entitled What Bernanke Doesn't Understand About Deflation that explains why this Ponzi Scheme is the greatest failure of the Fed and central banks around the world. 

His point can be understood this way: what an economy produces (GDP) plus the increase in private debt equals the aggregate demand for stuff. The increase in debt ahead of GDP means the country is living beyond its means, consuming more than it produces. At some point this cannot go on, and the debt begins to shrink. As it shrinks, GDP less the change in private debt equals aggregate demand. As debt shrinks the drop literally sucks demand out of the economy.

• At the peak of our credit bubble, new debt drove US demand to an astounding $18T, $4T beyond GDP of $14T
• By 2010, the decrease in debt turned GDP of $14T into demand of $12T - an absolutely brutal turnaround of -$6T in two years

From $18T to $12T in two years means a third of the wind got sucked out of the sails of the US economy. In 2010 alone demand is headed to a drop of 17% - about what happened in 1930. 

The next two years (1931 and 1932) saw drops of 27% and 24%. 

Current Data Trumps Recent Positive Indications of Recovery

The hunger for confirmation of a continued recovery led to a positive spin on the dismal GDP revision: that it beat even worse expectations. This week brings a ton of data, some of it current and some of it lagging. The few positive reports are getting touted even when a modicum of reflection would repudiate the confirmation of recovery. With this in mind, let's survey some recent news bits.

Housing: The Case-Shiller housing report was positive - but it reflects data back in June when we still had a homebuyers credit. We already know from more recent data that housing fell off a cliff in July when the credit ended. The chart which best captures where we are in housing is this view of psychology from The Big Picture:

Spending: the headline is that incomes and spending are improving. In July, incomes rose the same as June, which is encouraging, but less than May (0.3%) or April (0.5%). Spending rose faster than incomes, and in total spending is back up to 2007 levels, but growth remains relatively low and per-captia spending is still down. The trend remains downward since 2000: 

 

Incomes: The problem is how sustainable spending is when incomes remain depressed and the government transfer payments (which helped buoy spending) are abating:

 

Retail:  The back-to-school season has been slow, which has led to deep sales to bring in parents. It is thus not clear that spending will hold up in Q3. No surprise then that retail stocks are in full retreat. 

Purchasing: The regional PMI (purchasing mangers' index) reports are coming out, with the national PMI expected tomorrow. The spin is they are still positive, indicating continued expansion. Beneath this spin, however, the trend is clearly down. The Chicago PMI missed expectations coming in at a new low for 2010 at 56.7. The NY numbers also came in "decidedly weaker" than reports earlier in the year. With the Dallas report (next item below), all the Fed manufacturing surveys are in, and they all showed slowing or contracting activity:

Manufacturing: The Dallas Fed just reported continued weakness in "business conditions" at -13.5%, up from the dismal -21% of July but worse than the -10% expectations. Texas factory and production both came in at zero. New orders came in negative, which bodes poorly for the near future. The manufacturing portion of ISM is looking like it is already into contraction. PragCap reports that manufacturing indications out of the mid-Atlantic region are "decidely negative" for August. Business conditions and new order both were negative (around -7) from the Philly Fed report, pointing to the ISM index going negative in the next report:

Tech Sector: The tech sector has been doing very well in connected devices, and July chip sales were up 37%, but the growth rate is slowing. Yet Intel missed badly in its latest report, an early indication that the weak economy has caught up with it. In July it had reported strong demand. Cisco had also reported weakness, and in general across August Tech has flashed warnings. 

 

Market Will Test Fractal Finance This Week

I posed a simple test between Wave Theory and Fractal Finance last night. This is the fourth such test in the past few weeks, and so far fractals are ahead 3-0. Call this the preseason. The test is whether we have begun the dreaded P3 wave down to new lows, or have a sideways market for the next few weeks. The key is whether we break Sp1040 in short order, and stay below, or meander sideways. If we break above 1130, both lose!

The Fractal Finance model looks for Thrusts and Plateaus, and watches for the Bifurcation Point when we thrust out of a plateau (a trading range). We are currently in a small plateau between 1040 and 1067, which is inside a larger plateau between 1040 and 1130 that goes back to May25, the bottom of the action after the Flash Crash. Here is the near term plateau, courtesy Contrarian Advisor:

Tonight's STU is confident the downturn has *finally* started. They are working off a nested 1-2 count since he Aug9 high, which is captured in this next chart from EWP, who says the chart is shouting that the downside is Quite LARGE:

The STU view is that we should not retrace back above the inside wave ii high at sp1065 (es1072 in the overnight futures). The STU is working off some pretty powerful ratios and markers: 

• the Hope Rally, a big wave 2, went back 62% of the fall in the Dow off 2007
• the recent summer rally retraced 50% of the drop off the Flash Crash high in April
• the downward trend since has been in a fairly tight channel, an indication of an impulse wave

We now have nested 1-2s at three degrees of trend: the Papa 2 at the April high, the Mama 2 at the Aug high, and now the Baby 2 Friday. The STU expects a drop down that gains momentum and volume:

Wave (iii) should quickly draw prices below the July 1-2 lows at 9614 (Dow) and 1010.91 (S&P)

Could be. Yet volume is not confirming. While we had a 90% down day today, we had anemic volume again. Market Thoughts also worries over the low volume as deconfirming wave (iii) down (see next chart). They also note divergences across several indices, and have a scenario to make it all fit: that we are not in nested 1-2's but in a wave (i) down which should bottom shortly, perhaps below 1040 but above 1010, and then we have a Labor Day Rally.  Here is their take on volume:

Curiously, even the normally bullish Carl Futia is now near-term bearish:

If this market is about to rally as I expect we should see strength above the 1050 level early tomorrow. Failing that I think a further drop at least to 1025 and probably to 1010 will be the next development.

I have not mentioned Neely's views much recently, but it is worthy to note that he thinks we are about to rally. His model has us in a B wave since the Flash Crash, which is about to end in time and price, and it should be followed by a C wave rally. This pattern began on Feb5, with the runup into the April high an A wave. He thought this B wave was breaking as a triangle, but it seems to be better counted as a double flat. He is the most bullish of the wave theorists right now. If we break 1130, where both orthodox wave theory and fractal finance would lose, Neely could be considered the winner. 

The Fractal Finance near-term view is a sideways move, and this drop is part & parcel of it. Interesting is that a sharp False Break below 1040 followed by a Labor Day Rally would be consistent as well if the drop and bounce is fast. Hence watch whether we continue down on increasing momentum, or slink sideways into Sep, which suggest a run up above the recent plateau into at least the 1074 range if not higher. 

Lots of economic news this week, and it is the last week of vacation season. The market is normally somewhat positive into Labor Day, and quiet; but we are seeing fireworks on forex markets due to Japan initiating a new round of stimulus. A sideways move should not surprise, and it may be accompanied with an increase in swings in global markets. 

PE Ratio Drop is Signaling Trouble

The PE ratio has dropped rapidly in the past year, from 23 to 15 (see chart, courtesy WSJ). The WSJ analysis is this reflects increasing uncertainty ahead in earnings estimates. As I recently noted, 2011 estimates have dropped considerably in the past month. On top of that, the skew in estimates has widened, with the spread from lowest to highest increasing from $12 (between $85 to $97 next year across the S&P) to $15 (between $80 and $95). The WSJ concludes this measures an increase in uncertainty, and uncertainty begets a backing off of bullishness in stocks, which turns up in the PE ratio. 

 

It is interesting to look at the WSJ chart above for the past decade: it is as if the great credit bubble of Greenspan short-circuited a normal bottoming process, which is still ahead of us. Similarly, the great inflation under Jimmy Carter kept PEs skimming across the bottom until Volcker finally got it under control and the great bull market of the past 25 years was on. Both these examples support the argument that economic uncertainty depresses the appetite for equities. 

SeekingAlpha published a counterpoint to this conclusion: that the sharp drop is merely an artifact of PE being backwards looking:

Corporate earnings have improved very dramatically since the depths of the recession. A higher E with a flat-to-lower P means a lower P/E Ratio. Mystery solved.

This argument proves too much, since it also means as earnings rise in a bull market, PE's should be depressed. A quick look at the chart shows the opposite: PE ratios dropped rapidly in periods of uncertainty, such as 2002 and 1974 (and to the right of the chart, in 1938 and 1930-32), but rose during periods of economic (and earnings) growth.

I still believe the better analytical tool is to look at the first derivative - the rate of change - of earnings forecasts. As they drop, the market tends to drop; and with the PE ratio looking back 12 months, the drop in P should show up in a rapid drop in PE, especially as we step forward each quarter. Using this metric, right now we have rolled over from growth in forward earnings forecasts, which had reached elevated levels (to respect the recovery, such as it was):

 

The author of this chart has the following observation on earnings revisions and the S&P (emphasis added):

[A]nalysts were forecasting a near 20% decline in earnings at the market’s trough. Today, expectations are for 22% growth in the year ahead. The average annual gain on the S&P when earnings growth estimates have been below 4.2% has been a positive 17.2% return, consistent with last year’s monster bear market rally. Regrettably, the average annual performance of the S&P when earnings growth estimates have been above 14.2% has been a decline of 4.6%.

You could argue that at some point the sharp drop will bottom, and maybe we are about to bottom. The PE is still relatively high at 15; no major secular bull market began with PEs as high as they are now. PEs were below 10 in 1933, 1938, 1949, 1974 and 1982, all kickoffs to a bull (although whether 1974 fits is debatable). A further drop below 10 is probably required.

We might see an interesting phenomenon if corporations continue to take advantage of low rates to borrow: they might turn around and repurchase stock, as HP just announced. This would improve the P by reducing the number of shares, spiking the PE ratio. Related to that is the interesting speculation on ZH today that QE2 may not help the economy, but it could spur a wave of M&A: borrow cheap and consolidate your sector. This should also spike P, by putting an acquisition premium into stocks. Would this be enough to skew the past, and find a bottom with PEs as high as 15? It would take (in effect) more than a 50% premium in P across the S&P to create this effect - unlikely to say the least. 

Is the Chinese Central Bank Chairman on the Run? UPDATED

Bizarre story from this morning's STRAFOR newsletter, reprinted in ZeroHedge: that the chief of the bank has left the country due to a horrific $480B loss on US Treasury bonds. They have not confirmed the rumor, and suspect it was a planned leak from the opposition. The bank chief has higher ambitions, and is aligned with the current party chairman & the Shanghai Gang that took power after Tiananman Square 20 years ago. While the rumor may turn out to be false, the appearance of it suggests trouble in China at the highest levels. The most interesting speculation on the rumor is Zhou may instead be running from a corruption scandal. 

UPDATE: ZH now reports an update out of China: "China may punish Zhou because China lost $430B on its Fannie and Freddie investment." While it doesn't add that much, it makes more sense to pin the tail on Fannie not Treasuries. The report adds: "The truth is that many Chinese thought China lost all its investment in Fannie and Freddie after they were delisted from NYSE. It is also wrong because China doesn't invest with their stocks." Confusion reigns! Confusion helps explain why the short term Chinese repo rate spiked:

 

The Market is Looking Like 2008 All Over Again

After a crash as we saw in 2008, the punditry launched rationales for various crash analogies - 1929, 1987, Japan, etc. A veritable fleet of analogies was floated into the blogosphere. By themselves these comparisons are intellectually interesting and little more - it is not sound to extrapolate from a one-time sort of event. Market patterns reflect underlying psychology, so when a pattern is correlated to similar exogenous conditions, the odds of some level of predictability rise. This is why the 1937 comparison appeals to me, given the high-level similarities:

• crash in 2000, crash in 2009
• strong rebound off the bottom in 2003, rebound off 1932
• lots of stimulus and govt interventions in '04-08, similar in '33-'37
• recovery turns south in 2010, recovery faltered in 1938
• sovereign debt problems in Europe 2009, similar but not as severe as in 1931

This time around we avoided some crucial errors, especially the Fed intervention in 2008, which prevented the sort of freezing-up of the banking sector that we saw in 1931 after the Bank of the United States failed in Dec 1930; this may be a primary reason why the 1929 analogy failed to fit. There are also significant differences in the 1937 analogy, which is why it has been a bit remarkable that Summer 2010 is tracking closely to 1937 (with update posts here and here). 

In terms of timing, starting with 2000=1929, the tighter comparison would have been 2008=1937, not 2010=1937. Remarkably, the pattern we saw in the summer of 2008 seems also to match very closely as well to the market in the past few months. The exogenous events are also, oddly enough, lining up, especially the upcoming election: 

• back then we had a choice of a remarkable emergent force for change & historic figure (Obama) vs what looked like continuity with failing policies
• this time we have the a remarkable emergent force for change (the Tea Party) vs what has turned out to be less of change than a doubling-down of prior bailout/stimulus policies

The STU provided this 2008 chart on Friday, which I am reprinting with permission, and accompanied it with some interesting analysis:

 

In 2008 the peak of the summer rally happened on Aug11 with a subsequent bottom on Aug20 and a secondary top on Sep2. The "bifurcation" out of the August trading range didn't happen until Sep19, when we fell off a cliff. This time the summer peak has been Aug9, and the recent bottom on Aug25, both fairly close to the 2008 dates

You can see in the STU chart how they draw a 'plateau' around the period of Aug11-Sep19, showing the trading range. The bifurcation occurred on a second drop below the range; the first was a false break that was rapidly retraced into the range. 

The wave pattern has been an ABC flat, which has subdivided enough to have ended, or might have a small subdivision left. While the wave structure points to a drop Monday or at least early this week - and that remains the STU's primary wave count and prediction - the 2008 pattern suggests instead we meander upwards through the upcoming week (Sep3) and perhaps even a few weeks beyond. 

We just had a fifth Hindenburg Omen. A flurry of Omens does not increase the odds of crash after the second, but does strengthen the Fractal Finance case that market entropy (disorder) is increasing. (An Omen, if you recall, is when both new highs and new lows are high on the same day, plus other criteria). Entropy increases as a trading range extends, and leads to a sharper thrust out of the trading range. This means a sharp bifurcation is coming once the divergence in positions is worked out. That working-out shows up as a continued trading range. 

In the Fractal Finance view, we have been in a trading range (a "plateau") since May25 which has ranged from 1040 to 1130, with the momentary break of July 2 a False Break that was quickly corrected. The mid-point of the range is 1075. Plateaus are sideways moves like flats and triangles. and like triangles, often end near the mid-point. The recent drop off the Aug9 high also ran into a small plateau from 1074-1087. Thus a suitable end point of this whole trading range is 1074, the bottom of the recent plateau and the midpoint of the whole move. Neely as well often sees a retrace in a corrective move to the mid-point of a "box" built around the trading range. The 2008 experience, however, says the small degree plateaus are but a part of a large pattern, from Aug9 to sometime in Sep. While the 2008 pattern suggests we go higher than the mid-point, even retest the 1130 range at the top of the box, note that the bifurcation happened off the mid-point of the range (see chart and look at Sep19). 

We can now try our fourth test of Fractal Finance vs Wave Theory. So far Fractal Finance has succeeded in each test. 

• Wave Theory says the market will drop either Monday or early this week
• Fractal Finance says a trading range this week and likely longer, with at least getting back to 1075 range if not running back up towards the Aug9 high to retest the top of the larger plateau 

Global Warming Drives GDP Revision Up

I may have scooped The Onion with this headline. Revised GDP ay 1.6% beat the expectations of 1.3%, although fell below ZH's revised revision at 1.8%, but what caught my eye was this from MarketWatch: 

Wall Street appears to have been caught off-guard by an upward revision to electricity and natural-gas usage figures, which led to an increase in real personal consumption to 2% from the 1.6% initially projected.

A simple explanation, offered by Bank of America Merrill Lynch's Neil Dutta: households ran their air conditioners longer because of warmer-than-average temperature.     

The best news was the increase in business spending to replenish capital equipment, but the recent weak durable goods numbers suggests that trend may not continue into the Q3 number. 

The best bad news was that imports surged even more than in the prior report, to the best growth since 1984, which has a damper on GDP (the net of exports less imports is added to GDP), but that is likely stocking up for all those gadgets expected to be hot this Christmas, and is also unlikely to continue in Q3. Put into GDP numerology, real domestic purchases grew 4.9%, up from 2.9% in Q1, but real sales of domestic product grew only 1%, a drop from 1.1% in Q1. This means domestic demand is there, and if we get a drop in imports relative to exports in Q3, it might bolster the Q3 number - so look askance at predictions of a double-dip as early as Q3. 

Nonethelesss Goldman Sachs sees a slightly lower Q3 number, largely driven by inventory rebalancing still being high; as it lessens the GDP is lowered. 

The biggest risk to their revision is their assumption about fixed residential investment expanding at 27%, which seems nuts based on recent housing news. It has also been an area of over-estimation in past reports that led to downward revisions. 

 

Bernanke's speech was a bit of a dud, especially when he admitted that “central bankers alone cannot solve the world’s economic problems.” Why we would believe in Fed omnipotence is a topic for another day, but suffice to say the Fed claims it has more bullets to fire at the problem even as it confesses it is running out of ammunition. PragCap gives the Cliff Notes version:

• Bernanke sees no double dip (he also saw no housing bubble)
• Bernanke believes QE2 will “be effective in further easing financial conditions.” (Historical evidence and lending data shows that QE is a non-event)
• His two ideas that have everyone all excited this morning are: (1) changing his wording (which will do absolutely nothing for Main Street even though it might get Wall Street all excited for a few hours) and (2)he will cut the interest on reserves a whopping 25 bps (25 bps isn’t changing anything at this point Mr. Bernanke)
• Bernanke is oblivious to the fact that he has run out of ammo: “The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do"

The market has ratcheted around a bit this morning, which has emboldened bulls. The expectations game applies to GDP as well as earnings(!), yet the market in the short run tends to be driven by technicals not fundamentals, so too much can be made of momentary jinks and jives due to a news event. Later I will post on the wave structure, which anticipated the sort of sideways move we have seen over the last three trading days. 

Electronics Going Gangbusters and Signaling a Coming New Tech Boom (But Not Now)

History does not repeat itself, but it does rhyme - Mark Twain

In spite of the increasing doom & gloom in economic indicators - the market clearly expects a big downward GDP revision tomorrow -  I am hearing of component shortages for consumer electronics being hastily manufactured in China. Apple is still supply constrained on iPads and iPhones, shipping every one they can assemble, and this may be impacting commodity components (like diodes and MOsSETs).  

Spot shortages may seem paradoxical when industry after industry has underutilized productive capacity, housing is in the dumpster and autos are down to under 12M a year in the US (imagine, they crested 8M in the early '50s when we had fewer than half the population). 

Yet this story of booming gadgets and busting everything else rhymes with one of the hit products during the Great Depression: radio!  People wanted to stay in touch, and radio (plus telephone service) boomed in very bad times. So too today in the demand for connected devices. Android tablets are the next big thing, with knock-off Chinese units selling as cheaply as $99 already. The demand for smartphones, iPads and Android tablets appears to be overwhelming the supply chain and causing spot shortages.

This gadget mania probably explains an interesting anomaly in economic indicators: imports are up more than exports (all those gadgets coming in from China for Christmas), and intermodal containers shipped by rail are still increasing - in fact set a record for the year - but truck traffic is flat. Speculation: imports are driving rail traffic, but exports & general economic recovery are not picking up the slack in trucking.

There is no fundamental reason this will end until market demand is saturated, which leads me to speculate that we will see the Nasdaq begin to diverge against the Dow to the upside as the fruits of the current beneficiaries of Moore's Law begin to explode into the new huge global markets for gadgets and the accompanying Cloud services. The question is when.

One spark could be a few high-profile IPOs. Apple went public in 1980 amidst the last double-dip, and Netscape sparked the dot-com boom in 1995 at a time when the market had been considered sluggish since 1987. Google failed to be that spark early in this decade, but then it came out amidst a boom in housing and private equity, right after a horrific tech bust. Poor timing for tech to rebound. 

This time around we have a new revolution brewing, and any one of the current tech darlings - Facebook, Zynga, Twitter - could be the spark to the new tech boom.  In the past, tech booms come on their own schedule, when the ongoing improvements in technology lead to sparkling new applications: PCs, Internet, now connected devices. Tech booms have tended to lead out of bad times. Case in point: the PC boom happened from 1978-83 before the Reagan Revolution and amidst terrible economic indicators.

Rumors circulate on when we will see those IPOs, with Facebook the biggee. Facebook was recently said to delay until 2012. Zynga is said to be at least 18 months from IPO, putting it also into 2012.

For other reasons that may be a good time to begin expecting the next tech boom. The timing between these booms appears to be about 12 years from end to start: 

• the transistor boomlet from 1962-66 was followed 12 years later in 1978 with the PC craze
• the PC craze ended in 1983 and the dot-com mania began 12 years later in 1995 
• the dot-com fever broke in 2000, and 12 years later is 2012 ...

It probably takes something around that timing for (a) Moore's Law to go far enough ahead to create new magical toys and (b) the fund managers who got hurt at the end of the prior bubble to retire and be replaced by green newbies. 

I do not expect it in the near term. The SOX index of semiconductor activity has been rolling over, indicating perhaps a seasonal lag or maybe a longer cyclical drop. When the next tech boom comes, it will show up first in chips, then devices, then software/services, then IPOs!

The Seasonal Pattern Has Been Working Like a Charm

The seasonal pattern is championed by Sy Harding, and this weekend he points out how it has been working fine for his subscribers. You can see the seasonal chart here with some discussion. Suffice to say the pattern suggests to buy in Nov and sell in May. Sy usually gives the all clear signal in Nov based on the MACD crossing to positive. A typical year has: 

• bad patch in Sep/Oct 
• Santa Rally into Jan
• soft Feb
• good rally into April
• May is the tricky month, and usually has a down draft that swoons into June
• Summer Rally in July with an Aug top
• then back to the bad patch in Sep/Oct

The prior two years have not really fit the pattern, but were close. We had the crash in Sep/Oct 2008, and a rally in Nov, but it sputtered and went lower in Mar. We then had a good rally into May, then a sideways move with a small spike in June followed by the June Swoon to a bottom in July. That led to a nice Summer Rally into August, and it kept going in a stuttering fashion all the way into a slow patch in Nov 2009. 

Then the pattern got back on track. We had a Santa Rally from Nov 2009 to Jan 2010, then the drop into Feb and a nice rally into late April. After a sideways move into early May, the Flash Crash was followed by a June Swoon into July 2. Then we have had our nice Summer Rally into mid August. Now we enter the Danger Season. If the pattern persists, stay out until late Oct/early Nov. 

Earnings Forecasts Drive Stocks, Not Earnings

The Bear's bear, David Rosenberg, opines that it is not earnings but changes in earnings expectations that drives the market: 

[T]he peak in earnings forecasts coincided with the peak in the market [in April]. 

And guess what?  The forecast peak in the last cycle was in October 2007, again right when the S&P 500 was hitting its highs. Before that, earnings estimates were starting to get cut in August 2000, just ahead of the peak in the market.

In Ahead of the Tape this morning, the WSJ supported this point of view. Q2 earnings were strong across the S&P: up 38%, well above the expected 27% YoY increase. Yet the market is dropping - and began to fall just as earnings forecasts began to be revised downward for 2011 (see chart). 2011 earnings estimates started in January at 25% growth, were reduced to 20% in April, and now are hovering at under 15%. The change of view:

[T]allies with the outlook for broader economic growth, which has weakened considerably.

Even the 15% prediction may be revised downward, as it is nearly triple the expected GDP growth for 2011, which itself is being revised downward. Goldman this morning is urging analysts to cut GDP estimates even further, to the range of 1.5% in 2H10 and early 2011. Yet as recently as the last week of June, before the poor GDP report, the WSJ was touting only modest decrease in earnings expectations:

 

At the time earnings were expected to rise in the second half of 2010. No longer. 

We may be at "Peak Earnings": 

If the macro economic data continues to disappoint to the downside (as JP Morgan suggests) then it’s clear that analysts have been fooled into believing that the stimulus and 80% rally are self sustaining.

Clearly analysts have not yet fully embraced the economic slowdown. Why not? Using an expectations model from The Pragmatic Capitalist, they may have overshot mean reversion on expectations too much to the positive, and are due for a double dip there, too:

Morning Musings From Fractal Finance

The market is set for a fall, according to the STU, which has us back in a nested 1-2 down. They allow for the inside 1-2 to evolve instead as waves a-b of a flat correction, so a bit of an upside surprise may be in store this morning as the c wave of that flat unfolds momentarily. MarketThoughts proclaims "I am Spartacus!" for the multiple nested 1-2s, which augur for a gap down at the open, but hey too allow for a larger flat to emerge. Daneric shows the 1-2s as well as the alt count of a flat. which suggests a reversal back to the Sp1087 area:

 

This sort of ambiguity is part and parcel of wave theory, and can be very off-putting, so let me see if Fractal Finance can give better guidance. So far it has bested wave theory in the last two tests. 

The Fractal Finance view is a gap down without ambiguity. We had a sharp thrust down off the August top two weeks ago into a trading range, the "plateau" around Sp1075-87 from Aug12-17. We had a false break below and now can confirm a false break above. This chart from Carl Futia (who is bullish) shows the recent activity:

 

The trading range to the left of his ovals from Aug12 to Aug17 is the "plateau". Carl's first oval circles where we popped above and came back down, which confirms it as a false break. The second oval has us below range of the plateau, then back into it, and now below again. If we do get the small c wave, it should not go above the top of the recent range, or Sp1087. But can we improve the odds beyond that?

This next chart from EWP is telling: it shows momentary candlestick spikes that precede a move in the opposite direction - the message from a false break. The pop at the open Monday is another one of those, and predicts the next move is down, below the trading range:

Hence Fractal Finance is predicting a gap down this morning as the start of the next thrust down. I wrote this post Monday afternoon so as not to sneak a peek at the morning futures for guidance. Let's make this a fair test.

A lot of pundits are watching around 1060, but 1041-45 is a better range to watch, the level of resistance since last Feb. 

Hindenburg Omen Going Down in Statistical Flames

As the Hindenburg Omen meme has soared across the blogosphere, the reaction is coming in from statistical skeptics. One stats maven shows that the Omen is only modestly predictive (r-square of 45%), about the same as a more understandable alternative: how much is the market over-valued? 

 

 

A more prosaic criticism comes from the odd numerology in the Omen, such as the days low and high above 2.2%, or the second confirmatory Omen to occur within 36 days, and then predicting that within 41 days, half the time, a crash occurs. Why these particular numbers? Because the Omen is a backwards fit to historical data, which is pattern matching of the worst sort; a pattern must be based on underlying causality to be predictive. 

Nonetheless, the creator of the Omen has exited the market, expecting it to do its worst. He had expected to exit by Sep anyway, as we are in the seasonal bad period. 

The Omen has also emboldened a bull, who says if indeed we get the wash-out bottom in Sep/Oct, it would be the four-year low point, pointing to good upside in the last two years of the Presidential cycle. Yes, that cycle is the most steady of any, but even then should not be blindly followed. The typical pattern is driven by stimulus prior to re-election, but with the likely loss of control of Congress, Obama may be hard pressed to pass any more stimulus. Maybe the Repubs will push a tax cut, giving Obama the stimulus anyway? Ironies would abound. 

Earnings Expectations Come From Overly Optimistic Analysts

Mish reports how 58 of 58 economists were overly optimistic on the Philly Fed manufacturing estimate, expecting +7 when it actually came in -7.7. This comes after 42 of 42 economists were wrong on the unemployment report, expecting an improvement when instead we got a worsening.  Bespoke notes how unemployment hit 500K weekly claims, the worse report since November 2009, and 22K worse than expected. McKinsey has weighed in with a report on how earnings are consistently over-estimated by analysts, despite a decade-long effort of stricter regulation:

 

Right now analysts are expecting a year-end S&P of 1235. Bespoke looks at this and is shocked, shocked to find that all analysts are bullish and across the board their current estimates are almost exactly 10% higher than their price targets at the start of the year:

 

You can see a lot of ink spilled about how earnings this year were beating expectations, but as it turns out, the earnings reports drove the S&P to about a median performance, up slightly this quarter. The cheerleading about expectations is part and parcel to the overly-optimistic frame of analysts. 

Earlier this year the projected growth in earnings from 2010 to 2011 was around 15%, a pretty robust forecast in an economy with little top-line growth. It means in effect that the cost cutting begun during the Great Recession will continue, wringing out efficiencies rather than investing from growth. SeekingAlpha looks inside the numbers, and concludes that earnings increases in 2010 have now lowered the 2011 growth forecast to around a 125% growth into 2011:

If you believe these forecasts, the market is currently fairly valued. It had increased ahead of earnings in 2010, rising to the levels of expected 2011 earnings over a year early. The fall off the April high brought it back to current levels. A modest 12-13% growth would be expected in 2011:

Of course, this 'fair value' assumes the fairness of current PE ratios, which John Houssman finds 40% higher than normal. A simplistic argument compares PE ratios with interest rates; as Treasuries yields drop, PEs rise as a better performing alternative. In a world of QE and artificially low short- and mid-term rates, however, this simplistic view runs afoul of macro economic conditions. If earnings fail to grow, the PE ratio is too high, even compared with low interest rates. The stocks will simply not generate enough earnings growth to pay for the high stock price. This is one of many reasons why PE ratio analysis is misleading. You can read more on this in the flurry of blog posts on whether bonds are in a bubble and are stocks a screaming buy as an alternative. 

This brings us back to looking at macroeconomic conditions, not PE ratios or beating analyst expectations. The Philly report is a disaster. It is also consistent with the recent NY report. Both say that the manufacturing-led recovery is weakening. The Philly report includes a prediction as to future activity, which as you can see is trending downward and may follow the current conditions into negative territory - yet another signal of a double dip:

 

The jobs report is also concerning:

 

Unemployment had been trending flat since last November, but now is ticking up. Here is the prior regression on weekly claims. There clearly was a break in trend last November. It appears to have been due to the introduction of the Obamacare bill.  Others come to a similar conclusion from their own analysis. There may now be a new break, to increasing unemployment, but it is too early to make that call. I will post an updated chart when available:

That 1937 Analogy Fits the Bigger Picture

Doug Short does a nice set of analyses and charts, and does a take on how well the current market is tracking 1929-1945. His key chart shows the constant-dollar S&P, overlaying 2000-present (blue) on 1929-1945 (red). It is striking how closely the key turn dates seem to line up, especiaslly with the drop in the past few days matching the red drop on this chart:

 

We avoided the big drop that they got in 1932, and have now settled into a pattern that would suggest a further drop ahead, and even a lower low than last march 2009, but not the deep collapse touted by the über-bearish commentators. His chart even suggests timing for the low: Fall 2012. 

The charts look different in nominal terms, but over longer periods the inflation-adjusted constant-dollar index is a better comparison. There are several deflators to use; Doug chose the CPI, which has issues due to changes made to 'save' social security in the 1980s. Using the CPI prior to those changes would have shown a deeper drop in 2007-9. It is striking that even with the unadjusted CPI, we fell deeper in 2009 in percent terms that at the comparable time in 1938.

A lot of these comparisons are done with the Dow, but the S&P is a broader index which should paint a more accurate comparison. It also gives a different and more troubling picture. It is well known that the peak in 1929 was not breached again in the Dow until the 1950s, and in the inflation-adjusted Dow, not until the 1960s. The constant-dollar S&P skimmed slightly higher than 1929 in the '60s, but did not get back above permanently until 1985:

Hindenberg Omen Meme On Fire

One of the scariest technical indicators is the Hindenburg Omen: it predicts a crash, or at least a serious drop. It happens when the market skews with high numbers of both new lows and new highs. Under Fractal Finance principles, it reflects a high degree of chaos - distribution from one position to another - right before the market finds its new direction. 

You can read the requirements here, but suffice to say that when it occurs we also see a flurry of bearish blog posts. As now.

It takes two observations to make the Omen. While the Omen goes back to the '70s, the classic treatment on it came from Robert McHugh back in 2005, who added two more tests, including having two confirmed Hindenburg sitings within 36 days, which confirms the Omen.

The Double Omen has occurred before every stock market crash, but not every Double Omen is followed by a crash. A warning, not a prediction. But one with high odds: over 75% predictive.

We just confirmed a Double Omen:

 

The Double Omen preceded the 1987 crash, the 1989 mini-crash, the 1998 crash, the 2000 top, the drop before 9/11, and the plunge into the 2002 low. The last Double Omen was in June 2008 (crash!). 

A "crash" can be mild (>5%) to severe (>15%). The crash occurs within four months, with over half within 41 days. Odds are 77% will result in at least a mild crash (>5%). The odds from the previous 27 confirmed double Omens are:

• 30% chance of >15% drop
• 25% chance of >8%
• 22% chance of >5%
• 15% chance of a mild decline (>2%)
• 7.5% chance of failure (<2% decline)

The methodological debate right now is whether the low volume and high degree of program trading 'bots have caused a false signal. Maybe the Flash Crash was also a consequence of high-frequency-trading and the anomalous behavior of these 'bots. Or maybe take warning: we have a high fractal correlation with the 2008 drop right now. 

Green IPOs Have Been Mixed

Tesla at around $18.50 remains above its pricing ($17), although below its opening ($19), and so does JinkoSolar, which at around $23 has soared above its $11 pricing, but the rest of the green IPOs over the past year have been trading underwater. The rare earth company Molycorp came out in late July, priced below its expected range, dropped the first day, and has rebounded since, selling a bit over its offer price. 

SeekingAlpha runs a story by GreentechMedia that the riskier bets have come out first, and better ones are to follow. The next run of IPOs, however, look more like public venture finance that classic IPO liquidity events for investors - greentech as closer to pharma style IPOs, where the public provides long-term project finance. These too may stink up the room. 

After those comes some really interesting candidates, including the fuel cell company Bloom Energy and the solar-thermal firm BrightSource (in which I have a small indirect stake). Other interesting companies are Enphase, which makes a micro-inverter to turn solar cell output into usable electricity; Silver Springs Networks, which uses a mesh network to interconnect meters to the smart grid; and Solar City, which assists home and small business solarization. Rather than funding science projects, these IPOs will fund real businesses. 

More Bad News Blows in for Wind Power

 Visions of wind farms stretching across the prairie capture our imagination, and our tax subsidies. CEOs of great companies like GE shill for wind to sell turbines. Spain warned the US about the illusion of green jobs, which turned into a costly boondoggle that increased the cost of electricity and created few sustainable new jobs. 

The UK Mail reports that more than half the subsidized wind farms in England were built where there is not enough wind. Some deliver only around 5% of potential, while most others are under 25%. The report concludes that subsidies - and the allure of quick payback - are driving developers to build in the wrong places. Only eight of the 104 on-shore wind farms are above 30%, which is a reasonable threshold for proper siting. To add insult to injury, the Mail further reports that taxes to pay for these boondoggles are set to treble over the next decade. 

A Little Fractal Finance Magic

In my recent post, The Market is Due for a Bounce, I mentioned how Fractal Finance required a bounce, not a final wave 4-5 down as allowed by orthodox wave theory. Of course the bounce happened; and then Fractal Finance required it to be a false break and settle back into the trading range of 1074-1087, which it has now done. So far so good. So what is next?

I have been using EWP for charts and count, as they are clear and simply stated. Their most recent chart notes how declines have been sharp and bounces sloppy, a sign of a down trend. Last night they expected a decline, and got it today. They see the odds favoring a deep drop, but await confirmation, which is a break below where we got to so far today.

 

The Wed STU had an interesting take: that the bounce yesterday created a nested 1-2 with the break out of the trading range on Tues being wave (ii) off the recent drop, and the drop & rebound Wed being the inside waves i-ii. The Tues bounce filled the gaps mentioned in my Bounce is Due post, and retraced a little over 50% of the wave (i) drop, both suitable indicators of an end to a wave 2 bounce. The wave structure broke as a flat, which completed. If this is a nested 1-2 pattern, the market should have had a sharp break down. Today started that way, but has stalled within the prior trading range, as Fractal Finance predicts from a false break. 

The STU allows for a more complex pattern to develop, with a target of the 62% retrace around Sp1106 by Friday (tomorrow) or possibly into Monday. Given the five-wave up pattern on Tues, a zigzag could have been developing, but the deep drop today obviated that. If the market does continue back up tomorrow, a likely wave pattern is a larger flat, where the first wave back was wave A. The next chart shows this, courtesy Market Thoughts.

 

In Fractal Finance, the base fractal is a Thrust and Plateau, as shown in the final chart. In comparing this to wave theory, the sideways corrections (flats, triangles and double- or triple-corrections) form the 'plateaus' of disorder. The impulsions, impulses and zigzags, mark the 'thrusts' of order. Sometimes it helps to re-envision wave patterns that are given traditional labels. The recent ending diagonal, for example, entered a plateau around the turn of the month, and it was the sharp break below it that marked a change of trend - the bifurcation point. 

Often a plateau contains a false break below, followed by a similar one above. This happened over the past two weeks. A bifurcation does not occur until the thrust out of a plateau completely leaves its range. The test comes quickly. A false break needs to return back to the range in a much smaller period than the length of the plateau. (The market is fractal, and a plateau can hours, days, or even decades, as we saw from 1966-1982, or are seeing from 1998 to date.) So far this week, the plateau which began 7 trading days ago was re-entered within 2 days, meaning it has been a false break. 

Typically a bifurcation occurs at a triple-top or bottom, which wave theory usually would count as the ends of waves 3 - 5 - 2/B. Sometimes these triplets form a head & shoulders where 5 is higher (at a top, or lower at a bottom) than 3 or 2/B; but often they all hit around the same resistance zone. In either event they are distribution patterns, with positions rotating from smart to dumb money. The chaos theory, a plateau reflects a market seeking order - the pattern of distribution, as the relative buying/selling pressure equalizes as the direction of the market becomes vague. Hence a final run up tomorrow to around the same 1100 level a third time would be within the theory. 

More likely, however, is a the market melts down from here. The drop today ticked to the level of the prior false break of Monday. Typically a second false break is the precursor to a bifurcation. Hence tomorrow is another test of Fractal Finance:

• most likely we continue down
• if we have a triple top, we should not breach 1100

Double-Dip Watch: Uptick in Industrial Production

In this Summer of Disillusionment, where the plethora of bad news is driving a bond bubble, we had some rare good news: an increase in industrial production of 1% that beat expectations of 0.6%. Production is up almost 8% above year-ago levels, and if this pace continues, we should be back to a full recovery by next summer. This is the first positive surprise after a series of disappointing reports on retail sales, housing and building permits. Is this a harbinger of a change of trend back towards an economic recovery?

 

The report stands out against other negative news. This raises the concern that it is based on a statistical anomaly. A major component of the increase is the auto sector, and if that is carved out of the report a strange spike emerges in the data:

 

The spike comes from seasonal adjustments that may be skewed because normally July is a down month - so a lesser decline in July causes a positive blip up after adjustment. You can see in this comparison of non-seasonal numbers (red) vs adjusted numbers (blue) how a steep drop in actual production was turned into a steep increase in adjusted production:

The statistical blip is not showing up in other reports. The Empire State Manufacturing Index came out weaker than expected. The index is still positive at 7, and rose a bit from its July level at 5, but has fallen from a 32 level in April and a 20 level in June. When compared with the new orders component of the Empire State index, industrial production looks like it is rolling over towards a decline, not accelerating into a rise:

What We Should Have Done Instead of the Bailouts

Great analysis by Barry Ritholtz of how things would have turned out if we had taken an alternative approach to the bailouts and stimulus: if we had chosen the path of Sweden (which dealt with the problem) rather than Japan (which papered it over).

He is responding to Geithner's self-congratulatory op-ed in the NYT, referring to a Blinder/Zandi report on how much worse it might have been had we done nothing in 2008.  Barry says the proper comparison is not with doing nothing, but with doing something smarter than pouring money on the problem. 

Any counter-factual like this hypothetical, since we cannot replay the real world, but is useful to compare alternative policy approaches for future action. Barry uses analysis from David Weidner in the WSJ and David Leonhardt in the NYT to build the capitalist alternative to the socialist bailout:

• Bear Stearns: let it fall (it likely would have been bought by JP Morgan, as it was anyway, due to JP holding $9T of derivatives from Bear, but without a $29B government gift)
• Lehman: prepackage its restructuring, a point I have made previously
• AIG: carve the derivatives business out, rather than bailing out Goldman Sachs 100%
• Fannie/Freddie: wind down, before shoveling untold $Bs back in
• Insolvent banks: put them in receivership, clean them up, let shareholders/bondholders not taxpayers take the hit

Barry concludes we would have ended up with a functioning banking sector, a much healthier housing sector, smaller deficits, and a return of moral hazard. 

The Flight to Bonds Continues Amidst Deteriorating Economic Forecasts

Bond yields are approaching the historic lows of 2009 during the flight to quality. The rapid drop in the 10 yr in the absence of the 2008 banking crisis is truly historic. Since the April high in stocks all the mid-term Treasuries have raced down in yields (chart from EWTrends):

We may be approaching the end of a 30 year bond bull market, from the highs of 1980s to the potential lows of 2010. This chart from SeekingAlpha shows the trend:

The author raises the caution flag that a protectionist movement may be near. Seems a bit alarmist, but the Chinese currency, which began its float again to great fanfare, has now dropped for five straight days and is lower than it was then!  Congress is now, once again, raising the spectre of retaliation. 

A more prosaic explanation for the rush to bonds is a rise in fear, fear not of another banking crisis but of an economy rolling over again, this time (the fear story goes) with no weapons left to restart it. 

GDP forecasts are being slashed. Goldman joins JP Morgan and Deutsche bank in lowering the coming Q2 revision to the low 1% range, and increasing double-dip odds to 25-30%. Looking forward, ZH reports that a "Philly Fed" forecaster sees Q3 dropping from expected 3.3% to 2.3%, and slower growth in 2011 and 2012. Chances of a negative Q4 are rising. Please refer to the charts in the ZH link for details. 

Japan's GDP came in worse than expected, and led to a plethora of stories of how China has now overtaken it to become the world's second largest economy. Well, not quite, but perhaps by the end of the year. Europe's leading indicators have also rolled over, signaling a coming slowdown. 

The normally bullish Califia Beach Pundit reports that container traffic out of LA is showing signs of a slowdown even as imports are surging. (See first chart below.) While they see that import surge as positive, it may be due to elevated expectations of holiday shopping, expectations that are not being met. There have been a flurry of news stories of how retail is slowing and the dismal back-to-school sales are (they hope) merely delayed. The govt report can be downloaded here. 

 

Another poor sign is the rolling over of semiconductor sales based on a leading indicator. Since gadgets have been doing well, this is an ominous sign. 

 

Given the low rates, corporations are jumping into the bond market. Even junk bonds issuances are increasing as investors scramble for yield. This suggests that all is not fear. Corporations are said to sit on record cash, giving junk bonds a allure of relative safety. 

The question for investors is why buy at these low rates? There is less reason for a flight to quality today than two years ago. 

The wave pattern strongly points to a bottom coming in bonds, and then a bounce (in yields). The Monday STU notes that the gap up in the morning may be an exhaustion gap. Bullish sentiment towards Treasuries is now 98%, approaching the incredible 99% on Dec 16, 2008, right before the all-time high. 

One play is to buy the 30-yr. The recent Fed "QN" announcement targets the 2-10 yr Treasuries, which have dropped the most. The 30-yr may follow. The argument that inflationary expectations are keeping the 30-yr high are likely missing the dynamic that the Fed's intervention is driving the mid-term rates lower. Right now being long the 10 and short the 30 is a likely arb play that may be keeping the 30 yr lower (higher yields). On the other hand, the intervention of the Fed has paradoxically made the 30 yr less sensitive to interest rate changes than the shorter term instruments. Hence the 30 yr may not move if inflation kicks in, while the 10 yr will move more if deflation kicks in. 

Corporate bonds should also be looked at cautiously. The widely held belief that corporations are sitting on hoards of cash needs to be tempered by the even larger hordes of debt they hold. Just as corporate cash is at an all time high, so is corporate debt: $2.6T of cash but $7T of debt. 

The Market is Due for a Bounce

Summer doldrums, very low volume, and no conviction - except among the punditry, which expect a short term bounce. The pattern under Fractal Finance is pretty clear: we had a rise in July into a trading range, bifurcated out of the range & have stayed below, indicating a change of trend, and settled into a new trading range. The market was range bound for the past few days, but spiked below and came back above today - a false break. This suggests a break to the upside, to be followed by a drop. 

 

This chart from EWP is pretty consistent with all the major ewave sites today, including Daneric, Kenny and MarketThoughts, whose chart for the past five months I recommend. The bifurcation out of the range around Sp1110 and 1128 is pretty clear, and it had now fallen in a five-wave pattern with a strong third wave down. This is also how the STU counts it today. Typically a minor wave 2 bounce goes 50-62%, which suggests an outside level of Sp1106 (Dow10525). The gaps at Sp1189 and Dow 10380 shoud be filled on the way back. 

The economic news has trended towards poor, so it is being watched closely. The next two days have reports which could jink and jive the market. The bounce today off the false break (labeled wave 5 above) is not itself compelling as a start of a wave 2 bounce, so the STU warns of a possible retest or drop lower. The Fractal Finance model says otherwise - the false break is done for now. We shall see which one gives better guidance over the next two days. 

Is the Shanghai Market Predicting a Reversal in Commodities?

Wheat and other commodities have risen parabolically recently, an indication of a blow-off top in the making. Blow-offs are followed by severe drops. Is the blow-off top at hand? 

David Rosenberg noticed how the Shanghai stock exchange is a four-month leading indicator of commodity prices. The logic would be a variant on the old saw that stocks predict recessions by six months: that China is such a factor in real demand for commodities, a slackening of Chinese purchases will drive prices down, and the Shanghai stock exchange is a leading indicator of a coming slackening of real demand.  

 

SeekingAlpha revisits this correlation since we are now four-months after the latest fall in the Shanghai index. Are commodities about to follow?

Copper is the canary in the commodity coal mine - very sensitive to changes in real demand. Copper came to life in mid-June, in effect signaling that the Flash Crash was more likely a correction not a change of trend. The canary, however, is beginning to show signs of asthma - copper has reversed to down again; and instead of recovering from the Flash Crash we had several sideways months. 

During the period of the recent commodities bubblet, the USD fell fairly hard. The USD has now reversed, and very sharply, in sync with the drop in stocks. It may be my Aug4 turn date marks a major turn across all markets, with commodities shortly to fall hard. 

Market Still Following 1937 Pattern

 In 1937 All Over Again I laid out the case that we are following the pattern of the original double-dip, the reversal in 1937 that broke the hope of coming out of the Great Depression. 

James Shaw at SeekingAlpha had first suggested this pattern back in 2008, and updates his analysis today. The chart is a bit busy, but you can see he overlays a simplified pattern of our market on top of the 1937-42 market. If the pattern continues, here is the roadmap:

• flat for the rest of August
• bounce in Sept/Oct
• sharp drop in Nov/Dec
• sickening slide for two more years
• new low in 2012

Better Data Shrinks Q2 GDP to Under 1%

The Trade Deficit came in much worse than estimated when the GDP number of 2.4% annualized was released ten days ago: -$50B vs estimate of -$42B, an $8B drop from May's -$42B deficit. This is the worst trade deficit since Oct 2008. It is likely that JP Morgan will revise downward again, from 1.3% to 0.9%. 

The Stimulus is now becoming a drag, as it has passed peak spending and is decreasing each quarter; as is inventory rebalancing (see chart courtesy Goldman Sachs). Goldman sees the drag as peaking at -1.7% in 2011. Absent some sort of tax cuts (not increase next year, as is now baked in with the expiration of the Bush tax cuts), they are close to joining the double-dip camp. As it is, they have reduced their 2011 GDP estimates by 0.9%.

Morning Market Warnings

Overnight futures are down, although this does not always presage how the market opens. Hank Wernicki at Elliott Fractals nonetheless sees a hard drop Wed after the Fed's punt Tues. The market popped a bit on the Fed's announcement, then tanked into the close. 

An interim EWT went out tonight evening giving reasons why the rally since the Flash Crash is likely over. Well worth a look. The most interesting observation in the EWT is that the pattern of the past three months matches the pattern in 1987 between the Aug25 last peak and Oct2, two weeks before the crash. 

The USD seems to have found a bottom, and has moved sharply up since last Friday. Mr. Bond, as David Rosenberg is want to say, is also signaling a stock drop. Rosie points out that when bonds fall as much as they have since April (down 120 bp in the 10-yr), a stock (and economic) downturn follows. 

Double Dip Countdown: T-5 After Fed Punts

The countdown is getting closer to the double dip: 10 - 9 - 8 - 7 - 6 - 5, restarted after we put the countdown on hold last week. The Fed concedes that after an unprecedented stimulus worldwide, the US economy has never recovered and is beginning to slow again. This does not mean it will go negative, but when the economic cheerleaders face reality, it means things are worse than reported. 

Already GDP, which was reported at 2.4%, was downgraded (by JP Morgan) a couple of days later due to a poor durables report, and now has been downgraded by them again to 1.3% due to a poor wholesale inventory report. Tomorrow international trade comes out, and JP will be at it again. They note that the GDP gets reported at the end of the month, with estimates for items that come in a week or two after. They think the estimate of international trade was "extreme", setting up another downwards revision tomorrow. 

The other disturbing news is more leading indicators heading south. The US LEI is heading down, although not yet signaling a second recession. The Global OECD indicators are turning over and in some cases in negative territory. David Rosenberg's Euro bearish counterpart, Albert Edwards, reports that the Conference Board indicator (excluding a yield curve input) is now in negative territory (see next chart). He pulls out the yield curve since the short-end is artificially low due to ZIRP (zero interest rate policy). He concludes that market participants will soon realize that the US is Japan of ten years ago, and will follow a similar path of deflation and zero growth. 

The Fed took a partial step today which has caused a flurry of "QE's" to wing through the blogosphere, like "QE1.5" instead of the $1T "QE2" urged by Goldman. The best is "QN": Mish calls it Quantatative Nothingness, but more kindly call it Quantitative Neutrality, since the policy is really neutral: instead of tightening by allowing the agency paper they bought in QE1 mature (and thereby lowering the Fed's assets), or expanding their assets through Goldman's QE2, the Fed stayed flat by saying it will recycle the returned cash into Treasuries. 

 

Sadly, while QE1 held rates at the long end down, it didn't do much to restart lending. Remember that in our fiat currency regime, the Fed doesn't print money but cajoles the banks to lend, which creates money. Despite the low rates, housing is in the dumpster (at the lowest levels since 1963) and consumer loans continue to fall. Here is David Rosenberg's take: QE is a "push" phenom, and where credit demand is collapsing, the Fed is pushing on a wet noodle. 

 

The credit markets responded with the biggest drop since the crisis, with rates also in the dumpster. Over at SeekingAlpha they conclude that the Fed's move is largely symbolic, since they are running out of ammunition. 

 

Mish in his Quantitative Nothingness post today looks into the yield curve, and finds it flattening, especially in the middle (seven-year). The five year is approaching its record lows of 2009, but the 30 year barely moved - hyper inflationary fears after the current policies fail? Or perhaps there is an arb play going on, to buy the mid-term bonds and short the long bond. 

The Fed tends to move cautiously, so the most astute comment of the day came from over the pond in the Globe & Mail: that the Fed is showing it will take whatever steps are necessary to prevent deflation, but it will do so in a measured way when necessary. The next step might be to monetize State pensions, which face a huge and growing shortfall. They had been designed with 8% returns in mind; but in the New Normal that is hopelessly optimistic. As the pension actuaries face up to the shortfall that a 4-5% return environment creates, the States will be forced to either pull back their commitments or put more money in to the pension plans, further withdrawing spending from the economy. Since the Fed's low rate policies and QE have dropped returns, it makes sense they figure out how to bolster the pension shortfall - but doing so simply pulls more focus away from a real recovery. 

Implications of the Market Wedge Formation

Today was the lowest volume of the year. The Summer Rally usually comes on light summer volume, especially around this time which is the peak vacation period. The market is also treading water ahead of tomorrow's Fed pronouncements. The recent "leaks" over "dissent" inside the Fed & the trial balloon over a mortgage relief program have gotten the market to expect some sort of new direction. Perhaps as a consequence, the market has formed a bearish ending diagonal (ED) wedge pattern which reflects a psychology of compression pending some expected event. 

Chart from AllAboutTrends

The psychology of an ED is worth noting. We saw similar ED wedges right before the Bear Stearns bailout and the auto bailout during 2008. The compression comes from expecting something which changes the trend, in those cases from down to up (momentarily), and in this case from the growing fear of a double dip to a new round of stimulus. Usually the market rises into FOMC days, expecting a continuation of policy, and drops after when they got what they expected and nothing more. This reflects the pull of bull and bear. Tomorrow, however, the compression indicates that the market expects something new, and they may be sorely disappointed as the Fed's leaks do not mean they will act pre-emptively. Often a wedge will have a throw-over above trend before it reverses sharply down. Will the hope of a Fed change pull the final thrust out of the wedge?

The psychology of Goldman Sachs is also telling. The are worried that the Fed will delay the launch of QE2 tomorrow, and fear that would be a mistake because it is already priced in! It is QE2 or bust for stocks, ZH opines cleverly. They expect:

[A]n announcement that the proceeds from maturing or prepaid MBS will be reinvested in the bond market (most likely Treasuries). [T]he gradual tightening ... that is implied by the current policy of letting the balance sheet shrink is inconsistent with what we expect will be a significant downward revision in the forecasts of the FOMC as well as the Board staff since the last meeting

This compression also is showing up in Treasuries and the USD. The Dollar may have bottomed Friday, according to the STU, or will tomorrow; it sits in a sideways fourth wave, and a final little thrust down - which may coincide with tomorrow's stock rise into the FOMC announcement - would signal the end of the move down.

Does the Market Have a Final Twist in Store?

The market topped on my turn date, August 4, but after the poor employment report, had a sharp drop that was not made up by the close today. Technical indicators are waning, such as declining volume during the up move from the past month and the lagging of more speculative indexes (Nasdaq, S&P small cap) to the major indexes (S&P and Dow). A very clear head & shoulders has formed between the January shoulder, the April head and now the August right shoulder. Interesting is how evenly spaced it is - the time from the right shoulder to head, and head to next shoulder, is almost identical. Most telling - and all over the blogosphere - is the wedge pattern in the recent market rise, an ending diagonal, which I showed several days ago. Even the STU now accepts the ending diagonal pattern. All of this increases the odds that a top is in.

I have been on the theme that Mother Market will take the path that fools the most market positions. The STU was reluctant to accept the ending diagonal because it was so widely touted in the financial punditry and blogitry - if too many market participants take positions based on that belief, Mother Market may still find one more twist, to trap bulls and bears alike:

• Bear Trap: The Big Tease may have minor waves 4 and 5 to go. The last two days fit that wave 4, which if so should continue sideways for a week or more before a final thrust up towards Sp1150. This is a potential bear trap: the sideways move increases confidence in shorts, and the thrust up causes them to scramble to cover
• Bull Trap: EDs often have a false break above the converging trendlines followed by a sharp drop below - a "throw-over" discussed in some detail in the STU tonight. This is a potential bull trap: the sharp thrust causes bulls to pile onto what looks like a bullish breakaway up that then reverses sharply down

Supporting the case for a bullish breakaway is the new high in the NYSE cumulative advance/decline line. This case gets dissected in Trader's Narrative: there are a lot of non-operating entities in the NYSE, and the S&P does not show the new peak. 

The percent of stocks above their 50 DMA is at a high level (75%), but not at a peak; this is usually bearish as it is hard to sustain - unless the market is in a bullish breakout. 

Next week should be interesting. The bulls need the breakaway or their case gets swamped by the increasingly bearish technical indicators, and yet the apparent start of that breakaway may be the false breakout of the ED throw over. 

A Top of Sorts is Near

Today was my turn date, which means a top this week.This might be it, or just an interim stop before we get back to the Sp1150-75 area. Turn dates are chancy things, and it appears to me that we have more upside, in part because I think we get back to Sp1150 before falling, and also because I expect the Dollar to reverse at about the same time. It has retraced 57% of the rise in the Dollar Index, and should be expected to go a bit farther, to the 62% area, before bouncing.

The stock top and Dollar bottom may resolve this week. Friday has the unemployment report, and it will be watched for guidance on the economy after the mixed GDP report last Friday (which is likely to be revised down from 2.4% to 1.7% given poor news on durables Monday). The STU thinks after the 8:30a pronouncement, market sentiment may break, beginning the fall.

As you might expect, the STU thinks the top is nigh based on wave structure. This chart excerpted from Daneric shows the recent pattern: a triangle fourth wave and the fifth wave thrust out of it. The thrust has gone back to 62% retrace in the Dow, but is below that in the S&P. A thrust the width of the triangle is normal, and targets near 1140, which is the 62% retrace given a bottom at the low point (1011 on Jul2).

In my Big Tease count, and the STU count, the low point is May25 at 1040, giving a target of 1151. Look for a thrust to 1140-1150 range in the next two days.

The STU also comments that each move up since Jul2 has broken in five waves, meaning they do not see this as a triangle formation, nor an ending diagonal, with one exception: the Nasdaq had a clear overlap of waves 2 and 4, and has fallen behind the Dow and S&P, compressing into a fairly clear wedge.

The bullish view is best expressed by Carl Futia, who brings out the Three Peaks and a Dome formation. The next two charts show the formation and the current count of Carl. The implication is very bullish: the market should now run up above Sp1200. This gives a good contrast over the next two days: an impulse up that crushes through the 1140-1150 level supports the bullish case, while a sharp thrust that stops in that zone supports the near-term top view. 

   

 
 

Double-Dip Watch: GDP Report Was Mixed UPDATED

I have been running a double-dip countdown but Friday's GDP report was ambiguous as to the imminence of the double dip even as it was generally greeted as confirming a second-half slowdown and bringing the double-dip in closer. Hence rather than tick the countdown down I will put it on hold and see what the mixed signals mean. 

UPDATE: JP Morgan says that the Friday GDP number of 2.4% annualized will be revised down to 1.7% after new data on non-durable goods that came out Monday. [Other updates in italics below]

The Street's view was of slower-than-anticipated growth with smaller-then-forecasted increase in personal consumption. Goldman predicted even lower growth, so it came above their expectations, but below the median. Still, put this in perspective:

• Early this year predictions were for 4% growth in Q2
• A month or so ago predictions were lowered to 3%
• Last week the consensus became 2.5%

So we already have a second half slowdown, even before the second half starts - a slowdown in expectations. And doubtless the Q3 predictions will be lowered as well, since the key takeaways are discouraging:

• Inventories are slowing: Inventory rebalancing was increased in Q1, but more than final sales, and was lower in Q2, indicating inventories are about to go from a positive to a negative in GDP
• Personal consumption is slowing
• Residential investment will drop: it was boosted by the homebuyers credit

Still, almost all components were positive:

Another mixed message from the report: the Great Recession has been worse even greater than thought. GDP going back to 2006 was lowered, and the dip in 2008 was deeper than previously reported. In effect, we were already treading water back in 2006, before the recession officially began, and have now had 3 1/2 years of slow to negative growth. On top of that, the cumulative drop in GDP was deeper even as the recovery out of the dip is slower. 

 

Personal consumption was also lowered in prior years, and as The Big Picture summarizes, the key contributors to Q2 GDP growth were government largesse, while personal spending was below expectations. A toxic cocktail for Q3 and beyond, as the Stimulus ebbs, the States face huge budget disasters, and the consumers are saving again.  

 

All was not bad, however, which is why the report is best characterized as mixed. Bright spots:

• 21.9% rise in spending on equipment and software. 
• 4.1% rise in real final sales, up from 1.3% in Q1.

Unfortunately, these categories are not enough to make up for the shortfall in inventories and residential investment. Pending home sales fell to a record low in June. Much of the rise in real final sales was due too a surge in imports, up to 29% from 11% in Q1, while exports were up only 14%. As a consequence, real final sales of domestic production only expanded at 1.3%, barely up from 1.1% in Q1. Also, the great increase in business spending, which we would want to bolster production, probably is not for those purposes. We have too much capacity, and companies are sitting on cash rather than expanding. I suspect that the increase in software mirrors what we saw in the Great Depression: companies hoarding cash since they lacked good places to invest for growth, and spending it instead on productivity tools such as IBM punchcards (then) and new PCs (now). Hiring machines instead of people. 

Other mixed news comes from outside the report, and could support a GDP growth of 3-4%:

• GM just reported a 25% increase in auto sales*, while Ford and Toyota rose only around 3% .. overall auto sales were up 9%, a good sign
• Global chip sales up 45%
• ECRI's growth index fell further, to -10.7% from -10.5%, but their index rose a bit 
• The National PMI index fell, but less than expected, from 56.2% to 55.5%. A reading above 50% indicates expansion, so no recession indicated, but the trend is down. (See chart below.)
• The Chicago PMI came out higher than expected, at 63%; up but still below April's number

* GM sales increase is artificial since it was in bankruptcy the first part of July a year ago.

 

Optimism aside, other indicators beyond ECRI also point down, including the latest from the Consumer Metric Institute, which is definitely pointing down:

My take: the mixed report has some glimmers of hope, and we might see more inventory building than expected due to anticipation of a good holiday sales season. This is apparently what drove the surge in imports. The impact would be a positive Q3, although maybe in the 1.5-2% range, and a positive Q4, seasonally at a higher annualized rate. The double-dip may emerge in Q2 next year at the earliest. 

Market Pundits Converging on a Scenario

It is passing strange when market pundits converge on a common point of view from very different directions. The wave theory punditry & blogitry have been all over the map, but now are gaining conviction over a near-term peak in August, maybe within a few days of my Aug4 turn date (ie. this week or early next). The market has been in the Big Tease, which is working maximum damage on bull and bear alike, and pushing the pundits to the precipice. Today was the bulls turn to get momentarily exuberant. Will swimming against the bullish tide pay off for the pundits, or are they all about to tumble down the wall of worry into the abyss of irrelevance?   

Neely has been saying how in the middle of a formation, predictability is the lowest. He has had the market in a final corrective pattern since the Jan-Feb drop: an A wave to the April peak, and a B wave which is breaking as a triangle. We are now in leg D of that triangle, and predictability has increased, as has his conviction that the D leg will end soon and the market reverse down.

The STU got prematurely enticed by the S&P futures overlapping waves 4 and 2, and expected August to start down. No mention of that today. Just as well - the futures do not lend themselves to wave theory as well as the cash indexes since they expire, and that distorts the picture. The Dow did not have that overlap, and although they saw it in the S&P cash, over common time frames (eg. 15 mins) I saw no overlap, it was the slightest of overlaps (1088.9 vs 1088.1). They have us in the final thrust up (wave 5 of V of C) and note that we are at the 62% retrace of the whole drop off Apr26. Wave 5 could be done; or could have gone only to inside wave 3, so has a bit more to go in inside waves 4 and 5. 

Robin Landry has a similar view, and expects a top in the first half of August at below Dow10800. He sees the wave count as complete today, just as the STU does; but allows for the final jink and jive of little waves 4 and 5. 

So three of the major pundits come to a similar view from very different places. 

The blogosity of ewave sites has also converged on another view with the same consequence: that we are in an ending diagonal (ED) C wave. This chart from Blankfiend shows the ED at the end of a wave count like the Big Tease: wave 1 ends on May25 and wave 2 is breaking as an expanded flat with a deeper bottom to the B wave than the end of wave 1. 

The ED is a clever way to get rid of the overlap of waves 4 and 2: in an ED, that overlap is expected. The final thrust up should compress, with 3 shorter than 1 and 5 shorter than 3, and converge somewhat to a point of lower highs and higher lows. So it seems to work, and you can see similar charts from Daneric, EWtrends, MarketThoughts, and others too numerous to mention. Market Thoughts gives guidance that for 5 to be shorter than 3, the outside level in the S&P cash is 1150.

While clever, the ED has some challenges, including that all waves should be "3s" while the STU was adamant today that there are clear "5s" in the C wave, perhaps anticipating all these blogostic EDs. 

My Big Tease count has a different read on wave C: that wave (iii) of C is not yet done, and what is listed as major (iv) above is instead minor iv inside (iii). It is that minor iv which the STU was worried overlapped with minor ii inside what is labeled (iii) above. (The STU counts that (iii) as (v), having found a small waves (i)-(ii) inside what is labeled (i) in the chart.) This means we would be in wave v of (iii), and have a bigger waves (iv) and (v) to go. Such is the fun with wave theory! 

Hence the Big Tease is not limited by the ED short wave 5, and instead should go above 1150 in the current run up, possibly by Aug4; and then might get to 1175 later in August. Right now we have to see how the next few days go.

ContrarianAdvisor gives another view, more in line with Carl Futia's "box" approach. I highlight it because it is also similar to Zoran's Factal Finance approach, of a "plateau" or trading range following a sharp thrust - in this case, after the Flash Crash drop, we have been in a two month trading range. 

This box analysis also predicts a top soon, after running back to the top right of the box. Zoran often expected a False Break above the box, then a drop back inside. Watch for either hitting the 1131 area and dropping, or punching above then falling back below. A Bifurcation to confirm the False Beak and the end of wave C would have to fall pretty sharply below the bottom of the box, or Sp1010. 

A final convergence comes from a reader and frequent commentator, DG, who has taken Neely's approach and extended it. He posted this chart a bit ago and I thought to share it with you. You can read his analysis in this comment. His work says the final leg of an expanding triangle, leg E, should end by Aug6, or the end of this week. 

Market Entering the Danger Season

Stocks tend to follow a seasonal pattern, with a strong period from Nov to May, a sideways move over the summer (which often starts with a June Swoon, creating a Summer Rally in July), and a drop in Sep/Oct. Sell in May indeed:

 

August has marked notable tops, such as Aug25 in 1987 and Sep3 in 1929 (not quite Aug but close enough), as well as the last peak before the huge drops into Nov 2008 and Oct 2002. Since the recent end of the seasonal strong period was in April not May, it is possible that we peak early in August, not late; or even have peaked already at the end of July. Keep in mind that that these sorts of patterns are tendencies only. In 2009 August was choppy but did not mark a high. 

The more immediate question is that the wave structure is signaling a top is in. We peaked last week and have been dropping since. The wave count would either make that peak a completed wave, or an end to wave 3 of the final wave. If we are in the wave 4 that follows that wave 3 top, with a final snap up wave 5 to go, the market should not fall into the territory of wave 2. Well, we peaked at Sp1088 last week and came down to hit the 1088 level on Friday (see chart, courtesy Kevin's Elliott Waves):

Friday's STU goes farther and highlights how we breached that level in the Sept S&P futures (ES), and slightly overlapped in the S&P cash as well. The Dow has yet to overlap, which would be at 10265, but the Naz overlapped its Jul21 wave 1 high at 2236. Wave Theory thus indicates that the trend is down, at least in the ES and Nasdaq indexes, and *maybe* the S&P. EvilSpeculator urges laser focus on Sp1088 over the next few days to see if the "touch" shows a support level or is the &P going to follow the ES down.