Planet Yelnick

The New Normal in Venture Capital

The "New Normal" is a characterization popularized by PIMCO, the big bond fund, to describe a low-rate, low-return environment that they expect to persist for a considerable period. This environment is affecting all aspects of financial investing, and it should be no surprise that it is transforming the venture capital industry. 

What has emerged is a new venture ecosystem, characterized by "capital efficient" funds which raise a modest amount of capital and can deliver good returns to their investors with $50M "quick flip" exits. When there are few IPOs and the number of Billion Dollar Babies can be counted on a couple of fingers, this is the only approach that makes sense for the limited partners (LPs) who invest in venture funds. The big funds are refocusing on long-term capital-intensive cleantech projects, which are more in character private equity deals. The statistics are vivid: as reported by Silicon Valley Bank and summarized in the attached chart, small funds have returned dramatically better than big funds. The funds below median are 24x more likely to return over 2x cash-on-cash to LPs than the funds above median (48% vs 2%): 

 

To make this work, the capital efficient funds are investing in lean startups: ventures that follow a set of principles to enable a small amount of capital to go a long way:

• Open source - which is low cost and has been stress-tested
• Cloud services - low capital to the startup and easy to scale
• Browser/App-phone clients - free to the startup and wide-spread 
• Rapid product iteration - letting the market give feedback quickly
• Socially-connected - very low cost customer acquisition
• Pervasive mobile - enabling a whole new set of applications

Venture capital produces great returns during waves of innovation. John Doerr, the inimitable leader of one of the premier funds, Kleiner Perkins, calls this the Third Wave after the PC revolution (1978-1983) and the Internet (1994-2000). This wave has not yet been succinctly characterized, but the leading candidate name is Cloud Computing. 

An immediate criticism of capital efficiency is who builds the big infrastructure, if not venture capital? The answer is already clear: the big Internet winners are scaling out cloud computing platforms (Google, Amazon, Microsoft), and the PC leaders are clearing the forest with new client devices, such as the iPhone and the iPad from Apple. 

The technology model of every era of innovation defined the predominate venture capital model - the funds designed themselves to leverage the trends. The last era drove megafunds to lay the railroad tracks of the Internet. This era in contrast is about working at higher levels of the technology stack than operating systems, computers, cellphones or networks. Now that the tracks have been laid, what are the new apps that people will love?

The always-connected Internet cloud provides the answer: the eternal beta application, launched quickly, changed constantly, always seeking to find the combination of fun and function that captures the hearts and minds of users. 

The disruption of the New Normal venture model is likely to affect a whole passel of current funds. It has been much noted how the amount of money going into to venture capital has decreased, and this is putting the squeeze on mid-sized funds. What has been less noted is that the New Normal model may cause LP capital to rapidly switch from traditional VC funds to the new breed of capital efficient funds. 

The New Normal model comes with Logan's Run: if you are over thirty, you won't be funded. The mantle of what is cool has been passed from the Boomers, who still rule the funds, to the Millennials, the new generation of 20-somethings who grew up tech-savvy. The Millennials first flocked to Facebook, Twitter and Zynga, the darlings of the new era, and are feverishly checking-in with Foursquare, Gowalla and other iPhone apps. 

The New Normal entrepreneurs care little of the old brand names of traditional VC. Indeed, the capital efficient funds believe the traditional VC model is broken. Maybe so - we shall see how the adapt. As this Third Wave crests, it is likely the capital required to make serious companies will increase, as it has in the past, bringing the traditional funds back into the game - or leading to a new breed of larger capital efficient funds. 

Right now it appears the venture capital jungle is soon to be ruled by little furry mammals running rings around big funds. 

Three Scenarios and a Wildcard

The WSJ led this morning with The Dow's Worst May Since '40, but finished with a ray of hope: "a big drop in May has often been followed by double-digit gains over the next three months." After the deepest devastation in seventy years, optimism! Such is the slippery Slope of Hope that bear markets ride down. Be careful not to risk your capital over aphorisms like "sell in May" or "Summer Rally." Instead, let's take a look at the underlying wave structure.

For those of you who read the comments to this blog, I recommend the prior post, as it has a good discussion in the comments of the possibilities. In my recent goat rodeo post, a reader had noticed a rising wedge on the e-mini overnight. As the wedge predicted, in the morning the e-mini broke down and touched Sp1056, completing the head & shoulders pattern and signaling a bounce was on, as it was. Good advanced warning! 

Right now many of the comments are riffing off this month's EWFF and last night's STU, which together provide three scenarios, listed in order of increasing odds:

1. Summer Rally: new highs by August!
2. Big Tease: a rise to Sp1150, creating a triple top with January plus a large head & shoulders
3. June Swoon: not much more than Sp1120 (if that) and the big drop comes

Before I dive in, note that I have found (as have a lot of my readers) that the STU alt count often is the better count. EWI is an über-bearish group, and all the way up in the Hope Rally the alt count has given better guidance. Usually when the prime count is going awry, Prechter provides perspective in his mid-month EWT. Since the prime count (#3) and the alt count (#2) may start off about the same (sideways to somewhat up), I expect an important EWT mid-June. Given such a spread of outcomes, it might be prudent to wait. At the same time, the EWFF came out in the morning, and the STU came out after Friday's close, and was much more emphatic about the June Swoon. With all that in mind, here goes.

Summer Rally

This counts an ABC correction off the Apr26 top with the expectation of a five-wave rise to new highs to complete the Hope Rally. The Flash Crash is an A, the Flash Bounce is B, and the Double-Bottom is C. I think the strongest part of this view is the Flash Crash, which can count as a "3" if you take it off the orthodox top. Flat correction, or zigzag with an unusual B wave. The red count in this chart from WavePrinciple shows the Summer Rally count:

 

A major supporting factoid for this count is the strong breadth to the upside - it hit an all-time high. Thursday was also a 97% upside day. Tony Caldaro uses this to support his bullish case:

Market breadth, in the US, recently hit an all time high during the latest uptrend. Bull market tops are usually accompanied by a negative divergence in market breadth, i.e. 1987, 2000 and 2007, not new highs. Some of the six economically sensitive SPX sectors start to display negative divergences, versus the SPX, prior to impending bull market tops. Currently only the XLU (utilites) failed to make a new high during the latest uptrend. Therefore we have to conclude that equities are in a bull market, they have not topped, and they currently display no signs of topping in the near future.

The EWFF pre-emptively dealt Tony's argument. The Flash Bounce open on May10 was the third largest in S&P history. Looked at in isolation, the strong breadth seems bullish. But the other two even stronger opens were on Sep19 and Oct13, 2008, right in the middle of the huge crash down. Those days were retraced within one or two days; the recent Flash Bounce was completely retraced in seven days. This is what also happened in 1930-32: big exuberant rallies within a sickening slide down that Slope of Hope. 

Another version of the bullish case comes from PUGridiron, which gives a view from Purdue of what the really bullish count could look like. As their chart below shows, they count the Mar09 bottom as a major bottom, fitting the four-year cycle low (a year early) and targeting a top at the peak of the next Presidential election in 2012. Under the PUG count, this Flash Crash would be a major wave 2 (P2 in their count) before a rip-roarin' P3 up to new highs: 

They give the Hope Rally a five-wave impulsive count, which we have discussed before in the context of Tony Caldaro's bullish count. This count is problematic since there is no alternation in the two corrections on the way up (Jun and Jan). Tony recognized the problem of simply calling Mar09 to Apr26 as five waves, and had a more complex count to overcome that weakness. That count too had problems, as many waves were disproportionate (higher degree waves smaller than inside waves). For a variety of reasons Tony has changed his count to match the PUG simple five-waves up from Mar09 to Apr26. He still has the problem of a lack of alternation but he is looking across a lot of global markets to create a unified count. Read his posts to draw your own conclusion. 

The bullish count is highly dependent on the Flash Crash being a corrective wave down. a "3" not a "5". One way to correct this "3" to a "5" is to consider the Flash Crash bottom as a wave iii with a truncated wave v to complete the pattern. I commented on this previously. Alternatively, the Flash Crash could be considered a 'botware bottom, with wetware (humans) having stopped well above, leading to the same fifth wave bottom on the day after. Here is a chart that shows the truncated fifth:

If you follow Neely or Zoran Bifurcation Theory, you would mark the top not at the high point but at the last peak before we broke down out of a trading range. This also gives the Flash Crash a proper count as an impulse down. 

If you peruse this next chart, you can see how the thrust up off Feb5 ended at Sp1213, before the peak (marked with a blue 3), had a second top at the peak; and then had a final top on May4 before the plunge. That final top at ~Sp1205 is the Bifurcation Point, where the market ran out of the prior two-week trading range between 1182 (hit three times) and 1209 (hit also three times):

 

A bifurcation of this magnitude makes it unlikely that we have the bullish case. We also broke below the Feb5 low (Sp1045) as well as below the Feb16 Bifurcation Point that broke out of the trading range around Feb5 of Sp1060 to 1080. These breaks indicate that the current correction is correcting at least back to the Jul09 low. 

Of course, the optimist would say that support at the Fed5 level has held! Consider the optimist case, that this is a normal wave 2 correction after a wave 1 up from Sp667 to the top at Sp1220, or 553 pts. The minimum correction expected would be 38%, which would be 211 pts, or Sp1009. Instead we have only corrected 33%. The normal wave 2 would go back 50-62%, or to Sp943 - 878. Thus, even if the fabled Summer Rally is ahead, we have more downside to take care of first. 

Under the category that Mother Market is a mischievous maiden, this means the Summer Rally case should start with a June Swoon! 

Big Tease

The tease is a rise to Sp1150, which might take most of June and even meander into July to complete. The wave count would make the Flash Crash a wave [iii] down, the Flash Bounce wave [iv], and the Tuesday May25 bottom at Sp1041 the end of the first wave down off the top. Interesting for contrarians is that among the many wave sites, this count is a rarity. It was discussed in some detail in Friday's STU. 

With all the ink spilled about the Summer Rally, you might expect similar length on this count, which I tend to prefer, but no need. The Big Tease count is more straightforward than making the Flash Crash the end of wave 1 down. In it the Flash Bounce would become a wave [iv], and it goes back into the range of the fourth of the prior third, a normal relationship. 

The Big Tease implies that we are in a wave 2 back up which should retrace the whole drop from 1220 to 1041, suggesting a bounce to the Sp1130-1151 range. This is consistent with the head & shoulders, since normally that would go to at least Sp1140, smack dab in the middle of that range. Rather than pick and choose among indicators, follow their logic until it breaks. 

June Swoon

The Swoon counts wave 1 to the Flash Crash, wave 2 to the Flash Bounce, and Tuesday's low as an inside wave [i] down of wave 3. The last three days have been a normal 50% retracement (very clear in the e-mini) and took 38% of the time of wave [i]. This is enough for it to be finished and the June Swoon to start right away. A lot of blog sites have this count. Here is Daneric's chart: 

 

He has a fine discussion of the minute behavior we might expect on Monday Tuesday, including a head-fake down (maybe before the open in the e-mini futures) and then a run up to the next level of Sp1122, closing the gap at Sp1115. 

Interesting as well is this Three Drives pattern, which suggests a run back to 1120 is in order before a drop to Sp990:

If we drop, a key item to watch is the Death Cross of the 50 DMA over the 200 DMA. The 50 DMA is now providing resistance, not support, and a cross of it with the 200 DMA would be a sell signal for many funds:

 

The 200 DMA is widely watched, and we recently went below it and came back to test it from below. Down volume increases as we approach from below. Not being able to cross it is a very bearish sign. More on moving averages here. 

A final topic to note is some wavists found a leading diagonal in the drop to the recent low. Blankfiend led the discussion and later repudiated the LD (since wave 3 was larger than wave 1). Wavists saw both a small LD and a large LD. The implication of both is rapid downside next week. Here is the large LD chart:

 

The LD folk should step back a bit. This pattern enlarged beyond the small LD or big LD all the way back to Apr26 can be considered a bullish descending wedge:

 

Conclusion to this scenario: we could just drop Monday, but more likely have a little more retrace to go (1120 area) before we truly drop. 

Wildcard

A reader with the handle DG has posted a comment of an interesting variant on a Neely count: that we are in a diametric pattern. Neely counts us in a contracting triangle with the Flash Crash as leg A, the Flash Bounce leg B, and the recent dive leg C. This suggests a trading range that narrows into the late summer.  

What to Watch Next Week

As the STU puts well, Mother Market should tip her hand early:

• A drop below Es1065 (futures) / Sp1065 (cash) / Dow9953 means big drop commencing. The break below the low last week is as clear an indication as one gets that more downside is ahead
• A rise above recent intraday highs of Es1107/Sp1104/Dow10264 means we at least head above 1115 or to 1140 first

For a view into broader market participants, watch the 200 DMA and the possible Death Cross closely, as a lot of funds watch those indicators. A sideways move which bounces up against the 200 DMA will bring the 50 DMA rapidly down. A Big Tease rise to 1140 in short order would come right into the 50 DMA (see chart above). A drop off that would also pull the 50 into the Death Cross with the 200. 

This Big Tease to Sp1140 and the 50 DMA line of resistance, then the drop which pulls the 50 into the Death Cross, would be the most disconcerting scenario, since it would disappoint the bears who want the immediate drop, and turn into a huge trap for the bulls who would relish piling on. The Summer Rally turns into a Summer Valley. 

Inverted Head & Shoulders Pattern Worked

The reverse head & shoulders formation noted yesterday worked like a charm to predict the market move today. The chart below from yesterday's STU gave clear guidance as to what to expect. Steve Hochberg has been on a roll lately, and is providing crisper setups than a scan of the blogosphere would lead you to believe. While the market has come back to the neckline and hovered there most of the day, it should spike higher to the Sp1120 area over the next few days, perhaps after one downturn before the end.  

 

Yesterday across the board of wave sites the odds were said to be 50:50 as to today's action. Like the Monty Hall Effect, the head & shoulders pattern was a tell which increased the odds to better than 50:50 on the upside. You can read the literature on the head & shoulders pattern, and even when followed precisely (they are oft recognized but seldom rigorously confirmed) they only give a probability of a move to follow, but it is a useful tool to increase the odds of a pick. Here is some precision from a recent post:

The EWT recently laid out the theory behind the head & shoulders pattern (EWI makes it available for free, in case you would like to peruse an EWT on point to today). Edwards & Magee's book says that the first shoulder should rise on heavy volume, but the second shoulder should have "decidedly less volume" than either the head or the first shoulder. ... The EWT notes as well that the whole formation should come after an "extensive trend". ... Many purported head & shoulders patterns fail these two tests. The weak volume indicates exhaustion of trend and a coming rotation to the other direction. 

Shanky, PUGridiron, WavePrinciple, and others had comments on the inverted head & shoulders this morning. At times the pattern resolves to a market move beyond the neckline the same distance the head was from the neckline, which in this case is 50 pts in the S&P, giving a target of Sp1140. Daneric is today's contrarian, finding the inverted head & shoulders "so obvious" that he thinks instead we will end short of that target. He remains within the range of a 50-62% retrace, or Sp1107-1122, with a lower target range around where we are now as most likely. 

The STU did not label the waves up from the head, but I have seen two counts floating around: an ABC - X or a 1-2. You can pop over to Carl Futia to read a bullish view, and several sites (such as Kenny) maintain an alt bullish count. Kenny notes that volume is not confirming a breakout. Before the bears take comfort, note that EvilSpeculator sees a pattern on the NYSE A/D ratio which is very bullish. This is what to watch tomorrow to see if this is a fake-out or something more. 

Given that the head is the end of an impulse down, this should break as a "3" corrective wave, not a "5". Most likely it breaks as an ABC-X-ABC, meaning we are in the second A wave and should expect some sort of pullback B wave before the final thrust up to close the gap at Sp1115. And then we end this goat rodeo and head south.

 

Market is Turning Into a Goat Rodeo

First we got the mark-to-close tease up on Friday, then the mark-to-close tease down on Monday, then head-fake down/up Tuesday, and now a mark-to-close drop Wednesday. The wave pundits seem equally divided on which door to pick, so many are hedging their bets hoping not to be the goat at the dance. Will the real market please stand up? 

EvilSpeculator put out their three pigs post to add to this dog & pony show. They narrowed it after the close to a two-pig contest with the odds at 50-50 tomorrow that the correction is over (and we drop) or that one of the greased pigs jumps through the hoops, sending the goats above Sp1100. 

Kenny may get the prize, again. (Maybe Evil could send Kenny one of those greased pigs?) He picked up on a thread of discussion meandering through various sites today of a reverse head & shoulders pattern in the e-mini, which became the top point in today's STU. The pattern also shows up clearly in the S&P, with a very flat neckline at Sp1090. The pattern suggests we continue down tomorrow but stay above the Sp1056 level of the left shoulder, then head back up. 

Futures are slightly up in the after market. A reader (Roger D) gave a nice chart showing the e-mini in a rising wedge. This suggests a break-down tomorrow to complete the right shoulder, then the rebound above Sp1100.

This would set the stage over the next two to three trading days to close the gap at 1115 and get to the 1122 area. This may get the bulls feeling their oats, but the rise from the bottom broke in three waves, and then we had the drop today, which means that this wave is merely corrective, not the start of a new bull. Many ewavers count it as a "3" up followed by an X wave back, with a second "3" up to go. If the bulls pile on, the subsequent drop will get their goat. 

We might be getting guidance from other markets. Treasuries had a big rise (drop in rates) as the Euro crisis drove money to safety over here, but rates are now rising, and the Euro has risen then fallen back. It may be the USD and the Euro are in a sideways dance for a few more days while Treasuries are falling, and this might encourage the stock market goats to dance their way back up. The whole goat rodeo may suddenly come to an end as Euroland problems re-emerge next week. 

Monty Hall Market

The market gave investors three doors to choose from this morning (big drop, small drop, no drop), and in best Monty Hall style, teased us by showing one door not to choose at the open (no drop). Investors who were betting on the big drop may have felt confirmed in their position, but an understanding of the The Monty Hall Problem would have clarified that the odds favored the other door. 

This problem is well studied but little understood. In the game, behind one door is a cool prize, and behind the others is a goat or similar joke prize. Contestants can choose one of three doors with no information, creating odds of 1/3 for any choice. Then the game show host opens one of the two unchosen doors to show a goat, and asks the contestant if they would like to change their choice. Oddly enough, most contestants hang onto their initial choice, when switching is a 2:1 favorite. 

Many people - including PhD's in stats - get confused by this. They think that after the goat has been shown, the odds shift to 50:50 as to which door the prize is behind, so why not just stick with the first choice, stubbornly? Not so: before the pick, the odds the prize was in the other doors was 2/3, and after the goat is shown, the odds are still 2/3 - but now in only one other door. The 50:50 odds would have been correct of Monty Hall were to pick the other door randomly, revealing the prize 1/3 of the time; but the host has superior information, and only picks the goat. 

Being stubborn as a goat makes you the goat!

After the market broke below Sp1170, the bottom of the trading range "plateau", it was as if Monty had opened one of the doors to show the goat was behind all the wave counts that meant a continued correction. The choice was down, but which door? Big or small drop? The market trended down on lessening breadth and volume, and began to come back almost immediately That was the "tell" to watch, according to yesterday's STU. 

Today we finished a little wave v to end a wave 1 down from May13. Today's special STU adds that we hit the lower trendline of the drop and bounced, confirmation of the pattern. This chart from EWTrends captures the action and gives targets for this wave 2, which normally should run at least 50% back up (Sp1107), and may go 62% (Sp1122):

 

Fascinating to me is how quickly some wavers now count the whole Flash Crash and after as but a correction in a continuing Hope Rally, an ABC flat that just ended this morning. By breaking the Feb5 level (Sp1045) and the February Bifurcation Point at Sp1063 on Feb16 (which marked the moment when the market shot back up above the congestion around the bottom), the market has confirmed a longer and deeper correction than that. 

This wave 2 is a great setup to take a short position, and may come quickly - the end of this week or early next. There is a gap way back at 1115 which will likely be closed, so the bet is for a robust bounce back to the Sp1120 area. 

The Market is Jittery - What to Watch

We are in a serious downdraft yet the chorus of calls for a rally is increasing. After all, the last two corrections in the Hope Rally ran about this far in time before turning. The mark-to-close airpocket in the last 15 minutes today, however, has made the bulls jittery. They fret over Asian markets opening down, even though that is typically a reaction to US markets, not a harbinger of tomorrow; and they may panic when they see how strongly futures are down in the after-market - Dow below 10K, S&P down below 1060 - even though they tend to mislead more than predict the next day's market open. Are we about to crush through Dow10K and stay below?

Comments to my prior post give a good range of orthodox wave theory expectations, and I recommend taking a look at them. Neely expects a sideways move with sharp ups/downs - a triangle (of course). EWI has been calling things pretty well since April 26, but interesting the STU tonight is on the cusp:

1. Friday's opening low could have ended a wave 1 down, and today could have ended a wave 2, setting up a powerful drop .. with the caveat that normally waves 2 retrace more than this has
2. Friday could have ended a minor wave iii within wave 1, and we would be in a wave iv that may have ended or may float sideways a bit longer (developing into a triangle, albeit a smaller one than Neely's)

EWTrends provides a useful chart to see these two possibilities. They label this as STU Option 2, the wave iv triangle (their blue 4). Simply by making the blue 3 as the end of wave 1, you can see STU Option 1, and also see how the retrace off Friday's low has not been very impressive. It would normally go back above the gap noted on the chart around Sp1110:

 

EvilSpeculator has a similar view, that we are on the cusp of either a normal wave 2 rebound at least to Sp1110 if not Sp1135; or a deep drop that should run below Dow9K and Sp1K - and stay below the magic Dow10K level. (If you feel jittery, you might subscribe to his service to see his more detailed analysis and target levels.) 

The STU advises to watch the strength of any decline tomorrow. Under Option 1, if wave 2 has ended short, downside volume & breadth should accelerate with a drop. Under Option 2, if wave iv has ended, the drop is a wave v and given the vigor of wave iii, should fall on modest volume and diminishing breadth, signaling distribution towards a bounce. Of course in both cases waves 2 or iv may break in a complex way instead, and we go up tomorrow. Even the STU's advice seems to jitter a bit. 

One way to try to parse through these jittery wave recommendations is to apply a little Bifurcation Theory. Given some time tomorrow I may put up a pencast describing how Bifurcation would apply to the Hope Rally. If you look at the past four days and stretch the chart, as in the next chart from Kevin's Elliott Waves, you can see how the market has been in a box for the past three trading days:

In Bifurcation terms, this defines a "plateau" after a sharp thrust down. The core wave or fractal of Bifurcation Theory is a thrust and a plateau, and plateaus tend to break on a triple top or bottom. This one is defined with a top along Sp1090 (ignore the false break to Sp1095) and a bottom along Sp1070 (again, ignore the false break to 1055). 

What to watch is a break out of the box, either above or below, that stays above. After the false break above and another one below, the next break will be defining. Hence:

• A break below 1070 means to follow the advice of the STU above, to look at volume to determine how deep the drop will be
• A break above 1090 points to STU Option 1 as well, in this case meaning a wave 2 retracement at least to close the gap above Sp1110 before the deep drop
• A continuation inside the box points to STU Option 2, a wave iv breaking sideways and then a relatively anemic drop followed by a strong wave 2 rebound up towards Sp1035 or higher

IPO Window May Be Closing

ReachLocal (RLOC) priced this week at $13, well below its range ($17-19). It opened and sank below $12 then rose to finish the week above $15, still well below the range. 

This disappointment has spawned speculation that the IPO market is freezing up. One can dismiss the RLOC situation due to a horrific couple of weeks - they were on the road in Europe the week the Euro seemed about to implode - but it comes after other withdrawn or poor offerings. 

The next interesting IPO is Tesla, which is scheduled to go on the road in June.  It just cut a deal with Toyota, on the backs of a deal with Mercedes, so as a business it seems to be in high gear. Electrics are the future of transport, and Tesla is the first new car company out of the starting blocks. This IPO should give it access to the gallons of capital it will need to compete at world scale. 

Note: I have an indirect venture interest in RLOC and Tesla

Technical Note of Caution

An expectation has built today of a big drop tomorrow. The wave structure would support this, with one important caveat noted in tonight's special STU: the wave down could be interpreted as either a nested 1-2 "coiled spring", meaning a meltdown is right ahead, or a completed minor wave down, in which case a sharp bounce is ahead, at least to Sp1095 and maybe above Sp1110. We should know at the open tomorrow which it is. If a bounce, it will be but a temporary respite. Clearly a bit has flipped in investors minds, and the market has found a new direction: down. 

Markets seek order, but are most often in periods at the edge of chaos searching. When they find order, they move much faster than before, especially when gripped with fear bordering on panic. During such periods they fall hard, then have big bounces, which are always interpreted as the bottom. (This is why bear markets fall down a slope of hope.) The whole period from May 1930 to Sep 1932 was marked by sickening slides interupted by rapid bounces - a saw blade down that sucked the life (and capital) out of the bulls. We may be entering a similar period. 

Do not interpret a sharp bounce as a reversal. We had one the Monday after the Flash Crash, and within four days had reversed back down. We are within spitting distance of the Flash Crash lows, and far from the highs of just a week ago. 

The efficacy of propping the market up with bailouts seems over. Rumor is of a big confab in Europe to try yet again to keep things together. The first Greek bailout flopped, the Euro-TARP failed to stem the panic, and the desperation move by Merkel only dramatized the impotence of bailouts. Germany and France have agreed to coordinate on supporting the Euro, and this leads to hope of a broader Euro intervention plan. More on that as it develops. 

Both the Dow and the S&P broke below their 200 DMA, an arbitrary but widely-watched indicator. This often acts a s a trigger for big funds to unload. We may see an attempt to get back above, and its failure could spark the rout. 

Fallout From The Crash: GDP

The Eurozone bailout requires austerity to take down its benefits. This will decrease GDP. While much is made of Germany benefiting from a lower Euro with improved exports, a lot of the exports are intra-Europe: about 35% go to the PIIGS, and another 30% to the rest of Europe. As their trading partners weaken, the lower Euro simply drops the value of German exports that remain outside the Eurozone. 

We already see the PIIGS begin to take austerity measures, as well as other countries (ZH provides this handy chart):

• Spain announced public wage cuts to drop the deficit from 11.9% to 6%
• Portugal has moved twice to reduce the deficit from 7.3% to 4.6%
• Ireland had already made moves
• Even France announced a budget freeze at inflation levels

Deflation has shown up in Spain and increases worries over negative Eurozone GDP in Q3. Ireland expects a big drop this year (7.7%) and another drop next year (2.7%) due to getting the horrific deficit under control. EU GDP rose only 0.2% in Q1, up slightly from 0.1% in Q4. It won't take much to send it down into the double dip.

Goldman Sachs calculates the drag from austerity at -0.49% and the benefit to Germany at 0.49%, a wash. Still, this is very rough, and they have been projecting 2% GDP growth in Europe, while the last two quarters came in around a tenth of that at 0.2%. Their back-of-the-envelope calculation could easily tip negative. 

In addition, the whole world is slowing. Even before the crash, the OECD released its leading indicators, which "pointed to a slowdown in the pace of economic activity."  The slowdown is led by China, which has been slowing its torrid growth since it began its stop-and-start measures to put a lid on inflation and an overheated recovery. 

The US had a disappointing Q1 report, which Goldman Sachs estimates was essentially zero growth absent temporary factors (stimulus and inventory rebalancing), and they project a poor report in Q2 with the same 0% underlying growth. Given these temporary factors fade in 2H10, they will act as a drag on GPP of -0.5% in 3Q10 worsening to -2% in 3Q11. 

It will take growth in employment and corresponding growth in spending to counter this drag. I have commented that while employment growth in Q1 was promising, it is largely based on suspect statistics. There was a lot of delight at the recent retail report, but looking at the part of retail used to calculate GDP (excludes cars, oil and building materials), retail has turned down after rising since March 2009:

The recent increase in consumer spending has been largely attributed to dipping into savings and spending government transfer payments, since earned income has not increased. 

A third possible source for spending is coming from a new angle on mortgages: "strategic defaults," to simply squat in houses without paying, expecting a workout. This is a consequence of bank forbearance on foreclosures, and has sparked a whole underground movement to squat and thrive. Troubled homeowners are being advised to sit tight. Strategic defaults are now trending towards significant levels, 12% of all defaults in Feb. 

It remains an urban legend - to squat & spend - but the magnitude of potential extra cash is pretty large at $8-12B/month, or over $100B/yr:

Leading indicators remain mixed, although ECRI is slowing as is ADS, which has now trended to negative. This morning the Conference Board surprised when its index went negative. Small business continues to have severely restricted credit, and has ticked down after a brief spike of better conditions in Q4. The one bright light has been industrial production, which has looked like a V-Shaped recovery, but it too is flattening:

 

Euro Rises as Merkel Emasculated

The Euro was expected to bounce as Merkel's move was expected to have a momentary improvement as shorts covered. The Euro bounced, but for a different reason, and one that suggests the Euro has bottomed for the moment. If so, the Euro should begin a bounce of several weeks or months.

What happened this morning? Other countries declined to go along with Germany, and after a brief short covering, everything reversed! It reminds of the moment in Animal House, when John Belushi rushes out of the frat saying "Who's with me? Let's go!" and no one does.

Merkel's move is a bust. Spreads widened when they were supposed to narrow:

Credit-default swaps on Europe’s most indebted governments fell initially on concern the restrictions on short-selling will devalue existing agreements. They erased those declines as it became clear Germany failed to persuade other nations to join in the ban.

Germany largely failed to persuade other nations to follow its prohibition and the U.K. Financial Services Authority said the ban doesn’t cover branches of German institutions outside of Germany, indicating it will have little impact on trading in London, the biggest hub for swaps bets on European government debt. 

Merkel's move now looks like an act of desperation. As Mish comments:

BaFin put the ban on short selling even after it announced that it found “no evidence” that credit-default swaps were being used excessively to speculate against Greek bonds

This explains why ZH's day of chaos never happened. Governments look impotent. London markets are bigger than Germany's, and continue trading with naked shorts. Also, the data simply does not support Merkel's fears - while shorts have increased dramatically, the types of naked shorts she worried about the short positions are not that large and are actually lower than two months ago:

The funniest story is that one of the leading shorts is the Greek central bank, betting against itself! You cannot make this stuff up. How can you take government "regulation" seriously? The banks don't.

So what drove the Euro up? It appears that the ECB and other European central banks are finally intervening:

The massive 200-pip jump in EURCHF in less than 10 minutes (13:00-13:10 BST) is the work of no other than the Swiss National Bank intervening to sell its own currency. But the 80-90 pip jump in EURUSD must also be the work of European banks intervening on behalf of the ECB to boost the ailing euro. The events of the last 2 weeks imply that coordinated central bank intervention is possible. If it took 2 days for the ECB's to make an about turn on bond-purchases and for Berlin to institute a ban on naked shorts, then the prospects for intervention are very plausible

What is troubling is it wasn't a coordinated move, but driven by capital flight from Germany (Euros) to Swiss Franks. In order to manage the conversion, the Swiss bank had to intervene to prevent the Swissie from running up! Ambrose Evans-Pritchard reports that "€9.5bn flowed into Swiss franc deposits in a matter of hours," and this came on top of €56bn interbank loans reflecting flight out of Club Med. 

This means the battle between the wolfpacks and the central banks has now been joined by panic and capital flight, which is the same psychology of May 1931 after Creditanstalt Day. This battle should last at least several weeks - it lasted a month back then - until the central banks lose patience and resources, as the flight overwhelms the interventions. 

Besides going long the Euro, it may be time to short the German bunds (their sovereign bonds). This likely also means the end of the gold rally, which I had assessed a week ago, that the momentary spike of in gold after the Flash Crash may have been a blowoff before a hard reversal. 

It was also my view in the last few weeks that once the rescue attempts were seen to fail, the Euro would bottom and reverse. The failure of the Euro-TARP so far combined with the failure of Merkel's move indicate that the market now accepts that we are done with bailouts and gimmicks. Instead, the PIIGS now have to either fix their insolvency or spin out into their own currency and use devaluation to realign their currencies. This is a foundation for a rebound in the Euro, at least for a while.

It may seem paradoxical that government intervention tends to cause the opposite of what is intended, but that is what history shows. Markets reflect real forces, and government attempts to fix prices or stem tides tends to get overwhelmed as markets find ways around obstacles. This lesson has been learned over and over going back to at least Diocletian's price controls in 300 AD. They failed.

Markets are order-seeking mechanisms within chaotic nonlinear systems. When they find order, they move very quickly, much faster than governments. Governments in contrast tend to be the slowest actor, intervening usually after the trend has exhausted. In this case, the moves to rescue the PIIGS come after they have gotten so deeply in trouble, the rescue simply kicks the can down the road and deepens the insolvency. I do not think any market participant believes Greece will escape default - even the Greek central bank bet against itself! - it is simply a matter of when. Hence the rescue was not seen as solving the problem, just bailing out over-extended banks. 

Once the rescues are dismissed, Euro deflation looms due to debt default. Hence the better bet is not against the Euro but in favor of deflation. Right now it is not clear that the market has come to that realization; we seem to have a momentary bump due to intervention and capital flight. How long and strong the bounce will be probably depends upon short-term intervention vs. long term belief in deflation, and a timing arbitrage as to whether one can jump and get out before the bonds default. 

If we remain in the Creditanstalt Month of capital flight and panic, this bounce could be short-lived. The world may seem a lot more complex and sophisticated than back then, but the psychology remains the same. Human nature does not change. Nor does government psychology. Adherence to the Euro today is acting like compliance with gold then. The parallels are striking.

My conclusion is of a near term bounce followed by a further collapse - it is after that deeper bottom the deflation expectation will emerge. Neely concurs, and put out a call to go long mid-day today. He sees the Euro in a large triangle (of course). Today's STU also sees a major move back up in the Euro, especially because sentiment has become very bearish (98%). Depending on wave structure, this is either a relatively short ABC correction, or the start of a multi-month move. More from them as the pattern reveals itself. 

In the longer run, however, the Euro may be doomed. It is a flawed currency, since it is not backed by control over fiscal policy. A lot of ink is being spilled on this in the blogosphere. EWI commented on this five months ago and their comments are worth reading (below the fold):

AUD Tumble Down Under

With the Euro in its expected small bounce - and may have more to go due to what happened overnight - the Australian Dollar continues to tumble. The AUD fell over 3c in the last day, a huge move, and broke below its Feb5 low at 85.75c, confirming a double top. A technical bounce may come, but the trend is decidedly down. There may be initial support around 82c, but the next major support level is the July 2009 low at 77c.

 

The other currency pair to watch is AUD/JPY, driven by the granddaddy of the carry trade, the Yen carry trade. The AUD bounced off a key Yen support level at 76, but seems destined to crush through shortly. If so, this confirms unraveling of the carry trade and serious weakness in the AUD. 

Note: I moved the comments on the Euro to a new post

Run From the Euro!

The Euro had its short-term bounce, but when Germany announced a ban on naked short selling, the Euro began to fall and got below $1.215 after-hours. The reaction from Goldman and other banks has been shock and awfully negative criticism that boils down to: run from the Euro!

ZH has been on a roll on this issue, predicting chaos tomorrow in markets:

One bond trader said he expected Wednesday's trading session to be one of the most volatile in living memory: "It will be complete chaos, I really don't know what the Germans think they are doing."

The Euro is not directly affected, yet. The naked short ban applies to sovereign debt and CDS's. The Euro, however, is a way to play this.

The received wisdom on short bans is a short ban has a temporary boost, as shorts close out their positions, so the Euro may initially bounce; but then the short ban undermines confidence in the instruments affected. When you remove shorts, you do not remove sellers; you remove liquidity. Shorts add liquidity for the longs - they are the other side of the trade - and if the longs can push them back, they rush to cover in a short squeeze, driving prices up, losing capital quickly, and often losing their ability and appetite to continue. Mish succinctly summarizes:

All these short sale restrictions are going to do is create a vacuum. Once the shorts are driven out these shares will plunge

The vacuum comes from buyers unable to find sellers to match their ask, and standing aside. The shorts have left. The shorts were the other side of the ask. The trend down remains, and the sellers try to find buyers at lower prices. As they overwhelm buying interest, the market falls.

The Flash Crash is an example of what happens when one side of a trade is removed: the sellers seek lower bids, and as the price drops, the market crashes.

Prior short bans have led to market crashes. Here is Mish's example:

 

Will we see a crash in the Euro? The Germans are banning naked shorts, not all shorts. This is a ban of a different character. The shorts can still play, but they cannot short beyond the number of instruments, in effect engaging in highly leveraged shorts. As an example, normally to short a stock one needs to borrow each share first, so the total shorts cannot be more than the public float, and are usually a small fraction. In a naked short, one can take a position without borrowing the underlying instrument, or in the case of derivatives, having someone on the other side. Naked shorts allow positions much larger than the float, or more commonly, larger than normal daily trades.

Karl Denninger applauds Germany for taking this move, and wishes it on Obama as well, to take control back from banks who have made huge mischief fleecing markets both before and after the financial meltdown. His point is well-taken in that traditionally the financial sector takes 10-12% of profits as a "vig" for its services, but during the Greenspan Bubble took 33% of all US profits ($2T of $6T over the period), and at the peak in 2007 was sucking 40% of all profits from American industry into its maw.

Others agree, including ZH and Jesse's Cafe Americain, and see the broader political design in the German move:

• the ban is a hammer that can be used to default on CDS's without consequence, putting more control back onto the German government
• the ban is also a reaction to the failure of the US to reform its financial system, and a repudiation of the current US financial reform bill

Put simply, the Germans are implying that the Obama administration is in the pockets of big US banks. Merkel remarked on this in a recent speech:

To some degree this is a battle between the politicians and the markets. But I am firmly resolved -- and I think all of my colleagues are too -- to win this battle....The fact that hedge funds are not regulated is a scandal," she said, adding that Britain had blocked previous efforts to do this. "However, this will certainly have taken place in Europe in three weeks," she said, without giving more details." Reuters 6 May 2010.

This is but the opening salvo. A transaction tax may follow, as well as measures impacting the Euro directly. ZeroHedge has a series of posts tonight, including this comprehensive look at what may be ahead.

Politics aside, the other big move today happened in Australia, where the RBA did not raise rates on fears of turmoil in Europe. As predicted here a week ago, the carry trade is rapidly unwinding, with the AUD falling hugely in the last two days, rushing to an 82c support level it seems.

Bubble Echo in Commodities UPDATED

Oil is in the news, and the huge gulf spill is giving credence to even higher oil prices - yet oil has dropped. At the same time, despite the flash crash, other commodities have continued to rise, closing in on levels last seen at the top of the bubble in July 2008. Are we in a huge Bubble Echo in commodities, and is oil signaling a top?

We all remember how oil went to $147/bbl in 2008 and then fell fast to $31 six months later. As it was rising, the cries of Peak Oil! rang out, but as it dropped, we shook our heads and mumbled about a huge commodities bubble. 

Peak Oil is passé (see chart, courtesy InfectiousGreed), but Oil is half-way back to those bubblicious heights, and again the conventional wisdom is justifying high prices on faux fundamentals and momentary events. Lost in the noise seems to be it rose before the spill. 

 

What is behind Peak Oil is a serious discontinuity: oil becomes more expensive to extract, and global production finds it hard to keep up with demand. We already appear to be beyond the era of cheap oil. Chris Martensons' Crash Course has more on Peak Oil. The US military is worried. His blog has just put out a great resource on this issue, with specific advice for investors, to wit: if Peak Oil hits, we won't see oil spiking to $500/bbl, but a political and military response. 

But we are not there yet. Instead, something else is driving up oil, and it is not increased demand. Miles driven have dropped during the Great Recession, and on a month-to-month basis has dropped since the start of 2010:

Sunday's NYT has a great graphic of oil going in reverse. Even during the oil crises of the '70s, per-capita driving increased. In the Great Recession, in contrast, per-capita driving is decreasing, yet oil prices have bounced back up. What gives? If the demand is down, and we are awash in supply, why are prices back up?

Maybe China is driving demand for oil? Nope. Chinese miles-driven has been flat. Chinese data on this stat may be statistically sketchy, but the NYT reported last Dec how Chinese car sales are booming but gasoline sales are flat. 

As recently as May 2, oil was heading to match its 52-week high of Apr6. Pundits were calling for a breakout. Just before the breakout, we saw an increase in the same sorts of cries to buy! buy! we saw in 2008. So it goes at a bubble top - where were they when oil was hovering at $50? Instead it did a triple top and collapsed. It had bounced off the 50 DMA after the second top, but this time it ran through the 50 DMA without pause, jittered a bit around the 200 DMA (around $76/bbl) and kept falling. 

The best explanation is that we have been in a bubble echo. The signature of a bubble was recognized before the triple top that "trading activity seemed to mirror the pattern leading up to the oil market's breakdown in the summer of 2008." Commercial interest peaked last December, just like it peaked in late 2007, six months before the bubble burst:

 

Oil had also gone into contango (indicating too much oil). Yet even this pundit was caught up in the bubble, expecting it to continue up despite the warning signs. Bubbles can do this to pundits. 

After the peak of commercial interest, speculation drove oil and other commodities to absurd heights in 2008. You can see the same pattern now; speculative has gotten back to bubble levels:

 

Besides oil, Copper (the Cunary in the commodities pits) has given off a big warning signal: it began falling in April around the time oil began peaking, and has since dropped below its 200 DMA for the first time since coming off the commodities peak in 2008. This is a warning sign that manufacturing is slowing.

 

The WSJ's blog noted this warning sign as well, and attributed it to China tightening. This meme is gathering adherents: the FT noted it back in March, and the UK Telegraph's Amborse Evans-Pitchard picked it up in April, that China's credit curbs could cause a Great Unwind of commodities. Chinese base-metal stockpiling reached "epic" levels in early April. Of course the pundit expected it to continue.

But not everyone. David Rosenberg came out with a great predictor of commodities: the Shanghai Index. He shows how it leads the CRB Index by four months (72% correlation). It peaked before 2008 top in commodities, and it peaked again in Nov 2009. Since then it has broken down out of a four-month trading range, right as oil and copper have burst. A week ago CreditWritedowns posted a comprehensive analysis of this indicator and others which supports the Great Unwind thesis. 

  

MPPTrader provides a comparison of oil & copper to gold & silver, showing how the crude oil and copper futures have broken below trendlines. Oil is well below, and copper has recently rallied to test the trendline. If it kisses it goodbye, it is pretty well confirmed that the Bubble Echo is done. 

UPDATE: The STU led its latest update with commodities, showing in the chart below that the CRB commodities index has broken decisively below the trendline that guided its rise since the beginning of 2009 as well as the Feb5 low. The STU has been predicting this for months, and will likely continue to highlight this change of trend since it supports one of their core investment theses: deflation. The PPI came in negative in April, a surprise to pundits, and CPI will be reported tomorrow.

 

Target for the Euro

Reports out of Europe say a huge scramble for gold coins is on. Dealers have run out of inventory. This is a microcosm of the Creditanstalt Problem: at some point bailouts no longer work, and creditors run for the exits taking the rescue funds with them. As a senior PIMCO manager said: "the risk is that investors are using the ECB as a vehicle to exit their positions." Well, duh! Amazing it would happen at the same time period in May as it did in May 1931. 

The Euro hit the next support level at $1.233, the Oct08 level, and after going slightly lower to $1.223 bounced around the time the ECB announced concrete steps to sterilize their recent purchase of PIIGs bonds (in order to maintain the supply of Euros as constant). This may alleviate inflation concerns and spark a short-term recovery. If turns down again and breaks below that level, the next range is $1.164 - 1.18, which provided support back in 2003-05. Chart and analysis from MP Trader (via SlopeofHope) below. 

Goldman Sachs in contrast has a target of $1.35. They think the Eurozone will grow about as fast as the US with Germany making up for austerity among the much smaller PIIGS, and hence think rates settle back a bit. More on that in a later post. If the ECB intervenes strongly enough, a huge short squeeze could drive the Euro back above $1.35 quickly, and it might settle back down there. 

Calafia Beach Pundit points to purchasing power parity (PPP) levels, which are $1.15 in the Euro and $1.42 in the Pound. Both these currencies might get there, fast, and overshoot to the downside. The most over-valued currencies, however, may stay that way a while longer:

• AUD at 89c is way above parity at 68c, giving it a lot of room room to drop
• Yen at 121 per $1 also has a ways to drop from its current 93 

Those two currencies are way above PPP due to the carry trade. The Yen is a major carry-trade currency, and the AUD is a major beneficiary of the carry trade in both Yen and USD. Per my recent post on the AUD, if the carry-trade unwinds due to the crash, both have a lot of room to drop vs the USD. Of course, any rate increase in Japan puts their country into a deep hole, given that interest on the debt (at very low rates) can hardily be covered by taxes. 

 

China Bubble: Shanghai Market Crashing

China's Shanghai Exchange (SSEC) has decisively broken below a trading range and is dropping fast, down 5% Monday, 20% since early May and  25% so far for 2010. Just ten days ago, as China announced more tightening, Marc Faber warned of a China crash.  Dr. McHugh put out a crash! call this weekend. After the big drop off 2007, it was first to rebound, starting in Nov08, and the first to peak, in Aug09. It has been in a big sideways move ever since, but has now dropped below the lower trendline (chart courtesy ContrarianAdvisor):

   

It is down 25% in nine months, and well below the 200 DMA, both signals for a big bear market. Earlier this month the momentum oscillator (ROC) crossed to negative, another bear confirmation. When the 50 DMA fell below the 200 DMA in late March, it was a Death Cross signal:

Now, a case can be made that this is a short term drop, not a crash, but it is getting more difficult after the fast drop of the past two weeks. Given the volatility of the SSEC, these signals may go away quickly; also, while it looks like the SSEC is foreshadowing US markets, the reality is that it is much smaller and some pundits say it has little impact on the US. Instead, it is more like the NASDAQ, driven by the retail investor, as compared with the other Chinese exchange, the ADR, driven by institutions. (For a really good dissection of the SSEC, go here.) Hence the views of Jim Trippon, who expects a bounce, and the blog trendlines, which follows China and India closely, that expects a bounce as well. Trendlines reasons that while the SSEC is in a bear market, after the current downturn, it will go back above the Aug09 levels to complete a C wave of a big ABC off the Nov08 low. So far it has only retraced 2% of the big drop off 2007, and a 50-62% is more common, as we saw with the Hope Rally:

 

In some respects, however, the SSEC both presages and reacts to other changes globally. It may not lead the US, but it acts as the most sensitive canary in the global coal. As I will lay out more in a post on commodities, a fall in the SSEC preceded the big bubble peak in commodities in 2008, and it may be signaling the peak of the bubble echo in commodities. The logic is straightforward: China has become a huge buyer of commodities, and in the past year has been stockpiling. A fall in the SSEC is the leading indicator of a pullback in China's economy. 

Also, Euro weakness may be hitting China. Europe is a large trading partner with China, and the Euro drop may accelerate an SSEC drop, as it means less imports from China. The SSEC may not yet be responding to that, but they will. 

Most likely the SSEC is falling because Chinese manufacturing growth is slowing. The tightening is having an effect. This was signaled by the turndown of the Chinese PMI in Q1:

 

It is interesting to read economist opinions on China's red hot 11.9% GDP growth in Q1: largely sanguine about Chinese prospects even though the Q1 jump is largely an artifact of a weak Q1 a year earlier. There have been concerns over suspicious Chinese stats. They measure GDP differently - essentially when budgeted, not as actually produced. The hot Q1 really means spending is out of control, hence the tightening, which includes some fairly dramatic nullifications of local government loan guarantees - an indication of out of control debt-fueld bubble. 

Another indication was the surprising Q1 trade deficit. Those sanguine economists opined it meant China was rebalancing, meaning increasing consumer spending (imports from trading partners). On the contrary, it was due to investment-growth, not consumption. Imports surged due to stockpiling of commodities, and exports weakened due to weakness in the US and Europe:

 

Other than a passion for imported cars, which is driven by their version of Cash4Clunkers, China is not on a consumption spree:

 
Instead, China seems to be careening down the Stimulus Road, out of control, and now trying to grab the steering wheel. The WSJ has wondered what China will do to push back an incipient inflation, and believes they will have to allow the RMB to appreciate. Mish then asks this question in regards to a rise in the RMB, given tightening:

What would happen if China stopped its stimulus cold turkey, pricked its property bubbles, and allowed the RMB to float freely, and in response the Chinese stock market collapsed, social unrest picked up, and hot money poured out of China?

Well, the stock markets in China are crashing. China 2010 may be Japan 1989. The huge Chinese stimulus has caused surges that look a lot like Japan after the Plaza Accord in 1986, or the US in 1927 after the Brits went back on gold at the wrong level.  

The Euro Strikes Out

Euroland needs to gather its forces to fend off the woldpack of shorts. As of Friday they had risen to record levels (see chart, courtesy ZH). I have heard reports that European TV news is projecting a fall with no bottom to the Euro. 

A huge rescue attempt should commence this evening (Monday am in Europe) as the Wolfpack War continues. As I go to press, the Euro is ticking up slightly down stromgly from its after-market dip Friday, and is a pebby below the Friday close. Ominously, LIBOR rates are ticking up, indicating a lack of trust in sister bank solvency. If we don't see intervention, Europe has given up already. The contagion from capitulation could happen extremely fast:

What makes this crisis so dangerous is not just that Europe’s banks are still reeling, with wafer-thin capital ratios. The new twist is that markets are no longer sure whether sovereign states are strong enough to shoulder rescue costs. 

The implication for stocks - if there is a midnight rescue - is yet another Monday Pump up. We fell Friday in five waves down and bottomed mid-day at Sp1126. The wave structure supports another wave 2 retrace of 50- 62% or into the Sp1150-56 area before rolling over. It might take a few days to conclude, but it should reverse with another day of drama down and push us below Dow10k/Sp1k. Given that Asia opened in the red and futures are down strong (over 100 in the Dow), we might instead get a poor start and an attempted rally into the close Monday. 

I see more confusion and doubt over this than there should be. I suppose many pundits have become spooked by the rally-that-never-corrects, and expect it to magically restart up towards new highs. This shouldn't come as news, but - it just had a huge correction that broke out of prior trendlines. It has come back up to test the trendlines, and fallen back below. It had been rising in shrinking volume, and now that it is rolling over, volume is increasing - a classic sign of distribution, where stronger hands are dumping them into weaker hands, who will cut and run should the market drop again. ZH adds that the cumulative tick has decayed much faster than the S&P, an indicator that sellers are hitting bids in a swooning market:

Time to shirk off the doubts and look at the wave structure. If you buy the truncated fifth count, where Thurs was a wave 3 bottom and Friday a wave 5, the subsequent waves look normal:

• The initial bounce off the 'bot bottom was around 38%, a normal wave 4
• The bounce off the truncated fifth (so far) has been around 62%, a normal wave 2
• A bounce to Sp1156 or so would be another normal 62% retrace, of smaller degree

Stories came out Friday that the 'bot bottom was not 'bots alone but Waddell & Reed, a money manager which sold off a large order of e-minis during the 'bots-gone-wild 15 minutes of fame. This lends credence for treating the Thursday plunge as an Elliott Wave phenom, not a glitch or an anomaly. This makes the drop off Apr26 a "5" whether you call it at the 'bot bottom on Thursday or at the truncated fifth on Friday. A "5" of this magnitude means a change of trend. We aren't done, and have more downside to go, and any sharp bounces will now just shake out the timid.  

Friday's STU was pretty clear on this: in four trading days we have retraced the third biggest gap up in S&P history. The biggest on Sep 19, 2008 was retraced in one day. The second biggest on Oct 13, 2008, was retraced in two days. "The inability to sustain's Monday's gains is a bearish signal that should not be ignored." Any small bounce this week should be followed by an even stronger drop than last week!

Neely counts the sharp drop as the start of a triangle. We have a really clear test of NEoWave vs. Elliott Wave. He must count the drop as a "3", since triangles are a set of five 3-wave moves. (For readers who do not subscribe to Neely, he has the Jan-Feb5 drop an X wave, the rise since wave A, and says we are in a triangle wave B with a C to go to new highs. The sharp drop is leg a of B, the bounce leg b, and we either are still in b or have started leg c.) Neely says higher highs ahead, EWI says the top is in. 

Fallout From The Crash: Gold

Gold is a hedge against bad government, not just inflation - Martin Armstrong

The biggest winner from the crash is gold, which has shot up, especially priced in Euros. The wolfpack of shorts continues to push down the Euro, rushing through the $1.25 level  to the $1.23 territory, rapidly submarining the Euro-TARP. It may be that the Euro is already headed for the trash heap of history. 

Or maybe not so fast. The net non-commercial short positions are at record levels. If the ECB is all-in, so are the shorts. I expect a big rescue mission this weekend, to try to squeeze the shorts. 

As wolfpack warfare wages on, the question is whether gold is in a parabolic blow-off top, which says get out, or is signaling the collapse of paper currencies is closer than we think, which says to protect capital at all costs. 

After persuing the pundits, my take is a near-term top which could be followed by further gold upside, but not right away. First those currencies need to crumble! The uncertainty is how close the top is. Let me walk through fundamentals, technicals and monetary economics. 

Monetary Economics

The gold spike engenders the knee-jerk reaction of impending inflation, but the money supply indicators are plummeting right now (chart courtesy Pierre du Plessis). Europe is actually contracting (below zero in the chart) whereas the US is growing money very slowly. 

With such a drop in money, it is no surprise that EuroZone GDP is flat, and may be about to fall into a double-dip. Given that velocity of money is also down, this is deflationary, and with the Fed having ended its QE program, unlikely to change. 

 

Normally such a deflationary environment is bearish for gold. To understand where gold may go, it is important to step back and reconsider the Quantity Theory of Money (QTM). Bear with me as I summarize the hyperinflation vs. deflation debate. 

Hyperinflation: I tend to skip the frenetic goldbug sites imploring you to buy gold, so I missed this Hyperinflation Watch piece by one of the leading proponents of a return to real money (gold). It came out just before the Apr26 peak, and noted how the money supply in the US was doing something that has seldom happened: it was shrinking. 

Rather than see the coming deflation, the author (James Turk) creates a new moniker, the Haverstein Moment, named after the ill-fated Reichsbank President who caused the Weimar hyperinflation of the 1920s. He is claiming inflation is running faster than money growth:

The so-called “shrinking” money supply that arises when adjusting for the loss of purchasing power from inflation is a characteristic portending imminent hyperinflation 

Deflation: I do however pay attention to the writings of Prof. Fekete, who has gone deeper into money matters and gold than anyone since Murray Rothbard, the Austrian economist, in the '60s. He finds the Haverstein Moment "grotesquely unrealistic" in a cogent discussion of the hyperinflation/deflation debate. The Wiemar Republic was the post-war Germany after WWI, with a Reichsmark no one wanted and a devastated capital plant. How to compare that with the US today, between a beggar and an emperor? The value of a currency is fundamentally based on the productive capacity of the issuer, and when capital gets destroyed the currency must fall until the capital is rebuilt (or the money supply shrunk). Fekete's point is absent a wholesale destruction of US production, a shrinking money supply and reduced velocity is a harbinger of deflation. 

He offers an alternative theory, the Black Hole of Zero Interest:

When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.

Velocity. What money-supply watchers always seem to overlook is the velocity of money, how fast it turns over:

• Velocity decreases when deflation looms, as people hoard money (save, pay down debt, spend less)
• Velocity increases when inflation looms, as people trade it for tangible things (they spend it as fast as they get it)

When you look at the Weimar hyperinflation, and other incidents (Austria at the same time, Hungary in 1946, Argentina so many times), what you see is inflation is much higher than growth in money. This means velocity went up faster than the money supply. If people expect the Riechsmarks they get in the morning to be worth half as much by evening, they pile it in shopping carts and rush to the stores. THAT creates hyperinflation.

Nothing of the sort is happening right now. Verdict: gold should drop. 

Fundamentals

I would put this economics debate more prosaically as: we have barely begun the process of debt write-off and de-leveraging. That process will rapidly reduce the money supply, since in a fiat currency regime, credit creates money (debt becomes purchasing power and turns into bank accounts somewhere). Imagine what happens if the Euro-TARP fails to prevent the defaulting of Greek (and Portugal, etc). The debt gets written off and money is destroyed despite the attempts to keep the game going. As Fekete puts it:

Charles Ponzi's dream has come true. The US Government is duplicating Ponzi's scheme in the bond market

The magnitude of the Ponziness can be seen in a chart of equities adjusted for gold: 

 

If deflation is on us, gold will drop, as the Dollar (and Euro) will rise. If the Euro-TARP fails, the Euro will drop and rapidly bottom; the changed expectations of the coming debt destruction will then cause its value to rise. Oil has already rolled over, and so gold may soon, too. It would indicate an expectation that the wolfpack of shorts will outlast the ECB. 

So: gold tops near where the Euro bottoms, after the wolfpack wins. 

When might that be? It took the Austrian government a month to fail when they supported the Creditanstalt Bank in May 1931. While stocks seem to be unfolding this time around about 1/3 the pace of 1929-31, at the rate the Euro is sliding the endgame may be only a matter of weeks. The Euro has gone all in with a poor hand, and the wolves are ripping apart the pretense that more debt can solve an insolvency problem. 

If Europe fails to mass an intervention by Monday, the game may already be over, and gold will have topped.

Technicals

Even though gold seems to be spiking, we have not yet seen the sort of piling on that signals the endgame of a mania, indicating it could still run beyond sense. Indeed, while investors are feeling the gold train has left the station, sentiment continues to indicate otherwise. Gold may longer be cheap, but it may not yet be in a bubble: Cramer hasn't touted it yet! 

The Casey Report provides this chart of technical indications in the XAU, which show no near-term top (a much larger version is at this link):

 

This morning David Rosenberg also weighed in on gold, with this chart showing that we are not yet in a parabolic blowoff. He notes that if central bank reserves were backed by gold, it would be at $3000/oz. (Some pundits have estimated that to back all currency in circulation, it would need to be $15K/oz, but that is not required under a gold standard.) Believe it or not, Rosenberg now thinks "$3000 an ounce on gold may yet prove to be a conservative forecast." 

 

A comparison of where gold could go to recent history from yesterday's NYT gives several price points:

• $2400/oz based on the 1980 peak adjusted for CPI
• $5300/oz based on the 1980 peak adjusted for GDP growth (6x)
• $5700/oz based on expansion of M3 (up 10x) over increased gold stock (1.5x)
• $3100/oz based on expansion of M1

I don't play gold, so I leave the calls to the pundits who do. EWI have been gold bears for a while, and their predictions have lost some credibility due to their Wolf! Wolf! premature calls of a gold top. The STU tonight however is quite convincing on gold: bullishness is at all-time records at 98%, which is such an extreme it has marked tops in the past in silver, currencies, bonds and equities. They say they will have more on this next week. 

When everyone is on one side of a trade, the money is made on the other.

EvilSpeculator has a crisp recommendation, artfully put, to get out. Read how they put it! Neely had been recommending loading up, but after the recent spike, says to stand back for now and be prepared to buy the next big dip. Walter Murphy has identified a pattern in the Yen/Gold charts which gives him a 25% upside target that is well-defined.

Maybe the smart move is to buy a dip on a modest or slow slide, but stand aside if instead we have the type of fall we saw in oil in Jul08: a falling knife, signaling the end of the parabolic rise. 

Fallout of the Crash: Pound Getting Pounded

First the Euro, now the Pound: the wolfpack is winning. GBP was $1.49 yesterday, and has entered $1.45 territory today, a huge drop. The Euro entered $1.25 territory and is now below last week's crash low-point. ZH suggests Europe is capitulating already. Volcker is now openly concerned over the disintegration of the EMU. 

US equities sold off on the afternoon. The Nikkei is opening down, and the Shanghai market may follow. This bodes for a bloodbath tomorrow unless the ECB and the Eurozone central banks defend their currencies. 

Stocks have been sideways for the week with an upwards bias until the selloff today. Should we expect a hard drop tomorrow, especially if the capitulation in Europe is on? Some wave musings: 

• If you peruse the bottom "wetware" chart from this post which removes the effect of 'bots gone wild, the normalized bottom occurred Friday. 
• If you then smooth out the gap up on Monday, a three-wave move has followed (with waves a/b on Friday and the gap move the start of c). 
• the c wave has broken in five waves (see chart from Market Thoughts)
• the whole pattern has retraced just over 62% of the drop: 1220 to 1094 or 126 pts down, then 1094 to 1174 or 80 pts back = 80/126 = 63% 

If the big drop was wave 1 down, this retrace is a normal wave 2, and the dreaded wave 3 is to follow. Hank Wernicki made a good short call mid-day today, and may be more right than he realized! 

 

Fallout From The Crash: IPOs

IPOs got sidelined by the crash: only two of the eight offerings completed, both below price expectations. Two hope to price this week, but the other four were "postponed," a polite way of saying canceled. Overseas, three large deals were postponed. So far 18 19 US IPOs have been postponed or withdrawn. 

Things improved this week, with seven of ten going out, but they priced at the low end of the range or below (eg. Telenav today).

I measure the health of IPOs by venture-backed deals, new companies with huge promise, much as new home sales is the best indicator of the health of housing. On this score, the market looks weak:

• MERU (WiFi) opened strong but has given back almost all
• AOSL (semiconductors) opened flat two weeks ago and is down 20%
• CNVO (on-demand software) was strong two weeks ago and is hanging on at 5% up
• SS&C (fund mgmt software ) opened flat, rose a bit, and is hanging on at 5% up
• CALX (telecomm equipment) opened poorly and is down 20%
• FNGN (pension software) popped up 44% at opening and remains 30% up
• QNST (online lead generation) priced below the range and fell, but is now up 10%
• TNAV (navigation software) priced below the range after lowering the offering size

After MERU did well, I had been watching the next 2000-era venture backed IPO, Nexsan (NXSN); but Nexsan had to postpone its IPO due to a bad announcement of a competitor. The venture press is playing up the TeleNav offering, noting that while it priced at $8, well below its $11-13 range, it rose to $9.80. The other two IPOs the same day both dropped. Maybe a hopeful sign, but a bitter-sweet success at best.

 

After TeleNav, the next test is ReachLocal (RLOC), which figured out how to do Google-like online ads for local businesses. RLOC was on the road in Europe last week (fun!) and is expected to price next week. This will provide a very good barometer of the tech IPO appetite following the crash. 

The WSJ has an upbeat article on start-ups this week, noting that 14 venture-backed companies have gone IPO so far this year, compared with only 8 in all of 2009 and 7 in 2008 - but what terrible years to be  compared with!  This chart from the article shows the ebbs and flows of IPOs:

 

We remain below the Q1 pace of 2006-7. In addition, last week 15 ventures got bought, a pretty good clip. If the IPO window continues to weaken or close, however, expect such m&a to continue, but at low prices - successful IPOs drive up m&a prices, weak IPOs embolden bargain-hunting. The WSJ piece ends with a good summary of the fallout from the crash last week:

Only a few start-ups are making the cut for deals and IPOs. ... Many other start-ups continue to struggle, leaving their venture-capital investors unable to sell them or take them public. Last week's volatility in the stock market, compounded by a still-fragile global economy, may also freeze further activity. 

Note: I have a small indirect interest in RLOC and NXSN. 

Fallout From The Crash: Stocks

Complacency already? I read a number of bearish bloggers expecting a continuation of the market-that-never-corrects already. I also see a feeling of betrayal in many financial blogs - they must have enjoyed the ride last week! With 'bots already the majority of trades, many investors have stepped to the sidelines and are viewing this as spectators. They wail for a good show! 

They should watch at night. The Vampire Market is back: the action is in Europe and the overnight markets. Much of it is below the waves, as the wolfpack of shorts try to submarine the Euro. It was pushed down towards $1.261 again this evening, then bounced. Last night the e-mini was run down almost to 1141 before running up to 1170. Quite a move. It is flat at the moment. 

Spectators indeed: ZH ran a good piece today on how retail investors had fled before the crash. Domestic inflows into equities have been negative this year, and there was a huge withdrawal from mutual funds the week before the crash (maybe they were reading Yelnick? This site was negative on Sinko de Mayo, the day before, and noted the bearish Diamond Formation the week before. Just kidding):

SlopeofHope says it all with one chart, drawing the line in the sand at a level right above where we are (and also right at the 50 DMA). His point is that often retracements test a trendline from below and kiss it goodbye. As a bearish investor, he prays for that kiss. 

 

Today's STU draws a different line, at Sp1182/Dow10965, the wave 1 lows of the fall off Apr26. They see the overall pattern going back to the Jan19 high as a head&shoulders, and we are making the right shoulder; and in a fractal sense it is mimicking the large head&shoulders back to 2000, with the end of this Hope Rally the right shoulder. Both have a similar look: a sharp drop off the head and a sharp retrace to the shoulder. 

The EWT recently laid out the theory behind the head&shoulders pattern (EWI makes it available for free, in case you would like to peruse an EWT on point to today). Edwards & Magee's book says that the first shoulder should rise on heavy volume, but the second shoulder should have "decidedly less volume" than either the head or the first shoulder. We fit that, since the Hope Rally has risen on slack volume. The EWT notes as well that the whole formation should come after an "extensive trend", which we certainly had in the dot-com days. Many purported head&shoulders patterns fail these two tests. 

The weak volume indicates exhaustion of trend and a coming rotation to the other direction. We saw that last week, as volume on the downside ('bots and all) was decidedly much more extreme than it had been on the upside. 

All well and good, but it doesn't say when. The wave pattern can be interpreted to be ready to end - a simple ABC up, and the final throes of the C wave. The level is about right to end, a bit above the preferred 62% retrace, but hovering around the 2/3 and 70.7% levels (that being half the square root 2, a level that emerges more often than it is noted but wave theorists). So far no change from my comments of Monday. 

SlopeofHope gets a twofer today, with an analysis of Mike Paulenoff of MPTrader. He resolves the question of how to deal with the software drop by relying on wetware levels (where the very human specialists in the NYSE put out bids) and dismissing 'bot levels. In the e-mini, he eliminates the plunge from es1113 to es1056 (1065 in the cash S&P). This means the wetware low happened on Friday at es1091. You can see from the chart the whole pattern resolves as normal looking, but as a "3" not a "5" , meaning a rapid correction only, not a change of trend.  

Since this came out, the market went up, supporting the bullish case.  

Fallout From The Crash: Euro

On this Creditanstalt Day, the battle over the Euro has been joined! The Euro was getting crushed in after-hours trading last night, pushed down towards $1.26. The shorts are wolfpacking it. This morning central banks rushed in to intervene, and the Euro bounced off $1.261 to run above $1.27, but has fallen off again. It remains well below the "we're saved!" peak of this weekend, at $1.31. If the ECB cannot withstand this assault, the Euro-TARP bailout is doomed.

The intervention caused a 20-pt reversal flip in the S&P futures, which had been falling towards 1140.

Curiously, the biggest expected losers, the French and German banks with excessive exposure to the PIIGS, might be able to make some it back by being wolves themselves - hedging in Forex markets by shorting the Euro. This is a partial win-win in a lose-lose situation:

• If the Euro breaks, they win on Forex
• If the ECB protects, they win on the bailout

What the wolves see is simple logic: the PIIGS are insolvent. Their income cannot cover their current debt. Piling more debt on top only prolongs the problem. The Euro-TARP tries to lower borrowing rates, but if the assault on the Euro drives rates up, the ECB is left with QE to self-finance the debt, which it wants to avoid. Hence something will break. 

Right now the spreads are widening for LIBOR vs. overnight index swaps (OIS), as they did in 2007, when they ran from 13 bp to 73 bp, and then "the rout was on." Last week the spread jumped from 9 to 18 bp, and since the Euro-TARP was announced, have widened to 20 bp. Bondsquawk also notes that 2-yr rate swaps have also widened. The TED spread (Treasuries vs Eurodollars, now called LIBOR) for 3-monthers is back to levels of 3Q09.

John Taylor (Stanford Prof and originator of the Taylor Rule for Fed interest rates) writes today in the FT that what may ultimately break is confidence in the ECB, and with it confidence in central banks. 

Fallout From The Crash: Carry Trade and the AUD

An explanation for the crash that is gaining credence (according to Art Cashin) is a spike in the Yen before the crash caused a rapid unwinding of carry trade positions, an idea that may have first been noted by Trader's Narrative. The Yen has the most reliably low interest rate for the cary trade, and fear of a spike in the US rates could move money out of USD carry and back into Yen carry. As the bond market is an order of magnitude beyond the stock market in size, Forex dwarfs bonds. A little carry goes a long way to whipsaw stocks. 

We saw a bit of normalization of carry currencies Monday, but will this sustain? If the crash is the warning shot of a change across lots of bets that worked during the Hope Rally, a lot of positions need to be rotated, starting with the darling of the carry trade, the Australian Dollar (AUD). 

A quick comment about the AUD in a ZH post on the crash caught my eye about the AUD. The post noted how markets stopped at the same time worldwide across almost every type of market including futures, bonds, gold and forex. How could this be if it were merely a glitch in a few stocks? And how could this happen so swiftly unless a substantial majority of all trading is in the hands of a very small number of firms who made the decision to freeze over just a few minutes? The markets came back around the same time, but a few lagged, and this raises a red flag: 

Finally notice that the EURUSD and AUDUSD are slightly late to the game to recover. Although the auction resumes about the same time, they continue to print precipitously longer.  This is all the confirmation of Cluesix' AUD analysis I need.  No one is talking about it today, but after Asia tonight they will; Asia (and even China) are next.

I dug up the Cluesix Report: The Case Against the AUD. It observes that the AUD is the most overvalued currency in a developed market, too high by 30%. It is highly dependent on financials and commodities, and commodities may be in a huge bubble echo. The Lucky Country's real estate may be as much as 50% overvalued. Speculators and carry-traders are betting heavily on the AUD uptrend. 

The carry-trade may be rapidly unwinding in the wake of the crash. The AUD will suffer the most. 

Committing economic suicide won't help: a few days before the crash, the the Rudd government announced a 40% tax on profits from its mineral resources, to get a "fairer share" of the natural wealth of the country. Reaction was negative to shock at the utter foolhardiness of the blunder from down under. 

The Case Against the AUD

An Australian business man shared his thoughts on the Cluesix report with me (excerpted below the fold):

Fallout From The Crash: Unemployment

Lost in the noise last week was the unemployment report. Weekend pundits gushed how we turned the corner. Have we?

Art Cashin dissects it this morning:

• For the last eight weeks, Initial Unemployment Claims have averaged 450,000 per week. So, over the last four weeks [the month counted], 1.8 million people were laid off. How does that fit in with the claim that 290,000 new jobs were created? The obvious answer is that it doesn’t
• The CES Birth/Death adjustment added 188,000 of those jobs. Birth/Death does not refer to people but to businesses. The BLS guesses how many new companies opened versus how many closed their doors. The BLS then uses that guess to guess again how many jobs those business created or lost
• Another 66,000 of the new jobs came from census hiring
• Another 26,000 of the new jobs were non-census temporary

Let’s recap:

• A guess produced 188,000 of the jobs, 66,000 were census and 26,000 were temporary. 
• 280,000 of the 290,000 “new jobs” were either temporary or the result of guesswork.  

Some turn. Some corner. 

A contrary view comes from the other BLS survey, the Household Survey, which has more skew in it, but has been consistently showing more gain in employment than the Establishment Survey. 

 

We Have Begun the Endgame of Greenspan's Experiment With History

The Wolfpack Fund is likely to fail. With the $1T Wolfpack Plan, the central banks are "all in" and have no more pieces to shuffle on the board. The wolves can concoct short positions faster than Europe can create money via the magic of synthetic CDSs. When Soros called the Bank of England's bluff in 1992, he had to play with real money. Now he plays with derivatives.

Wolfpack is the endgame of a series of moves by Greenspan (and Bernanke) since 1987, to flood liquidity against any banking panic: Mexico, Asian Flu, Russia, LTCM, Y2K, dot-com, 9/11, housing, TARP, TALF and QE. 

The moves became known as the Greenspan Put, the assumption that he would bail you out of risky deals. It reached its ultimate expression in the period that I call the Greenspan Indian Summer, the bubble from 2002-2007 that staved off Kondratieff Winter for the moment. Greenspan knew he was playing with history. 

Greenspan's Indian Summer ended with the Mother of All Margin Calls, a post of mine on June 15, 2007, predicting the end of the bubble and the top in the market. Where this might lead is to a new global reserve currency, but that is still a ways off. 

Right now the Euro is at risk, not yet the Dollar. After a period to sort out the new plan, the Euro should fall and the Dollar should rise. As this next chart shows, the Euro popped over the weekend and faded back down today. The bluff may be called quickly. 

Credit Writedowns cites Marc Chandler (the global head of Brown Brother Harriman’s top ranked Currency Strategy Team) for noting that today was still a wait-and-see attitude: the panic is gone but bonds from the "peripheral euro zone" have not returned to normal. Marc believes policymakers are repeating the mistakes of the '30s.

Behind Wolfpack is the potential for European QE and Eurozone inflation. The plan is supposed to avoid QE via sterilization:  when central banks across Europe buy toxic sovereign debt (putting Euros into the bondholders' accounts), the ECB is supposed to sterilize the issuance by selling quality bonds, likely German Bunds (pulling Euros out of the market). But if the toxic debt is bought at too high a value, the buyers will take a bath that the ECB will try to cover, putting excess Euros into the system. Euro inflation will push it even lower against the Dollar. 

What is unclear is how fast this will play out. If markets are back to where they were last Friday by the end of this week, the bluff has been called and the momentary hope will fade. What this means for stocks and bonds I will cover then, but right now note two points from the very interesting STU this evening:

1. "The world does not have enough revenue to service the debt built up over the past seven decades"
2. The unfolding crisis will be "too big too bail"

In one of those moments EWI calls Beautiful Pictures, the bounce today retraced almost precisely 61.8% of the drop off the Apr26 high, typical for a wave 2. The alt count of an extended fifth with a zigzag (= sharp) bounce has played out, not the wave 3 down with a fourth wave triangle bounce. The implication is more upside before the next big drop. 

A reader (VB) notes in a comment that Neely has found the retracement after an impulse down with an extended fifth often retraces more than 61.8%, in effect bouncing more given the violence of the drop. The next levels after 61.85 (Sp1162) are 2/3, 70.7% and 78.6%, or Sp1170 - 1187. Another way to count this is to end the big drop right before the 'bots drove it down, or at Sp1090 instead of Sp1065. This gives slightly different endpoints of Sp1177 - 1192.

Will this play out quickly? The STU points to a morning observation from Bianco Research: if you think of today as driven by the Euro TARP, the US TARP days were when it was leaked and then when it was forced down the throats of the banks. The first bounce lasted one day; the second two days. The market declined for six more months. 

In the mother of all ironies, traders playing a capitulation low on Thursday may be hoist by their own fat finger: the bullish blather that "this was all a glitch!" may mean the normal capitulation by the bears did not occur. This meme is well explored here and here by Trader's Narrative, a site with penetrating debunking of popular fancies in the market, which concludes: "according to the McClellan Oscillator, the market will make a significant low later this week."

First Thing We Do, We Kill All the 'Bots

While the punditry still searches for a "glitch", ZH got it right: we are seeing the consequence of a market driven primarily by 'bots. Read the WSJ take on this in The Dark Side of Algorithms, followed up by Computer Trading is Eyed, summarized:

When the NYSE went into a circuit-breaker slowdown, called by the human specialists, trades spilled over into other exchanges. The specialists only manage 25% of trades anymore. 

The 'bots take advantage of inter-exchange divergences and found them, as the NYSE fell behind.

Two major 'bots had also shut down from trading. The buyers had left the market. 

You can listen to the voice in the pits: there were simply no buyers, no bids. 

This is how Accenture got to 1c: the 'bots ran down price points in microseconds looking for a bid, and  seeing none, went to the bottom. No buyers, no bids. 

The mindless machine did what a human market maker would never do. A person would have realized something odd was up and stopped. The human market-makers did react, but their time scale is measured in seconds - an eternity to a 'bot. 

When the 'bots hit the bottom, literally, at 1c, they stopped, as any idiot-savant machine would do. When a real (human) bid came in, it was way above the fake HFT attempt to suck all the margin between bid/ask.

You could do a pretty funny treatment on this, when the dust settles: see what happens when you turn the market over to HFT 'bots gaming each other! Maybe this is how we can get to Dow 36,000!

Maybe instead this fall will scare the H (as in HFT) out of us. Read Sy Harding's morning rant: program trading used to arbitrage inter-market divergences, but that is below 1% of their activity. The other 99% is gaming the system for no useful value. Ever wonder why we get magic runs up near the close? Did you know that 'bots are now 50-70% of all trading? And where was their supposed liquidity when we needed it? 

How did our rudderless SEC let it come to this? HFT is designed to skim the margin between bid & ask, scamming the real traders who are trying to take or lay off a real position in a real market. The machines trade back and forth, gaming each other, and not taking real positions. Now that we know the purported "liquidity" justification is bogus, why wouldn't the SEC ban HFT Monday morning?

The fault lies not in our machines, but in our saves - our reckless attempts to paper over real problems with gobs of debt and heaps of hope. 

Economists talk of "moral hazard" and people's eyes glaze over. Let me try this: 

We live in the Era of Entitlement where: 

• Greece can live beyond its means
• Greek public workers can retire young
• California public workers deserve above-market salaries
• It is ok to fake an injury to get better retirement benefits 
• People who cannot afford a house should be able to buy one anyway
• Liar loans are ok as long as fees get paid and someone else bears the risk
• Katrina may have been a problem, but it was somebody else's problem, so we didn't need to stock fire-booms to prepare for an oil spill

... and on and on across all sectors of responsibility.

There is feverish activity this weekend between the IMF, central banks, European governments and investment banks to come up with a better bailout of Greece: a Wolfpack Fund. The first solution ran into the Creditanstalt Problem that I warned about two weeks ago: instead of calming markets, creditors took it as their last chance to run for the doors before the rest of the PIIGS-in-Poo failed. 

The Wolfpack solution is based on the false premise that the problems are coming from the pack of wolves (shorts) trying to drive down the Euro and the bonds of the PIIGS. The wolves are simply calling the bluff of papering over the problem without fixing it (which means getting the PIIGS debt back in alignment with their income). The Wolfpack fund is larger (€500B) than the last fix (€110B), but rather than ameliorate the run is likely to embolden it: it gives liquidity when the problem is insolvency. The PIIGS are still insolvent with no way to cover the debt nor the will to take tough measures other than to rely on the generosity of strangers to push the can down the street a little farther. 

The whisper this weekend is Wolfpack will be further backstopped by €1T from the Fed and ECB, financed by quantitative easing (QE). Since no one believes the Greeks are serious about solving their problems, what if this backstop fails? There is no other bullet left in the gun. 

The crash last week may have finally begun to change minds: Tom Friedman in the Sunday NYT talks of taking a root canal to the problem rather than painkillers. Andy Kessler in the WSJ suggests that the cornerstone of confidence in the Euro has broken, and the Euroland entitlement problem has to be faced. Papering over the problems and continuing the Era of Entitlement with false promises fueled by debt is not the path of serious people. Maybe it is time to take the problems seriously. I fear, however, the blue pill of the Keynesian dreamworld will require the final $1T backstop to be tried, and fail, before we can finally take the red pill and deal with the reality. 

Until then, party on! A Wolfpack Bailout will likely bolster the Euro and spark a 300-400 pt rally in the Dow. 

Hold the Optimism

Headlines: we have another stomach-in-throat drop coming, likely next week. Then a big bounce. The Hope Rally appears done. The air-pocket yesterday wasn't a mistake: only 30M shares traded in the fall, and no one can find a glitch. Fat Finger My Ass! cries ZH. Listen to the traders in the pit. We had already dropped 500 pts and when we fell like a knife there were no buyers. The only glitch was shocked disbelief. 

Fear is such a well-defined state it makes the market patterns clear. Greed too, but then greed is like fear - fear of falling behind. Just not quite as strong. During panics of fear and greed the market becomes easy to track. It has a trend. It is those times in between, when the market is correcting against trend, that markets become exasperating. This should be no surprise, as during corrections the system is in a high state of entropy (in a chaos theory or information theory sense - balanced inputs going in and out), whereas during trends the market has found order. One can look at markets as constantly seeking order, and when they find it, they move surprisingly fast. As we just found out. 

At the low yesterday, we had wiped out 8 months of gains in 3 weeks.  

The Hope Rally was corrective. It kept going up on shrinking volume and a narrower base - essentially, five big financial stocks like Citicorp. It seemed impervious to correction, and yet it meandered up slower and slower after an initial jump off March 2009. This is not how a trending market behaves. The financial press was fooled by the height of the bounce, not comparing it to the depth of the prior drop. In the end the Hope Rally corrected the 2008 drop in the normal range of a 50-62% retrace, and after breaking the 50% retrace, stopped right on cue at 62%. 

Thus it should not be a surprise that there is a large consensus among wave theory sites (Daneric/whose chart is below, Kenny, EWTrends, PUG, EWP, BlankFiend, Shanky/sort-of, among others): 

• the top is in
• we are in a wave 4 trinagle
• a drop below the spike low of yesterday is ahead

The implication (well stated by BlankFiend) is a pop and drop on Monday. The top of the A leg, Sp1138, cannot be broken in the pop, and the top of the C leg, 1129, should not be broken. If leg D is done, leg E would normally go back to touch the upper trendline, which is about halfway to C or 1116. The apex of the triangle points to 1113. It may not be much of a pop.  

 

There are of course a few optimists, such as Carl Futia, and a bunch hedging their predictions. That is to be expected. The bullish argument starts with the curious fact that we ended today spot on the 61.8% retrace of the rise from Feb5 (Sp1145) to Apr23 (1220). If this were a B wave of a zigzag, this is a normal outside distance for a correction, and the final C wave up to new highs should start on Monday. This argument treats the falling knife yesterday as an anomaly. Since no one has confirmed that a glitch occurred, it is better to treat yesterday as real but hard to believe. The buyers simply vanished. 

After such a severe drop, it should be no surprise that a bunch of technical indicators have become oversold, signaling a rally is due. At the same time, during crashes like this, indicators can stay oversold for a while. Catching a falling knife is a dangerous game. 

Give credit to where it is due: the Master got this right. EWI's Sinko-de-Mayo STU predicted a much deeper drop than all the others, including Neely, and we got it. 

Just a couple of weeks ago Prechter had set forth the many technical indicators of a top in his EWT. You can read the key points online today from EvilSpeculator. For all the bashing he gets, his record on the big calls since 2007 is very strong:

• called the 2007 top in June, right before the July top (October wasn't much higher)
• called the 2009 bottom in late Feb, within two weeks of the Hope Rally
• did not call the June top as the end
• prematurely called a top twice after that
• called this top within a week (Apr16 vs Apr23)

Tonight's STU confirms the triangle wave 4 count and predicts the deeper wave 5 ahead to complete the first big thrust down off the top. After that we get a bounce, which could retrace quite a bit of the drop (the summer rally before the Summer of Disillusionment sets in). MarketPulse gives some guidance for where wave 5 could end:

 

If that wave 5 breaks well below the Feb5 lows (Dow9835/Sp1044) and stays below (meaning doesn't pop right back over), this will confirm the end of the Hope Rally. 

The Hope Rally's hopes are hanging on a thin thread right now. 

If we bounce above that level, this signals that a final top is ahead, likely back up to the Sp1250 +/- 25 range. This seems unlikely, given how decisively we broke through the lower trendline of the Hope Rally, even given some alternative ways to count it, such as this large triangle (chart courtesy WaveCharts):

If the pop on Monday breaks through the 1129 and 1138 levels, the triangle may be a larger structure. Neely suggests this could be the start of a wave B triangle before the final rally to new highs. A bit of a dramatic triangle, but a count worth keeping in the back of the mind as we see how Monday turns out. 

The other possibility is that yesterday was an extended fifth wave, and is done at the Sp1066/Dow9870 level. A strong bounce would be expected, but not to new highs. A corrective wave cannot be a simple five-waves down. Typical levels for the bounce would be: 

• 38% bounce to 1125
• 50% bounce to 1143 
• 62% bounce to 1162

The next wave down would follow. If you still want to hang on that thin thread of a hope in the Hope Rally, the next big drop would have to stop above 1044. If this is a dramatic zigzag correction down, after the big bounce, the next wave down would typically go 100% (red pill) or 62% (blue pill) of the first wave. For the slim thread of hope, it would have to take bounce at least 50%, above 1140 at least, and then take the blue pill: 62% of the big drop of 154 pts is 95 pts. If indeed the bounce and drop somehow stays above the Feb5 level, after a few stopped hearts, it would be a great buying opportunity.

Today Was Everyone Going From Port to Starboard at the Same Time

The post mortems on the 1000-pt crash are coming in. AllAboutTrends gives a tour of the fateful 11 minutes of the drop and pop, and gives this advice: "when in doubt, stay out." A number of other sites are trying to pinpoint the glitch. The irony may be that the circuit breakers put in place after 1987 may have exacerbated this crash: specifically, the NYSE may have slowed trades, pushing the 'bots over to other exchanges and overwhelming them. Rather than add to the speculation of what happened, let me review some of the better commentary on "what does this mean" for the market.

ZH's "I told you so" piece is a must read. They had warned of what could happen when market liquidity is replace by high-frequency trading (HFT) 'bots gaming each other: 

[T]he market, for all intents and purposes, broke. Liquidity disappeared. What happened today was no fat finger, it was no panic selling by one major account: it was simply the impact of everyone in the HFT community going from port to starboard on the boat, at precisely the same time. And in doing so, these very actors, who in over a year have been complaining they are unfairly targeted because all they do is "provide liquidity", did anything but what they claim is their sworn duty.

Barry Ritzholz thinks more happened than just a mistake, as the market had already fallen 3% due to worries over Europe, but he adds this:

After work, I did some digging, made some calls, and came to the conclusion that most of the worst of today’s move was a mistake. Does that mean investors should buy with both fists tomorrow? No, though I think stocks could enjoy a nice snapback rally in the coming days. 

PragCap has a perspective across the Crash, the Election (UK), and the Tragedy (Greece). While Greece can, and probably should, and likely will default, the UK still manages its own currency, and cannot default, yet "they ... are somehow attempting to drive their economy into a near equally disastrous situation." The implication is that the Euro crisis will deepen and spread, even to England. On the Crash he notes:

This is now the second market crash in less than two years and could be shaping up to be the third time small investors have been seriously burned in a decade. You have to wonder how comfortable the small investor is in this market now. The game must appear entirely rigged to an unsophisticated investor and the accusations of a system error during yesterday’s trade has to make some people wonder why they are putting their hard earned cash at risk of a massive computer glitch.

Nic Lenoir of ICAP adds perspective to his target of Sp1041 in the futures, a huge additional drop ahead:

There is the danger of walking out of today's session with a sense of relief for equity traders, because that insane move was "just" a fat finger or at least it is the word in the media and on the street. There are three things to keep in mind: 

1. the market was down 3% already when the alleged input error happened
2. we are still in the middle of a major unresolved currency crisis threatening all of Europe and that led to deadly riots already 
3. the financial industry does not need any bad press right now and detractors just got some more ammo to push tough regulation

What to expect? 

• The head of the NYSE predicts "it will be pretty ugly" at the open on Friday. 
• As I draft this I see a lot of red on the screen from Asia, but in the same range as the drop today at the close. Usually the US leads, and Asia/Europe follow, so little guidance there. 
• Today felt like the similar drop-and-reversal of April 4, 2000, where the Naz dropped 574 pts (13.5%) and came almost all of the way back, down only 1.8% at the close. It was followed by several sideways-to-up days, and then the long slide to the abyss. 

I remember that April day vividly, as I was in NYC pitching a public offering, visiting nine mutual funds. As the day wore on the fund managers looked more and more shell-shocked. They had seen their whole portfolio busted and then saved in a mere 6 hours. When we met the last one, at the top of the WTC, she was bone-tired and barely responsive. I had this flash that she and many others may have tried to jump out of the windows mid-day, but since they were all sealed, unlike in 1929, she bounced back, shrugged, and went back into the market. 

The next few days were sideways, and on Friday we went out and got a price that was twice as high as the low on Tuesday. The week after the Naz began a slide from which it never recovered. 

Ghosts of 1987

In the weeks preceding the runup to today's crash I saw a number of overlays of the Hope Rally to the 1987 market before the crash, including this comparison and chart:

   

I expect more on this over the next day or two. We explored it here at some depth on the anniversary last October and later in December. Even before then, Yves made the first comparison. What shoudl be clarified overnight are the three main causes of today:

1. 1987: There are some eery parallels to 1987: pending financial reform, program trading then and now, and troubles in Europe: then a falling Mark, now a falling Euro. 
2. Big liquidation: There is a rumor of a failed large hedge fund. 
3. Mistake: There is also a real possibility of a "fat finger" today, hitting the wrong quantity key for P&G and driving program trading bots into a frenzy which abated pretty quickly. Here is that trade (from Market Ticker):

Here is the result (from Jesse's Café Americaín:

Sink Oh De Mayo

Big gap down at the open today bodes poorly for the bulls. The market pattern remains bearish, and with the problems in Europe widening when most everyone thought the Greek rescue would narrow them, the sands are shifting under the market. Oddly enough, market sentiment remains very bullish, which is bearish - it means we could have a lot of downside, as we have a lot of investors left to panic to the other side. EWI notes that a similar bullishness accompanied the last two corrections (Jun and Jan) in the Hope Rally. Tony Caldaro adds that the two prior corrections lasted around two to four weeks, suggesting this one runs into late May. His next target is Sp1146, then 1137, but notes we could to 1107. 

The nested 1-2 count worked this time like a charm. It worked so well, the STU has strengthened their count: rather than end the inside 1-2 down, today caused them to lengthen it. They have today's low as the end of wave i of (iii) down, with us in the wave ii bounce. This means the next run down will now be a triple 3: a little 3 of iii of (iii). This is the set up for a bigger gap down and a deeper drop. If we gap again at the next open, this is the triple 3. The wave structure is ambiguous, since the little wave ii could be breaking into an ABC first, and only has done A and part of B. C would be a small bounce back up before the fast drop. Given yesterday was a 90% down day and today was "only" 80% down, a small bounce is likely before the next 90% down move. 

A key issue is what it would take to confirm the drop as THE drop not just a B wave with a final run back up to new highs. The STU proposes to look at a drop larger than the prior two drops in both time and distance, which gives a target: lasting past May 20 and falling below Dow10363. Good stuff. Lots more in tonight's newsletter.

The STU count on Monday may have prejudiced some wave analysts to look for the end of iii or (iii) down rather than recast the drop today into merely wave i of (iii) down. It will be interesting to see if the students out-count the master. Let me highlight the two lead counts in this contest: 

• Daneric says that wave (iii) concluded today. After a wave (iv) bounce, a final wave (v) should carry to Sp1137-42. His chart:

   

• EWTrends has wave iii ending today. Wave iii is the inside wave to the larger degree wave (iii). We are meandering in wave iv, which could keep going sideways in a triangle with an apex around Sp1166. After inside wave v to complete wave (iii), we would have a larger wave (iv) and a wave (v) down blow a gap at Sp1124. His chart has slightly different numerology, with numbers 1 2 3 for the outside waves (i) (ii) (iii):

 
 

Gulf Explosion's "Fire-Boom-Gate"

You would think that after Katrina the Feds would be at least as prepared as Boy Scouts. Since 1994 they have had a plan to contain spills in the Gulf using fire-booms, and the former coordinator of Gulf response was scathing in his criticism of the response as not executing on that. It turns out they didn't have any fire-booms in stock, and the fastest they have gotten one in is eight days late. This might come back to bite the Obama Administration:

Representatives from the Obama administration emphatically maintain that from "day one" preparations were in place to handle accidental oil spills. Maybe the administration can explain to the residents of Louisiana why not one fire boom was available when an actual crisis took place?

Breakout, Shakeout or Fakeout?

The market fell as expected: the coiled spring of a nested 1-2 pattern sprung a gap down at the open. Wave theory was clear last night that if we gapped down we would break the recent low at 1182, which we did. We ended the day in what looks like a sideways minor fourth wave, with a fifth wave to follow. Some scenarios have Sp1045 (the Feb 5 low) as the eventual target, not necessarily tomorrow, but more likely the 1150 level proves support, which would mean a small drop, then a larger correction, then the final drop. Here is what is running around the wave-o-sphere:

• Breakout: Nic Lenoir of ICAP says "we are not done", since whether a 3 or a C wave down, it has more to go (ie. the fifth wave). He sees confirmation in forex, where the Euro broke $1.30 and the AUD fell almost $2, resting on 2000 DMA support. The aggressive breakout scenario says the top in and we break Sp1144, the Feb5 low, with more downside to follow
• Fakeout: Carl Futia mid-day thought we could bounce off 1180, but we ran right through that level. I am riffing on his headline above. He is likely in the fakeout camp, that the run back up to Sp1320 is still about to happen, and this drop could turn into a bear trap
• Shakeout: Kenny, Market Thoughts, EWTrends and a few others have the double correction shakeout, a sideways ABC-X-ABC that fools bulls and bears alike (see chart), with EWTrends and EWP giving a possible target of Sp1153 (a 38% correction of the whole rise off Feb5). The second correction, which we are in, may break as a triangle over more than a week, annoying both sides in the market. Market Thoughts has a good chart showing conceptually how the shakeout then leads to the final wave up

Leading Indicators Support the Slow Growth Scenario

The trend is your friend until it meets the bend - Albert Edwards, SocGen

More indicators are coming in besides GDP that we are not in a V-Shaped Recovery. It appears that the economy is in an "L-Shaped" slow growth mode (2% annual growth outside of gimmicks and stimulus) with heightened risk of a W-Shaped double dip.   

PragCap reports: "ECRI confirmed what yesterday’s GDP report is telling us – the economy remains in recovery, however, is beginning to slow." The ECRI index continued to grow, reaching the highest level in two years, but the rate of growth slowed to a 38-week low (see chart). Laksham Achuthan, managing director of ECRI, concludes: "overall U.S. economic growth will soon begin to ease, in line with the downshift in GDP growth shown in this morning’s data.”

 

The Consumer Metrics Institute's Daily Growth Index, which measures consumer demand, is a leading indicator of GDP, and has rolled over to negative. The CEA commentary notes that the index points to where GDP will be 17-18 weeks later. In Nov09 the demand side began to contract, and predicted the lower 3.2% GDP result. It dropped so rapidly that a two week swing would have changed the GDP: two weeks earlier, at 4.4%, and two weeks later, at 2%. "This is the sign of an economy in rapid transition." The index is now projecting that Q2 will come in as a -1.5% contraction. They caveat that factories often are reluctant to shut down that rapidly, so the drop may slip out - inventory rebuilding in Q1 may result in days-inventory increasing at retail in Q2, which would cause a factory pullback over the summer and into Q3. Result: a double-dip sooner than expected:

 

The Big Picture reports on Bob Bronson's latest prediction, of a double-dip. Bronson focuses on the Core Business Cycle, which is the Final Private Product part of GDP (GDP less inventories and government spending). He takes Final Private Product and maps it in the next chart. It shows how the private sector has fallen - a lot farther than GDP itself indicates:

 

An interesting companion analysis on SeekingApha looks at "True GDP", or what GDP would have been without massive borrowing. Over the past three years, real GDP grew a cumulative 1.5%, or $200B. Unfortunately, the government borrowed an astounding $4T to gain that mere $200B of GDP improvement. It simply disguises a drop in True GDP of around 30%, and will slow future growth by having to be repaid. Simply put, we did not get enough bang for the borrowed bucks.

 

This line of reasoning is another exemplar of the Diminishing Productivity of Debt, that as we use debt like a drug to continue a faux economy, it has less and less value. Eventually more debt has no impact at all on GDP, a position Japan may have reached. Recent data from the Great Recession supports that thesis. If the government could borrow our way to prosperity, Greece would be China. While that isn't disputed, the argument for Stimulus is that borrowing and spending is required in a downturn, evan if it should not be used as medicine in an upturn. The True GDP argument is that it isn't working in a downturn, either, because each Dollar of debt results in less than a Dollar of real productivity. It gets slowly wasted in upturns, and rapidly wasted in downturns, as now. 

The Big Picture adds another analysis, that the Conference Board also sees gloom, with the majority of people (60%) surveyed still expecting family income to go down. Only 10% expect it to go up. 

The implications of slow-growth mode are rolling in:

• Double-dip is more likely: the slow-growth mode is an "L" shaped recovery, but it raises the risk of a double-dip W. SocGen believes we rollover in six to nine months. 
• Unemployment should now get worse. It has been flat since Oct and may be slightly worsening already. An L-Shaped 2% growth (which is also being called a "square root sign" shape), is too slow to improve employment, and once the temporary census workers leave the rolls in a few months, the unemployment rate should rise.
• Trade deficit is widening. Trade is now a drag on GDP, as imports are rising faster than exports. This may be a consequence of the commodities bubble echo, and could flip the other way if the bubble bursts, but that may not occur until the Dollar Carry Trade fades, since it is arguably fueling the bubble echo. The carry trade should last as long as the Fed keeps short term rates low. 
• Interest rates should rise. The deficit is deteriorating, with BofA projecting it it at 9% of GDP in 2010 and 7.5% in 2011, up from 5.2% (projected), pointing to higher long-term interest rates, further dampening business recovery.
• PE Ratios may normalize. At 22 they remain at high levels, in part due to low interest rates (the PE in approximation is the inverse of bond rates) but also due to expectations of "rebound" growth (in effect buying forward today into year-end levels). Slow rebound means a more rapid normalization of rates to 15, which points to a 25-30% drop in equities. 

Ambiguity in the ISM Report

The ISM hit 60 in April, indicating a continuing V-Shaped Recovery in manufacturing. Despite the modest GDP report, is ISM signaling the V? 

At best, the ISM report is ambiguous as to the shape of the recovery. The ISM is a backwards-looking indicator. According to some commentators, the ISM came in a bit below expectations, but to others it was above. That expectations game shows up here!

Looking beneath the spin, here are the pros and cons of an ISM recovery:

1. that Q1 GDP was a bit depressed due to harsh weather, and we will spring back in Q2. One damper on that is that we already rebounded in March in good weather, and the effect may be over. Car sales in April came in down from March, and while they are up from the depressed 2009 levels, are still below the bottom in the 1991 recession
2. that inventory levels remain low, so there is upside in building inventory - if the consumer keeps dipping into savings to spend. Spending rose in March as savings dipped to the low level of Sep2008. Disposable income dipped as well, meaning this spending spree should be temporary
3. that this spending blip may be simply fueled by tax refunds, meaning it should stay in May but swoon by June 

The key, then, is consumer spending. John Hussman takes the view that this is not just a normal recovery, and in particular personal income less transfer payments is not following the prior path, but is in a "stark contrast" to other post-war recoveries:

 

The ISM is said to be priced in the market already. David Rosenberg nots that traders follow an "ISM aphorism" that says the positive report is sending a sell signal:

Buy the recovery story when ISM is at 30 and policy stimulus in full swing (13 months ago); fade it when ISM approaches 60 and stimulus subsides [which is where we are now]

The Diamond Formation

The SlopeofHope sees the glitter of a Diamond Formation in today's market, a rare and bearish pattern. Like a head & shoulders, it shows distribution of stock and signals a change in trend. The diamond is not a recognized wave pattern, and you can read in an EWT from 2005 how to interpret it under wave theory. 

It is interpreted by the STU tonight as a nested 1-2 pattern, and they give strong support to a stock distribution story: we had an all-time record of buying climaxes last week (at least back the past 20 years of the Investors Intelligence database). The STU notes that we had 1019 buying climaxes last week, whereas the week leading to the March 2009 bottom had exactly the opposite, 1010 selling climaxes. A buying (selling) climax is when a stock makes a 52-week high (low) and then closes the next week lower (higher), and signals rotation away from the trend. This chart from EWP shows the setup: 

 

If so, tomorrow should drop pretty fast below the recent lows around Sp1182 as we kick off wave iii of (iii). Indeed, it sets up a modest-risk, high-gain short, since if right, it drops hard and a lot, but if wrong, the stop can be confidently placed at the prior wave top (Cash Sp1209). Even if the nested 1-2 setup fails tomorrow, the broader indications of stock distribution signal that the top is very near. 

EvilSpeculator throws some TA cold water on this by noting that the VIX closed back within the 2.0 Bollinger Band (two standard deviations) below its 20DMA, giving almost giving a short-term buy signal (a reader adds that: to confirm, it now needs a higher close (sell) or lower close (buy) than the close of the day back inside the 2.0 Bollinger Band). If the STU is right and we do drop tomorrow, the aborted VIX signal will have failed, which says the "countervailing trend is strong" in the words of Friday's STU. That would be consistent with a 3 of 3 down. 

I have commented recently that the STU tends to find nested 1-2 patterns too frequently, sometimes with inside waves larger than outside. This one does not suffer from that, and both down waves can count as "5s" while the upwaves are "3s". Friday's drop still lacks an extended wave, but we have passed beyond that issue for the moment: either we get the hard wave 3 of 3 drop tomorrow or the nested 1-2 count is simply off. The other concern I have with the STU count is that the 2nd waves both retraced more than 62%, indeed 78% in the S&P and 89% in the Dow today. While allowed, generally wave 2's don't go past 62%, so it raises a red flag that some other count is on. 

I have seen some comment that we are back in the ending diagonal, but this pattern no longer fits that, and if a new ED is forming, it is premature to call it. Instead, as suggested today by EWTrends, we may be in for an extended sideways period, as we saw back in November. Wave Principle suggests one way to count this is as a complex correction wave 4 or a B wave before the final wave up:

 

The imperfect drop Friday gets counted as a "3" and today as another "3" for waves A and B of a second flat or maybe a triangle. Or, the wave (ii) is extending sideways out a bit, and the imperfect drop would be an X wave. In either case, we have a sideways move. 

If we do rush down, an interesting take on conforming the anomalies is from Market Thoughts: the Friday drop can be counted as a leading diagonal, a variant on the ending diagonal which has a compressed 5-3-5-3-5 impulsive structure without an extension. 

 

Gulf Oil Rig Explosion LInks

One of the Yelnick readers, nspolar, comes from the oil patch and shared some of the sources he is following on the disaster in the Gulf. I added to his, and note that the points of criticism are emerging even before we know what happened:

• A detail timeline comes from a social network for oil & gas professionals
• An oil pro who was on the rig tells of his experience and speculations
• A scathing criticism from the former NOAA head of Gulf response that the Feds failed to execute the pre-approved plan & made things worse
• Another scathing criticism over why shut down all the other rigs? 
• A milder criticism from the NYT of the slow response
• The WSJ focuses on the rig owner cutting corners, and shows the "fix" graphic below
• Most inexplicable is why send in the lawyers? To "keep the boot on their throat" as White House spokesman Gibbs oily spilled about BP? 
• Already a hoax has emerged of sabotage by a Cuban-launched North Korean mini-sub
• An Oil Slickonomics summary, with the bad, the worst and the ugly scenarios
• BP announced they have significantly cut the flow through the pipe
• Follow-up on the failure to pursue the pre-approved plan shows they failed to stock fire-booms

 

First we need to understand what happened and how to improve future drilling, then we can assess blame and politicize. Nspolar adds a number of insights below the fold, and this important cautionary note: 

In the end we do not know all the facts and at this point it is possible for events to have been misreported. The investigation as to determining the chain of events that led to the explosion and blow out will likely take weeks, before concluding.

Market Technicals Signal Sell In May

This is a companion to my prior post on why the GDP report is giving a sell signal, which looked at market fundamentals. Market technicals also give a sell signal. The current market pattern indicates a drop is due. Monday morning will be the tell: it needs to bounce or the bet is for a serious drop. 

Technicals

I went bullish in Nov08. A normal bounce from the deep drop goes at least 50%, so in Jan09 I predicted the Dow would break 10500, which it did in Nov09. Once we went past Dow 10500, the next target became the 62% retrace off the Mar09 bottom. 

This month's EWFF points out that the Dow (11258) and S&P (1220) came really close to the ideal of 61.8%. If they continue up, the target range is Sp1250-1275, around another 5% upside. 

Tonight's STU notes how we fell off the top in a five-wave pattern, which completed a fourth-wave flat correction, and they expected a fifth wave up. The first two waves make that count problematic. What would be the wave 2 of 5 broke as a "5" not a "3" and retraced 78% instead of the normal 50-62%. If it drops a bit more, and especially if it breaks the mid-week lows (Dow10965/Sp1182), the market would be highly likely to head down much deeper. 

The market will always tend to surprise, and so rather than just a drop or a bounce Monday, we might see a jitter. The wave structure of a five-wave drop in the prospective wave 2 of 5 means a bounce and drop has to happen Monday to restructure the wave into a "3", turning the five-wave pattern into a double zigzag down. Alternatively, we might see a gap down. The wave structure of the five-wave drop lacks an extended wave, which a normal impulse wave has. It would take a Monday gap down to create an extended third or fifth. If that happens, it would be very clear the market is in for a world of hurt. 

Hence wave theory says: either a jitter and a bounce, or an air-pocket down.

If we do drop, the STU points to Dow10730/Sp1150 as key levels, the place where the prior breakout up occurred. This drop could be the end of the Hope Rally, or the last major drop (a B wave) before a final thrust up. It doesn't matter at the moment which, since in both cases the play is for a drop. A break of the Feb5 lows (Dow9835/Sp1045) mean the Hope Rally is done. 

The STU has a wealth of other predictions which suggest a change is near on the USD, Treasuries and gold. It will be really interesting to see if a temporary save of Greece leads to a switch in sentiment. British elections next week, and then German elections a week or so later. One way or another, some major market will be putting out Mayday! Mayday! Stay close to things the next few weeks