Is the Equities Party Over?

by: Kurt Kasun posted on: June 26, 2008 | about stocks: DBC / DIA / GLD / IVV / QQQQ / SPY    
For this week, access to much of Elliott Wave International’s forecasts and chart work is free. Many traders and investors boldly proclaim that technical analysis, such as that provided by Elliott Wave and others, is akin to voodoo and advise investors to stick to the fundamentals. To which I reply: ignore technical indicators at your peril. Such avoidance/arrogance (you think you are so much smarter than the market) is particularly damaging to portfolios in two instances. One, when they involve macro themes which the names in your portfolio will be unable to escape. Two, when the change in trend only occurs after a long period of time: The longer the period before trend reversal or violation, the more powerful the potential effect on your investment.

The following chart is from Elliott Wave International:

We see that we have demonstrably violated the trend lines for the bull markets for the Dow Jones Industrial Average dating back to 1982 and 2003. It appears likely that we are going to test the trend line for the market dating back to 1974 for the third time this year. The market was unable to sustain a move above the 1982 and 2003 bull market trend lines during the market rebound following the Fed bailout of Bear Stearns (BSC) on St. Patrick’s Day.

A violation of the 1974 supporting trend line could spell doom and start a mean reversion which would bring the average below 5000 as the chart provided by sharelynx.com indicates:

click to enlarge 

 
You can easily make the argument that the DJIA remains extended versus its 200-year trend line and is therefore still very vulnerable to a big correction. Few stocks would be spared in such a downdraft. Do you have a slightly greater appreciation for technical indicators? 200 years is a long time. If we are taught that movements always revert to the mean, then we are almost assured that a correction is inevitable. But when? It could be this week.

I am surprised in the low reading of the CBOE volatility index [VIX] as we look to dive deeper and test the March lows in the S&P 500 and Dow Jones averages. Either traders are very confident that the March lows (and the supporting 1974 trend line) will hold or they are obliviously complacent and poised to endure much pain if it does not. The Nasdaq is holding up relatively well which is bullish as it tends to lead. The financial stocks have taken out their March lows and they also tend to lead the market. This is bearish. Perhaps market participants are betting this is the final washout for the financials and the market will soon move higher as all of the bad news is priced in. This song risks becoming a broken record.

The lows may in fact hold. I am very concerned, however, with the general contentment the market is displaying as it absorbs the selloff and we approach the edge of the cliff (again). Regarding the title of this week’s commentary, the party has been over for quite some time for tech, real estate, financials, and retail, yet many commentators continue to recommend them. A couple of weeks ago I was helping a friend pick mutual funds for his 401(k) plan. Of the 20 or so funds available, amazingly, none of them placed materials, energy, or commodities as the top group by sector representation—some had energy in third, but always after tech and financials—this after several years of under-performance. It just goes to show you that the vast majority of the world is composed of sheep and people are slow to adjust to long lasting trends.

But what about the stuff that has been working that you had the forethought and wisdom to have beneficially invested in? The focus of this commentary, is on the groups of stocks that have benefited since 2002—base metals, energy (oil, coal, natural gas), agriculture, precious metals, and infrastructure. What will happen to them as the broader market indexes swoon? And what about emerging markets? While some emerging markets continue buck the trend of a developed world slowdown, showing signs of economic resilience, there appears to be less evidence of the ‘decoupling’ of their financial markets.

I think the outcome depends on whether the US Government is successful (either unwittingly or through cleverly deceptive foresight) in fighting the deflationary effects of the deleveraging of financial companies and consumers and the deflationary effects of having to service the tremendous debt overhang we have amassed over the last few decades. I remain in “camp inflation” and believe that we will hit the accelerator on the money printing machine (as will other countries around the world) and will monetize our debt and devalue our currency (more against tangible assets than other currencies). This will result in higher prices against lower wages and a standard of living adjustment we have not experienced since the Great Depression. But it might allow us to avoid a total collapse of society as holders locked into to (what will be) relatively low interest rates might be able to afford to make their mortgage payments which would be much cheaper in tomorrow’s dollar terms. Keeping people in their homes might be the best we can hope for.

The risk to this view is that the Government would prefer to actually preserve the value of the dollar and willfully select a deflationary outcome, or that they would fail to properly execute an inflationary scheme. To the extent our Congress is involved, you can bet they would not fail to execute in creating inflation.

If you wanted to prepare your portfolio for either scenario, an easy strategy would be to go long a precious metal ETF and short the DJIA. Look at the chart below provided again by sharelynx.com:

 

You can see in the chart above that the world fiat currency regime is becoming increasingly wobbly and appears to be reaching the limits of sustainability. The emerging megaphone chart pattern portends gloom for the DJIA and boom for gold as the ratio descends from almost 50:1 to 1:1. The Long/Short strategy would work best in deflationary environment and would also work for you in an inflationary world as gains the price of gold would far exceed gains in the DJIA. However, if you still hold to inflationary view, as I do, you want to be flat out long gold and not short a market that might not be rising in real terms, but would in nominal terms.

This is why it is important that the 1974 trend line hold as support. A sustained drop below it would force me to consider that we are in store for deflation and that the Fed is either unwilling or unable to prevent the deflationary outcome. We would also need to consider exiting most other commodity-related investments (with the exception of precious metals) which have worked so well for us since 2002. Commodity bulls continue to make the case that we have at least another decade for the bull market to play out. While I respect this historically correct view, I continue to believe that the "decennial pattern" is more likely and a spectacular leg to the rally into early part of next decade will result into a "blow-off top." Either scenario for commodity bulls is wrong if we are on the brink of a deflationary collapse.

It is therefore crucial to monitor market activity and to see if the major support levels are breached. I expect this current episode to be another deflationary panic event and that the DJIA will hold and continue to be range-bound between the 1974 bull market trend lines and the 2002/1982 bull market trend lines for another year or so. 2009 will likely be the year to increasingly transition into precious metals and out of your other commodity holdings.

Excerpted from the 6/23/08 Global MegaTrends Portofolio's Newsletter.

Disclosure: None

This article has 13 comments! Add yours below...

Kurt Kasun

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This article has 13 comments:

  •  
    bonanza60
    Jun 26 08:37 AM
    Seems like a total collapse would take gold with it. After all, you can't eat it or wear it.
  •  
    fxtrader07
    Jun 26 08:58 AM
    'Ugnore technical indicators at your own peril' Hm. You claim, that they show where the market is headed. I have seen legions of TA-guys, especially elliott-wavers claiming victory on several occasions only to lose their arse later on. It's all about interpreting this stuff - and I have yet to see someone doing it successfully consistently. Elliottwave International (Bob prechter and his folks) have been way off the mark so frequently over the past many years that it simply doesn't matter anymore what they say. At some point, the crash will come, right. Given their poor track record it might not be now, when they expect it. Just to mention, EWI has been forecasting gold to crash to below 250$/oz time and again from 2001 through 2006 when I simply stopped wasting my time on their nonsense. (Other great calls of them were "mother of all shorting opportunities" in the dow at 10.500, 11.500 etc. in 2004 and 2006)
    Btw., long-term successful investors like Buffet, Munger, Whitman, berkowitz, klarman all couldn't care less about this technical analysis humbug. It simply distracts you from the big picture. And this is all the more true when it comes to equity indexes. There are many stocks that fell between 25 to 70% already, not just banks and homebuilders but even base metal stocks or health care or biotech or semiconductors or retailers or refiners - you name them. If it were not for energy and multinational giants the indexes would already be much lower. so it might rather help to look at those who held up and the likelihood of them to crash now. because if they don't, there is simply not enough crash-potential left to sink the markets much further from here.
    I am not expecting a new bull , certainly not. but rather sloppy volatile action setting up lots of bear- and bull-traps along the way. Something, a long-term value investor won't care for (other than for spotting opportunities in cratered stocks). TA-guys might do well here, too - or lose their shirt in sideways minefield-type of action
  •  
    Lorddarley
    Jun 26 09:44 AM
    I don't think there is much sense to this "analysis."

    The entire capitalization of the world's equity markets is only 50 trillion or so (as of 2007). Some of this is crap, so the stocks of quality companies, which are needed for pension funds and insurance company portfolios, can't be more than 30 trillion market cap.

    Assuming a reasonable cap rate, you could buy all the world's quality stocks (theoretically) for $3 trillion or so a year. Do you really think stocks are undervalued?

    Helping to finance this theoretical purchase is the labor and ambition of billions of people just getting started on the path to prosperity.

    Stocks of the world's quality companies are a screaming, unbelievable buy if you can think past the next few quarters.

    LordDarley




  •  
    Josh Stern
    Jun 26 10:18 AM

    Congratulations. It really takes some big balls to make a predictions based on a trendline where you show the data that was used to fit the trend and the reader can clearly see from your graph that the fitted slope is much lower than it would be without data from 1800-1850.

  •  
    Pangaea
    Jun 26 10:40 AM
    It looks like today the Dow has broken that 1974 trendline, as it is back on its Jan-08 low...
  •  
    GMiki
    Jun 26 11:48 AM
    I do read the Elliott Wave stuff, but I think it's much less on target than those who use the fundamentals.

    As to a losing market taking down gold--why? The market is down more than 200 today and gold is up about 25.
  •  
    blah-blah
    Jun 26 12:51 PM
    So we're going to see a 66% correction because of a 35 year old trend line being broken. Should I just sell everything now or just keep a little in case you could possibly be wrong?
  •  
    CLH
    Jun 26 12:56 PM
    In one place you say as many do that the gov. will print money. Under present rules this is not possible. Our money is debt money. When the gov. lowers interest rates people borrow money. Right now no one wants to borrow so no new money can be printed. This is the same thing that happened in Japan. Interest rates 0% but people dont borrow. This is a deflationary collapse and will last until debts are paid off.

    Gold will go down with everything else.
  •  
    Mike Stathis
    Jun 26 02:58 PM
    In a May 5 article on SA, I advised investors to sell the market (Stay Clear of Traditional Asset Classes)

    seekingalpha.com/artic...

    At the time, the Dow was around 13,100.

  •  
    bds231
    Jun 26 03:18 PM
    To put aside the validity of the article's conclusion for a moment, take this quote:

    "[the DJIA is] very vulnerable to a big correction. Few stocks would be spared in such a downdraft. Do you have a slightly greater appreciation for technical indicators?"

    This is a circular argument: Technical indicators make a significant prediction, therefore technical indicators must be correct.
  •  
    ikonoklastik
    Jun 26 08:45 PM
    That Dow/Gold chart is a piece of garbage. Any asset can be priced in terms of another to create a synthetic chart like that. It's a lot more illuminating to chart dollar/gold because that plot will show you a meaningful symmetry. And the assumptions behind using a TWO HUNDRED year chart are absurd. How many other pre-Industrial Revolution metrics would you like to share in order to "prove" your thesis? Oh pleeese.
  •  
    algoa456
    Jun 26 11:17 PM
    The problem with EWI is that it functions on the stopped clock principle that is right twice a day. They have been calling for the mother of all collapses since the mid 1990s. Missing the run up in tech and other great opportunities.

    It indeed may now be the end of civilization, but EWI has cried wolf so much we no longer believe them.

    Having said that I do use technical indicators. I find they work well for relatively short time scales - as durations lengthen fundamental and macro analysis comes into their own.
  •  
    buzz6068
    Jun 27 12:14 PM
    This is an excellent, excellent piece! Whenever one tries to prognosticate the future, one may end up looking foolish -- its all a probability game. However, this article is not about predicting the future, but how vigalent one must be over the next year because the next 12 months will be pivotal. Thats what this article convinced me of.
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