Trader’s Narrative

Guest Post by Nico Isaac

The following article includes analysis from Robert Prechter’s Elliott Wave Theorist. For more insights from Robert Prechter, download the 75-page eBook Independent Investor eBook. It’s a compilation of some of the New York Times bestselling author’s writings that challenge conventional financial market assumptions. Visit Elliott Wave International to download the eBook, free.

Once upon a time, the term “Black Monday” was to Wall Street what the name “Lord Voldemort” was to Hogwarts. It turned the air freezing cold and sent traders flinching around every corner in fear of a repeat of the October 19, 1987 or October 28, 1929 meltdown.

Case in point: The 2008 “Black Monday” anniversary. At the time, the U.S. stock market was locked in a ferocious downtrend that included regular, triple-digit daily declines of 400 points and more. Needless to say, when the final two Mondays of October arrived, the least superstitious investors surrounded their portfolios with more good-luck talismans than a Bingo player. See October 19, 2008 AP headline below:

“Black Monday: Stocks Sink As Gloom Seizes Wall Street. Prolonged Economic Turmoil” is seen.

That was then. Today, the usual dread surrounding the back-to-back string of “Black Mondays” is nowhere to be found. In its place, media reports abound of a new, global bull market “shrugging off,” “ignoring,” and “making a distant memory” of the event.

For one, “gloom” hasn’t “seized” the U.S. stock market in quite a while; from its March 2009 low, the Dow has risen more than 50% to above the psychologically important 10,000 level. For another, the mainstream experts insist that today’s financial animal is unrecognizable to that of 1987, and especially 1929. In their eyes, it’s a completely different — i.e. safer, smarter, and sounder system.

We beg to differ.

See, while the usual experts want to put as much mental distance between today’s market and those that facilitated the 1987 recession and 1929-1932 Great Depression — the physical similarities are impossible to ignore; more so, in fact, to the latter scenario.

Here, the October 2009 Elliott Wave Financial Forecast presents the following news clip from the October 25, 1929 New York Daily Investment News.

Now, take a look at these headlines from the week of October 12-17, 2009:

“The Great Recession Is Over.” (Reuters)

“80% of Economists Say The Worst Is Behind Us.” (CNN Money)

“The Bull Is Back” (AP)

“The Economic Recovery Is Well Underway” (Wall Street Journal)

They’re interchangeable — Eighty years later.

Along with a similar extreme in bullish sentiment, the performance of stocks between now and the 1929 situation is cut from the same cloth. After an initial plunge from August 1929 through late October 1929, the US stock market enjoyed a powerful rally well into the following year. NOW: After a steep freefall from its October 2007 peak, the US stock market is once again enjoying the fruits of a powerful rally back to new highs for the year.

Also, on closer examination, the October 19 Elliott Wave Theorist (EWT) uncovers an even deeper parallel between the 2009 rally and the 1929-30 one. Here, EWT presents the following snapshot of the Dow during the Depression-era advance:

As Bob Prechter points out — in 1930, stocks rallied to the level of the preceding year’s gap. Bob then reveals that the same level has been reached now.

So, we all know how the 1930 rally ended. The question is whether the 2009 advance will experience the same fate. As Bob explains in the Theorist, the only way to know for certain is to “look at the reality of the situation.”

For more information, download Robert Prechter’s free Independent Investor eBook. The 75-page resource teaches investors to think independently by challenging conventional financial market assumptions.

Since last year we’ve heard rumors about a “Wall Street” sequel in the works from Hollywood. Amazingly enough, the latest news is that it is in fact going forward and will probably have Michael Douglas reprising his role as the infamous Gordon Gekko.

As any trader knows, “Wall Street” is the classic trading movie which came out in 1987. What most people assume that it came out before the crash in 1987. Which is probably why it has gained a false reputation as a contrarian indicator for the crash. But in fact, the movie was released on December 11th, 1987 when the Dow was around 1,900 - off the lows of Black Monday, but still every one was completely shell shocked.

It looks like the sequel will also come on the heels of a crash of sorts. That is assuming we don’t have another leg down from now till the movie is released

The TED spread is one of the most basic gauges of fear in the financial markets. TED stands for Treasury Eurodollar because originally it was calculated by taking the US 3 month treasury bill and subtracting it by the 3 month Eurodollar contract rate. Today the spread is calculated by taking the difference between the 3 month US T-bill rate and the 3 month LIBOR rate.

This is an important indicator because while US government issued fixed income is perceived to be “risk free” (or as close as you can theoretically get), LIBOR rates are commercial lending rates and are not. So therefore, the difference of the two isolates counterparty or default risk in the market at any point in time.

Of course, this is a generalized measure of counterparty risk across the financial markets and is not reflective of individual corporate bonds. Think of it as being a measure of credit risk the same way that the VIX is a measure of volatility. I can guarantee that it is one of the ingredients in the “Panic Button” indicator from SentimenTrader. That indicator by the way, has now shrunk back to less than 1 standard deviation away from its mean.

Right now the TED spread is showing enormous stress in the global financial markets:

Today it closed at 313 basis points which means that we have broken through the previous record set at the darkest hour of the 1987 “Black Monday” stock market crash (300 basis points). Ponder that for a second.

On the other side of things, in the summer of 2000 (remember those days?) the TED spread shrank to almost nil as everything was well with the world and everyone held hands singing songs of monetary bliss while basking in the sunshine of the “Goldilocks economy”.

Monday’s jarring market woke everyone up from the snooze fest we’ve had to endure recently. The 500+ point drop reminded those who were around then, of the 1987 crash. But of course, there was a world of difference between the two Mondays. Today’s bounce is, believe it or not, the normal thing for the market to do when it has undergone a large gap down.

Whites Of Their Eyes
Finally we saw some fear in the market as the CBOE Equity only put call ratio reached above 1.18 - that’s high but not near as high as it could potentially go. Today it pulled back once again below parity (at 0.93). But honestly, no one is convinced until they see this and other fear gauges spike into the blue yonder and higher, and then remain there for two, three or more days.

Lasting bottoms are carved out of pain and a total collapse of confidence. Although the news headlines are very pessimistic and one would almost be forgiven to jump into “contrarian” mode, the sentiment gauges don’t quite show the definitive panic that must precede an inflection point. For example, according to the Hulbert Newsletter Sentiment Index, the average newsletter editor is more bullish now than at the low in July. This, even though after Monday’s close the market was lower.

The volatility indices, VIX and VXN did spike higher but again, last summer and just a few months ago in January 2008, they got as high at 37.50 - so we are close, but still not high enough.

Devastating Breadth
Taking a quick look at the market internals, there were only 36 advancing issues on the NYSE and only 390 on the NASDAQ. The declining issues dwarfed them at 2,921 and 2549 for the NYSE and NASDAQ respectively. Trading volume was so lopsided that for each advancing share there was 172 declining shares. I haven’t done the calculation to see but it looks like a same assumption that Monday was a classic Lowry’s 90/90 day to the downside.

Technical Damage
There was serious technical damage all over the place. Not the least of which was, as mentioned before, the close below the July low. But what worries me, is that although there was damage done, it doesn’t show up as extreme on the charts as the screaming headlines would have you believe. For the most part the market is still approaching a final exhaustion. Where I would feel comfortable saying that there has been a washout of selling.

And yes, this is exactly the sort of thing that happens at the worst of times, when we are close to a major bottom. But I’m not convinced we are there yet. We are close, but before we get there we’ll see more volatility.

Take a look at the percentage of stocks trading above their 10 day moving average. Even after Monday’s decline, there were 17% above this short term moving average. For a lasting bottom, I’d like to see below 10% and preferably below 5%. Or take a look at the high low ratio:

Probably the most important thing to take away is that while heavy selling is a necessary part of an change in trend, by itself it doesn’t guarantee anything. But if heavy selling is followed closely by intense and almost indiscriminate buying, then chances are it is the real deal.