Trader’s Narrative

By Elliott Wave International

It’s one of the first rules in the book of mainstream economic wisdom: a country’s economy is the thermometer which “reads” its stock market’s temperature. If financial conditions are heating up, stocks rise; if they are cooling down, stocks fall. Were it so simple — millionaires wouldn’t make up a measly .15% of the global population.

Obviously, there’s a major flaw with this logic; namely, it isn’t true. Time and again, stock prices smolder to near boiling even as economic growth chills to the bone. (The opposite also holds: Stock prices cool down even as the economy is on fire.)

Take, for instance, Germany’s main stock index, the DAX 30. On August 13, Europe’s number one economy reported a .3% rise in gross domestic product (GDP) — Germany’s first quarter of growth since January 2008. Soon after, the DAX began to rally and finished the day at a fresh, ten-month high.

In no time at all, every financial media outlet from Wall Street to la-la land had their story: “Germany’s DAX rose nearly 1% on the GDP data. The big picture will be one of ongoing gradual recovery through 2010.” (LA Times)

One problem: the DAX’s bullish flame has been burning since the index landed at a two-year low on March 9, 2009. YET — the economic data over those six months has been about as “hot” as the Arctic Circle. Here, the following news stories from the time say plenty:

• March 24, Wall Street Journal: “There’s a slew of evidence that Germany is in an economic freefall: A 19% drop in industrial output, a 23% decline in exports, a 35% drop in new manufacturing orders, and on. The numbers we’re seeing are just mind-boggling.”

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• April 30, New York Times reveals a 17% year-over-year decline in Germany’s exports and writes, “With 47% of its GDP generated by exports, Germany would suffer a severe contraction in its economy.”
• May 16, Wall Street Journal: “In the fourth-quarter 2009, Germany’s GDP plunged 3.5%; its worst performance in nearly four decades.”
• May 17: Tens of thousands of German workers march through downtown Berlin to express their anxiety over the alarming increase in unemployment: at 7.7%.
• June 29 Associated Press: Germany’s GDP has now fallen by nearly 7% in the past four quarters with widespread expectations for a 5.5% to 6% contraction by the years end.
• July 3 WSJ: “Germany’s own recession is the deepest of any major economy in the world, apart from Japan.”
• September 8 speech by Germany’s Chancellor Angela Merkel: “We are in the worst economic crisis that the Federal Republic of Germany has experienced in 60 years.”

You get the picture: During the DAX’s entire six-month long winning streak, Germany’s economic figures have been bleaker than bleak. The mainstream correlation was broken in its box along with any preemptive opportunity to position for the uptrend.

That, however, was NOT the case for EWI’s European Financial Forecast. Here, the following archive of our analysis shows the extent to which objective analysis of the market’s internal measures keeps traders ahead of the biggest moves:

March 2009 European Financial Forecast (release date: February 25):

“We favor the fourth-wave contracting triangle interpretation for the DAX. The DAX broke through a solid support shelf at 4014 this week so selling pressure could intensify before we see a notable rally.” The end of the wave v decline should come near 3440.

March 6 European Short Term Update (ESTU):

“The DAX situation is similar to the entire region. We believe that the market is closing in on a low; perhaps it’s a week away from finding a decent bottom.”
On March 9, the index did indeed “find” its bottom at 3588.

March 13 ESTU:

“We must entertain the possibility that the low earlier this week may hold for a time, weeks or months, and the risk-reward equation is not as heavily favorable for the bears.”

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Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

The spring rally that started on March 9th 2009 took the Standard & Poor’s 500 Index 37% higher by May 8th (almost two months exactly). Since then we’ve been bobbing and weaving, first lower, then higher but really not going anywhere:

It could just be that we have no come into areas of resistance which last pushed back prices in early January. Or there could be more a more insidious reason for the recent weakness in the equity market.

In a recent Wall Street Journal article, Paul Desmond, the award winning head of Lowry Research, argues that what we are seeing is not the start of a real bull market:

“A new bull market is one when investors are prepared to commit larger and larger amounts of new money to equities… What we have seen here is a very consistent drop in total volume going back to early April. Investors are risking smaller and smaller amounts of capital and that is a bad sign.”

Mr. Desmond says his data, going back to the 1930s, don’t show any new bull market with such a weak volume trend, which leads him to believe that this rally won’t become a lasting bull market.

Among the many metrics used by Lowry Research are two proprietary ones called ‘buying power’ and ’selling pressure’. Accordingly a bull market is distinguished by a rising buying power measure and falling selling pressure. While stock prices have certainly risen, there isn’t a demonstrable strength in Lowry’s buying measure. In fact, demand has been fading.

For further details about Lowry Research and how they analyze the stock market, check out: Lowry Research On Current Market Conditions.

Today the venerable Dow Jones Industrial index is undergoing changes to its component stocks: Altria Group, formerly Philip Morris (MO) and Honeywell (HON) are being replaced with Chevron (CVX) and Bank of America (BAC).

Actively Passive
Which explains why I always chuckle when people get into debates about “passive” (aka index) funds vs. “active” funds. As today’s change should evidence, all funds, including indexes are active.

Somebody has to decide: a] what to put into an index b] rebalance it using some formula and c] make changes to the components, from time to time.

In an active fund, those calls are made by the manager who charges a hefty fee and in the case of an index fund like the Dow Jones the decision is made by the editors of The Wall Street Journal. Same difference.

The only real distinction is the portfolio turnover and the MER. While changes to the Dow happen every few years, an actively managed portfolio can have positions traded into and out up to several times a day.

Better Out Than In
Another interesting twist to this debate is that historically, stocks deleted from the Dow Jones end up outperforming the ones that replace them. That goes for not just the Dow but all major indices.

For example, Chevron was in the Dow before until it was deleted on November 1st, 1999 in a swap that involved 3 other boring stocks getting dumped for sexier stocks: Home Depot (HD), Intel (INTC), Microsoft (MSFT) and SBC Communications - now AT&T (T). The editors of the WSJ weren’t immune to the lure of the internet bubble.

The four new stocks went on to produce an average loss of 40% while the deleted and unloved stodgy ones produced an average gain of 27%. So the Dow would have been much better off had there been no changes at all!

The most (in)famous change to the Dow is the elimination of IBM from the index in 1939. While it was eventually added again, according to Norman Fosback, the Dow would now be twice what it is today had there been no change.

Still like indexing? still think it is passive?

Technical Analysis
Rather than a typical technical analysis of the Dow using its own chart, I thought I’d share something a bit more advanced and perhaps more insightful.

The chart below is a ratio of two breadth indicators: the percentage of Dow components above their 50 day moving average, divided by the percentage of Dow components above their 200 day moving average. If it sounds familiar, you’ve probably read this: “Timing the Market with % Above MA Ratios”

Whenever the ratio spikes, the Dow is extremely oversold. The current ratio has spiked because the denominator is 13.33% - the lowest it has been in five years.

Anything in the 2.0+ range is beyond extreme. We’ve only exceeded this level in recent times when the market was making the 2002-2003 bear market bottom.

Fundamental Analysis
According to Morningstar’s fundamental analysis, the Dow is undervalued by 17%. They arrived at this valuation by doing an analysis of each component. They also expect the index to rise 50% in the next 3 years.

According to Jeffrey Ptak, “The Dow hasn’t looked this cheap to us since September 2002 when the index stood at 7,592″. Sound familiar?

The research note was released before today’s changes to the Dow but Morningstar added a note saying that Chevron and Bank of America will actually make the Dow even more undervalued, reducing both trailing and projected price earnings ratio and increasing the dividend yield.

I’m not big on fundamental analysis but when it dovetails so neatly with technical analysis, I can’t help but take notice. Oh and for another take on the general market fundamentals, take a look at the IBES model.

Remember to add your own thinking and due diligence.

There is a rumor that the (in)famous trader, Vic Niederhoffer, has blown up… again.

For those that aren’t familiar with Niederhoffer nor his history, click here to read his wikipedia entry.

For those keeping track, this monumental blow up makes it 2 for 2. Vic came close last summer when he suffered a debilitating loss of around 30% !

Incredibly Matador (his hedge fund) clawed it’s way back from the brink and survived.

But the rumor is that this time it is definitely over.

According to the unsubstantiated rumor, Matador has lost 93% of its funds! Their prime broker apparently forced a liquidation of their positions.

Seems the fund was short 15,000 1000 strike August ‘08 puts.

The same source is claiming that the Wall Street Journal will be coming out with an article about this. So keep an eye out for it.

This article from today’s Wall Street Journal features some prominent technical analysts (Paul Desmond and Steve Leuthold) opining on whether this is it for the bull market that started in 2002:

Last week’s stock-market carnage — the Dow Jones Industrial Average fell 4.23% for the week to 13265.47 — seemed an overreaction to most analysts, who focus on fundamentals like corporate profits and interest rates. The global economy continues surging, they point out, while most market interest rates remain low by historical standards. What matters, they say, is whether the credit crunch, caused by ill-conceived loans to home buyers and businesses, starts to interfere with growth and interest rates.

But another, less fashionable, breed of analysts sees storm warnings. Known as technical analysts or chartists, because they plot and compare a wide range of sometimes-arcane market data on graph paper and spreadsheets, they liken their work to hurricane tracking. They can see a pattern building, they say; the trick is distinguishing a brutal Category 5 storm from a less-severe Category 2.

Like hurricanes, market tops tend to have a lot of common features, these analysts say. Whether a bear market features a crash, as in 1987, or is marked by a long, painful decline, as in 2000, the end of a bull market usually sends the same signals.
A top commonly looks like a roof, with indexes bumping up against it until they sag. Indexes hit a series of new highs, but over time fewer and fewer stocks join in. Big multinationals gradually take over leadership from the smaller, more-volatile stocks that typically lead a bull market’s early stages.

Sentiment turns from fear to greed as investors push stocks too far. Stocks top out one by one, often with a small band of highly admired issues leading the gains, until there isn’t enough strength left to hold the indexes up. This usually happens when interest rates are rising, pressuring businesses and consumers. Money managers, reluctant to sell for fear of missing out on more gains, get caught in the declines.

The market looked a lot like this before its peaks in 1987 and 2000, and at the end of other bull markets. Today, it has some, but not all, of these characteristics. Hence the fierce debate: Is this a hurricane or just a summer downpour?

Finding an answer is tricky. Tops aren’t just the mirror image of a bottom. When stocks rebound from a bottom, as they did in 2002, they tend to surge. But when they fall from a top, they waver uncertainly, giving the appearance of a pause. The last time stocks topped out, in 2000, speculative technology stocks fell hard. But the Dow industrials declined very gradually, as did the Standard & Poor’s 500-stock index and even the large tech stocks. It took months for analysts to agree a broad bear market was really at hand.

There have been some signs of a roof forming lately. Markets have seen a series of records, with big stocks beginning to lead the way and fewer stocks showing gains. When the Dow industrials hit their record just above 14000 on July 19, many second-tier stocks didn’t join them; indeed, after a strong start, small stocks are down for 2007. Meanwhile, money managers who were skeptical for much of the past year showed signs of greed, setting aside doubts and jumping into the market.

At the same time, until last week, middle-size stocks had been holding up better than small ones, and the gradual topping out hadn’t gotten very far. Financial, consumer, telecommunications and health-care stocks, as well as real-estate stocks and utilities, all had turned down, but technology, energy, basic materials and industrial stocks all were holding up well. Market interest rates had risen, but not heavily.

Moreover, even after last week, the Dow’s worst in more than four years, the index remains up 6.4% in 2007 and 18.2% in the past 52 weeks.

Whether technical analysis is really useful at making sense of such data is a matter of some dispute on Wall Street. Some investors believe it is impossible to forecast the market’s ups and downs. Academic studies have shown that when most people, professionals and amateurs alike, try to move money in and out of stocks to beat market fluctuations, they tend to wind up with losses.

That helps explain why, in this era of passionate investor interest in corporate profit news and Federal Reserve interest-rate decisions, the hard-to-explain work of technical analysis has fallen into disfavor. Some brokerage firms have eliminated their technical research departments altogether. Still, when markets begin to sag, investors rediscover technical analysts.

Thanks in part to technical analysis, Steve Leuthold, who manages $3 billion as chairman of Leuthold Weeden Research in Minneapolis, stunned clients early last week by warning of impending trouble. Two days later came the Dow’s combined plunge of 3.8%, or 519.60 points, on Thursday and Friday.

Mr. Leuthold sees a bear market at hand — that is, a decline of 20% or more from the top. “I don’t think this is going to be the end of the world, but it could be a normal bear market that could go on for a while,” says Mr. Leuthold, who has been working in cut-off jeans and a T-shirt from his summer home near Portland, Maine.

Paul Desmond, president of Lowry’s Reports in North Palm Beach, Fla., interprets the data differently. “If a person’s hair has turned gray, it doesn’t mean they are ready to pass on,” says Mr. Desmond. The market has caught cold, he says, but “isn’t showing the signs you would normally see if it were near death.” He expects a rally in the next few days, and has advised clients that if it is broad and robust, they should begin buying again in anticipation that the market will recover.

The mixed signals have been frustrating for Phil Roth, chief technical market analyst at New York brokerage firm Miller Tabak + Co. Mr. Roth spends an hour or two each day updating 100 different charts by hand. He has been plotting his charts, filled with market indicators, on gray and green sheets of graph paper since he entered the business in 1966. He extends each chart’s length by carefully gluing on more graph paper; these days, they unfold like accordions.

Typically, he says, a bull market shows signs of age after three years or so, tops out and gives way to a bear market. This one seemed to be doing that when it sagged in the spring and summer of 2006. But it rebounded, then shook off similar setbacks in February and June to reach 14000.41 on July 19. Mr. Roth came to attribute its resilience in part to the newly ascendant hedge funds and other private-investment funds that were driving the market.

Of late he had taken note of accumulating warning signs. Even as the market rose, fewer stocks were continuing to reach new highs. The number of stocks trading above their average prices of the past 200 days was slipping. Utility and financial stocks were losing steam. The use of borrowed money for stock investments was hitting all-time highs.

Then, when the Dow crossed 14000 to hit its most recent record, Mr. Roth noted that many stocks in the broader market failed to rise. More trading was being done on falling prices, suggesting weakness.

On Thursday and Friday, his chart-plotting frequently interrupted by phone calls from anxious clients, Mr. Roth saw what he had been looking for: After three consecutive days of record trading volume, the Dow industrials, the S&P 500 and the Nasdaq Composite Index all broke below levels at which they had rebounded strongly in the past. Measures of selling pressure, such as trades on declining prices and the number of stocks that were falling, indicated panicky selling.

He now fears that because so many investors put aside doubts to jump into stocks, and may now be looking for a way out, stocks could experience “a climax in the market” — an even heavier dose of panic selling than investors have seen so far. He expects stocks to fall 10% — which they haven’t done since 2003 — then put in a weak rebound before falling further. And he doesn’t rule out the kind of collapse that occurred on October 19, 1987, when stocks fell 22.6% in one day, the biggest one-day decline ever. “I’m not saying it will happen again, but it could,” Mr. Roth says.

At Leuthold Weeden Research’s headquarters, senior research analyst Andy Engel, working with Mr. Leuthold, tracks more than 180 eclectic data points in heavy ring binders that look like Mr. Roth’s. They watch not only the kinds of market indicators Mr. Roth follows, but, unlike most technical analysts, also broad fundamental and economic measures such as inflation, money supply and corporate profits. They have long been concerned about weakening growth and the risk of higher inflation and interest rates.

Like Mr. Roth, the two worry that many measures of investor sentiment, such as polls and a limited use of options to hedge against declines, suggest investors are overly confident and riding for a fall. Companies also have been issuing more stock, suggesting insiders see this as a good time to sell. Demand for gold-mining stocks, sometimes a leading indicator of declining confidence in the economy, has been on the rise.

Mr. Engel’s and Mr. Leuthold’s indicators gave a false sell signal in the fall of 2005, which made them miss out on some gains. But their indicators were on the money near the 1987 top, giving accurate sell signals, and gave buy signals near the 2002 bear-market bottom. After being surprised by an initial sell signal two weeks ago, the two men waited a week, rechecked the data, then sent out a warning to research clients and cut their own stock exposure last Tuesday.

For his part, Mr. Desmond, of Lowry’s, says his skepticism that this is a bear market stems from extensive research on past market tops. A week ago he warned clients of the risk of a short-term decline, and he still thinks that is what this is. “We just don’t have the signs you normally have at a market top,” he says.

His research shows that, as the market forms its rooflike top, individual stocks slowly fall back despite the indexes’ continuing gains. At almost all market tops starting in 1929, when the indexes finally were ready to fall into bear markets, the vast majority of stocks already had turned down, and many had fallen sharply.

But at the most recent market highs, a number of stock groups such as basic materials, energy and technology still were strong. While small stocks have faded, middle-size stocks are holding up better.

The year 1987 featured a September drop similar to last week’s, followed by the October crash, Mr. Desmond says. That has made some of his clients worry. But in 1987, less-prominent stocks had been slowly deteriorating for months before that, and that process hasn’t advanced nearly as far this time. If this year is going to be an exception, with a bear market starting before this broad deterioration has taken place, Mr. Desmond says, it will become apparent in the coming days, as the bounce-back he expects would prove weak and disappointing.