Expect Severe Weakness Throughout August, September

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 |  Includes: DIA, QQQ, SPY, UUP
by: Bill L.

Overview:

The woefully backwards looking measures of the economy are missing the alarming rate of decline in the demand side of the economy. Patterns and indicators are aligned and in agreement; the current rise is exhausted or nearly so and that a new leg down will be starting immediately. Ironically, though we are at the precipice of a major decline, studies of sentiment and attitudes toward risk show complacency. The next leg down has the potential to be vicious.

It’s the Economy, Stupid:

The demand side of the economy has been contracting at a worrisome and increasing rate. For a few months now I have been posting charts (courtesy of the Consumer Metrics Institute) showing a drastic slowing in broad consumer activity. This is a much better predictor of future economic activity because the BEA’s read on the economy is just not predictive (especially at turns).

In fact I would completely ignore GDP if not for the fact that so many others follow it so closely. Measuring the supply side of the economy has just too many caveats, namely, producers are loath to cut production when the economy starts to contract, and are too fearful to increase production when the economy starts to recover. Just like the stock market, they fall victim to herd mentality.

Since this is mainly what the BEA’s GDP read is base on, essentially you are looking at backwards looking data plus the bias of factory owners. Large ticket purchases on the demand side however can be measured almost in real time. Since our economy is +70% consumption, this is a much more predictive and better look at economic activity. The picture however, is not pretty.

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Chart 1 – Daily Growth Index - Courtesy of the CMI

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Note how the DGI leads GDP by several months. If this is any indication, as it has been, we should officially slip back into contraction (officially) by the end of the year. In my previous article, the DGI was showing a steady -3% contraction in the economy. That has since dropped sharply, now to a -4% contraction and in only one week. So despite the rise in the stock market, the economy itself is going off a cliff. Look for future downward revisions in GDP and disappointing economic data.

Sentiment: Complacency Still Rules

In early April I showed several measures of sentiment, such as the put to call ratio, sentiment surveys, and the commitment of traders report, all of which were at their highest levels in years. And despite the blip in weekly sentiment surveys in bearishness, do not be fooled, complacency still rules this market. First, when sentiment reaches such high levels in bullishness, as in April, this is not a condition that is undone in a few weeks. Pundits on CNBC have been coming out of the wood work saying that the prevailing bearishness is actually bullish.

Prevailing bearishness? How so? That fact they are still looking for bullish rationales tells us that the prevailing attitude is actually still bullish. But let’s look at the facts.

Chart 2 – VIX, CBOE Implied Volatility Index

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The VIX has retraced a Fibonacci 78.6%, reaching a level of complacency nearly equal to that achieved right before the “flash crash.” I was shocked back in April when commentators were saying that the low VIX was bullish for stocks. As I have said before, lulls in volatility precede expansions in volatility, so a low VIX must be viewed as a negative, not a positive.

Furthermore, there is the well known, yet apparently ignored fact that investors become complacent at tops, and fearful at bottoms. The VIX clearly shows that despite an imploding economy, investors have little concern, and are quite happy with their heads in the sand.

Sentiment: Inaction = Complacency

I completely acknowledge that during the May – June decline, weekly sentiment surveys showed an increase in bears, however, in order for a long term bottom to be in place %bears needs to get much, much higher than was achieved during that period. Furthermore, to be blunt, even if there is a feeling of bearishness starting to spread, as of right now people are not doing anything about it.

Chart 3 – Mutual Fund Cash Levels (chart from here, edited by myself)

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You can see that every time that cash levels have gotten this low, the market has had a severe contraction. Despite a small uptick in bearishness, cash levels remain near all time lows, and equal to where they were in 2000 and 2007. Even if people are starting to worry, they are clearly not worried enough to act. Furthermore, it is ridiculous to start making “bottom” calls when there being little to no cash at mutual funds to fuel a sustained bull market.

Sentiment: Dumb Money In = Time to Get Out

The commitment of traders report also shows typical topping behavior. Small traders are typically far less sophisticated than larger players, and larger players actions tend dominate the market moves. At tops we can expect small traders to be doing the opposite of what they should be doing, and right now, they are buying.

Chart 4 – Commitment of Traders

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We can see that when the market bottomed temporarily in July, small speculators started selling, trying to short the rally to no avail. Meanwhile the smart money took the opportunity to buy and cover shorts. As of a week or two ago, large speculators, or the smart money has been selling, is now short (below the zero line) and prepared for the next decline. The dumb money on the other hand, despite the terrible economic, fundamental, and technical backdrop, is convinced the market will go higher still and has been accumulating speculative long positions.

In The Land of Deflation, Cash Is King:

The dollar is in a bull market. In September 2009 I started getting very bullish on the dollar based on some of the most extreme bearish readings I have ever seen (see my article “Mounting Contrarian Evidence Suggests Dollar Nearing a Bottom"). Since everyone was convinced that the dollar was dead, I knew we were on the verge of a major dollar rally. The next move in the dollar, I beleive, will have major implications on the next move in the stock market.

Chart 5 - UUP

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This is my comment on the dollar on Wednesday , August 4th, “With a near perfect Fibonacci retracement, very bearish sentiment, and now a reversal on high volume that breaks a trend in declining volume, the dollar may have very well put in a low.” Since the intermediate top in June, the UUP (dollar bull ETF) has retraced a Fibonacci 61.8%, creating a golden section. Accompanying the bounce off resistance is overwhelming bearish sentiment; traders are convinced the Fed will kill the dollar…again.

Yesterday(August 11) the close above 23.71 confirmed that there is indeed a breakout occurring in a long term bull market. A perfect recipe for the start of a new leg higher. If deflation is the scenario playing out (and it is looking more and more likely that it is), a turn up in the dollar should roughly coincide with a turn down in stocks.

The Bond Market:

Stock investors are notorious for stepping in front of a train at turns. Interestingly enough, bond investors tend to be one step ahead of stock investors at such moments. I’ve thought about this, and I believe this phenomenon is another manifestation of sophisticated versus unsophisticated investors. Small retail investors tend to stay away from trading treasuries because, to put it bluntly, they are not “sexy.” Retail investors tend to get wrapped up in stories of great earnings, promises of future growth, and captivating but worthless tips. Bond traders tend to react less to stories and more to data, furthermore institution may use treasuries as a liquid alternative to cash.

Chart 6 – 10 Year Treasury Yields

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We can clearly see that treasury yields are in a bear market. Despite the July rally in stocks, this did little to nothing to stem the demand for safety in the treasury market. Yields remain very low across the spectrum. If there is an expectation of inflation and growth, we are not seeing it in the treasury market. Instead what we are seeing is much more indicative of deflation. We can see the behavior I mentioned earlier, stock investors adding risk, while bond traders seeking to avoid it.

Market Breadth: McClellan Oscillator

A study I have shown several times in the past, the McClellan oscillator is quite excellent in letting you know when to a turn, or at least when a correction is very likely.

Chart 7 – McClellan Oscillator

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The McClellan oscillator reached an overbought level denoted by the green line, or 1.5 standard deviations from the mean. We can see that once this level is reached, a decline is very likely. This level was reached in March, right before the April top, and right before the decline in late June.

Recently it has reached one of the highest over bought levels ever, and a level not seen since late 2009, which preceded the slow motion crash, where the Dow lost 2,500 points in 2 months. The overbought level means that at minimum that market is due for a correction, and is extremely susceptible to large downward moves.

The Stock Market:

In previous articles I mentioned the developing head and shoulders pattern, a pattern I believe to still be very much in play. The market tends to unfold in a manner that will fool the most people, and by developing into a complex head and shoulders, most have completely forgotten about the important reversal pattern. Last week I also mentioned that a pennant or wedge formation seemed to be unfolding and that Elliot wave counts allowed for an ending diagonal.

Chart 8 – SPX – Multitude of Negative Signals

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I shall just quote Edwards & Magee here,

we might add that the Rising Wedge is a quite characteristic pattern for Bear Market Rallies. It is so typical, in fact, that frequent appearance of wedges at a time when, after an extensive decline, there is some question as to whether a new Bull Trend is in the making may be taken as evidence that the primary trend is still down.

I would also note that the wedge is one of the most reliable patterns to trade, with almost all rising wedges ending with a break out to the down side (82% to be exact, according to a 2000 study by Bulkowski). Breakdowns in a wedge result in an almost an immediate retreat to the start of the pattern.

Down Side Target:

In terms of targets, follwing a break out from a head and shoulders pattern the first target is the height of the pattern.

Chart 9 – Head and Shoulders Target

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We are getting a bit ahead of ourselves since we have not broken the neckline yet. However if the breakdown out of the wedge continues as expected, the height of the pattern is approximately 190 S&P points. So depending on where the neckline is breached, a target of 830 to 815 in the S&P is likely. A corresponding target in the SPY would be in the low 80’s. If this is indeed the third wave down in terms of an Elliot wave sequence, a third wave is typically 1.618 times the length of the first wave.

That gives us a target of roughly 845 to 805 (depending on what low you think best counts as the end of wave 1). So in this case we have two different methodologies giving us some confluence in targets, that we will see in the S&P in the low 800’s in the next two months or so.

Summary:

This is the situation: the declining economy, complacent sentiment, depleted long term buying power, the dollar, the bond market, breadth, and price patterns are all saying the same thing. We are in a bear market, the next leg down will be vicious, and it likely starting immediately.

Disclosure: Author is long SPY puts, long BGZ.