Dow: The Higher It Gets the Harder It Will Fall

| About: SPDR Dow (DIA)
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You won’t find this approach to figuring the direction of the Dow anywhere else. All I want to say about it is it seems to work.

This is the analysis used in May to predict that the Dow would reach 10,000 without a major reversal.

I’ve put on my estimate of where I reckon it is now (in red).

To my way of thinking it’s approaching the “danger zone”; (dotted black ring), although reversals when the mispricing is negative tend to be more restrained.

By way of explanation that analysis was based on three lines of logic; the first is to calculate what International Valuation Standards (IVS) calls “other-than-market-value”.

Second, you work out mispricing by dividing the price by the OTMV and I normally take away one to get the base-line running at zero.

Third, from that you look for patterns on previous bubble/busts (not just stock, oil, housing, commercial real estate, they all follow pretty much the same pattern).

That might sound “unconventional” (although IVS is not), but for example I used the same model to work out (in January) that the bottom would be S&P 675 (so that’s +/- 1%, which isn’t bad for a two month forward prediction), and the same model to say on 9th March that was the bottom, and on 20th March that it was a real rally and not a dead cat.

Anyway, what surprised me was how fast it fell from about 850 to 675 or so. The initial analysis said not for a year or more (at the time everyone was saying the bottom was in, my main point at the time was that the bottom was not in). In February I revised the timing although I still was thinking months not weeks. The methodology is not so good on timing as it seems to be on changes of direction.

On reflection, mainly based on looking at the pattern of the bust after 1929, I’m coming around to the idea that the US stock markets will be mispriced “under” for another ten years or so. My calculation says the “right” price now is about 15,000 on the Dow but the garbage of the past ten years of cronyism has to be flushed down the toilet before the market is not mispriced down (case in point the “Stress Tests”).

I have no philosophical explanation for that, it's just an observation of many past bubbles and busts. Although, I suspect that may have a lot to do with companies that are simply not viable without a bubble - holding on and playing accounting games, denying reality, and hoping the government creates another bubble.

I’d put a lot of the Wall Street banks in that category. Currently they survive by the “forbearance” of the regulators (“Stress Tests”), accounting gimmicks, and the benevolence of the Fed that lends them money at 0% or so, so that they can buy Treasuries at 4% (and perhaps speculate on the stock market or in commodities). As if that creates long term economic value (socially useless is how the head of the bank of England described it).

And in the end the long-suffering and apparently infinitely long suffering US taxpayer pays, either via the National Debt or via inflation.

I suspect that recently a lot of the speed of the increase in the market was thanks to the Fed creating money for speculators to play with. Clearly the penny still didn’t drop that creating bubbles, even if it’s to get yourself out of a bind that you created, is zero sum and because efficiency losses actually destroys economic value.

So I wouldn’t be surprised to see the Dow going up to 13,000 in six months, although the higher it gets the harder it will fall. So if the bust comes before 12,000 it might be 20% down (coming back to 9,500), if it gets to 14,000 it could be 40% (coming back down to 8,500). If it stays under 11,000 for a year I’d say a reversal (i.e. more than 10%) is unlikely.

And there is no guarantee that the Fed won’t keep inflating the mini-bubble that is in danger of being created until it pops. That appears to be what they do best, then when “surprise!” it all goes wrong, they panic. So predictable.

Looking at the pattern after 1929 and 1971 (both times a bubble popped – in 1971 it was helped by the Arab oil Embargo), typically there are four reversals before equilibrium is reached again (i.e. one main shock then three after-shocks).

In this case the Bust was #1, the second was September 2008 plus down to March 2009 (that’s one bust). Based on history there are two more biggish ones, i.e. 20% to 40%, to come over the next three to six years.

I have no strong opinion on when or what the trigger will be, although an oil-price bubble that is on the cards (popping) or a dramatic increase in the long term Treasury rates are likely contenders.

All the analysis does is measure “pressure” and general direction; but I suspect that the next six months will be a good time for traders who understand the short term to do some surfing (personally I don’t).

That said, looking in the past, the “trigger” for a reversal appears to be a period of rapid consolidation (as happened recently):

I’d say the next six to nine months will be harder to make money in the US stock market than it was over the past six months when everything went up. Quality is probably much more important now than it was then; and the risk-reward is less persuasive. I’d be amazed to see 14,000 by this time next year (that’s +40%), but not at all surprised to see 9,000 revisited (-10%).

Time perhaps to look at other opportunities; there are plenty around.

POSITIONS: Out of US Stock Market