When The Canaries Die, Get Out Of The Mine

Includes: DIA, IWM, QQQ, SPY
by: Bruce Pile

You do not stay ahead of the market by looking at lagging indicators.

The good leading indicators are diverging from the popular lagging indicators now.

Some very good leading indicators are in remarkable agreement.

In this time of great economic uncertainty, I am amazed at the indicators people look to for guidance on the future. When miners would take caged canaries down into the mine with them, these birds were a monitor of lethal gases building in the mines. The bird would die before any harm to the miners. They were "leading indicators" as we investors would say. In the coal mine we find ourselves in now, you hear little about leading indicators, however, and a constant babble about either coincident or lagging indicators. For instance, the mantra in market TV and press now is "wages are up" and "employment is OK." But these are lagging indicators. It's like taking a canary and an elephant down into the mine, carefully ignoring the canary and watching only the elephant as you are overcome with deadly gases. The miners (investors) will be dead by the time the elephant (everybody else) is overcome.

There is also a third type of indicator - Fed guidance. In 2007, Ben Bernanke told us we are not entering a recession and the housing market was just fine. The Fed is persistently a badly lagging indicator (to put it politely). Yet, all we hear and see is a steady drumbeat of wages, employment, consumer confidence, and Fed speak. We are all staring at the elephant in the coal mine - unless you search out the leading stuff.

What should we be looking at? Well, there are a slew of leading economic indicators tabulated by the ECRI, and they are showing a downturn as they always do before recessions:

Here we see that this canary has been dead for quite a while. I've added the continued downturn of the data since this August 14 chart with blue dots. All you heard on CNBC on August 14 was wages, employment, and when the Fed was going to rein in the booming economy with rate hikes. I don't think I saw this chart on CNBC back in mid-August, or ever for that matter.

As good as this ECRI chart is, I actually like keeping an eye on certain lead groups in the stock market as my canaries. There has been a train of lead and follow groups with a caboose, cars, and, and an engine pulling us into the mess we are approaching. Let's first take a look at the caboose, the RLX index of large retailers, a reflection of the American consumer:

This has been the engine in the bull market holding up far better than about any other index, and it has been the caboose so far in the bearish turn of late. The 5-year support trend has been taken out with the January carnage. All the other lead groups have led the bearish turn of the SPX including the usual leading small cap Russell 2000:

Since the early turn, the Russell has led very strongly down being over twice as much off its high as the SPX. Then there is the Dow Theory leader, the transports. I like to look at the Nasdaq Transportation Index because it has far fewer rails in it. Nowadays, rails are maybe more of a proxy for commodities, especially energy, than they are for the economy in general. So this index will be more isolated from the commodities mess and more accurately gives us classic Dow Theory results:

Note that it peaked even earlier than the Russell. When the Dow and SPX were on the verge of new highs after the August event, the transports were nowhere near confirming that action. Note that there was a serious breakdown in TRANQ back in 2012 also, but this was not confirmed in the Russell and other lead groups.

I purposely skirted the whole commodities thing in the above charts, but that is actually the thing that gets us closer to the heart of all our problems. And as I discussed in the article "The Debt Cycle And Rhymes Of Lehman Brothers" Glencore is about the biggest nerve center in commodities with tentacles made of loans, derivatives, and trading infrastructure wound throughout the financial world - a lot like Lehman was with mortgages. Looking at Glencore (OTCPK:GLNCY) as a leader in the turn:

Glencore was wilting slowly along with commodities up until the early turn down ahead of the following car in the train, the above transports. The nice one year uptrend peaked even earlier than the transports.

If we want something as an engine pulling the train into a possible train wreck, Deutsche Bank (NYSE:DB) would be it. They have become the leading holder of derivatives in the world, they are the biggest bank in Germany, which is by far the lead economy of all of Europe, and they are heavily exposed to Glencore and many other huge commodities companies:

If this is the engine pulling the train, maybe we should all jump! DB's peak was way earlier than the rest. You do not want the world's leading derivatives player, with at least $60 trillion worth of this stuff, to have a chart that looks like this. There is a lot of debate on derivatives with some saying they offset each other safely and are not a systemic threat. Everybody uses them. I am not an expert on them, but I respect the opinion of Warren Buffett. His opinion has been widely known since a Berkshire meeting in 2002, when he said they are "financial weapons of mass destruction." In a recent interview, he still holds that view:

When I took over the derivative operation at Gen Re which we inherited we had contracts that ran for 100 years before anybody settled up and in between people just kept marking the numbers down. So the amount of speculation in credit you can introduce into the system through derivatives is pretty extraordinary

Derivatives don't cause market instability, they become victims of it and amplify it. A big problem with them is that much of it is not reported honestly to anyone, so others don't know what their neighbors are exposed to - putting a drag on rescue efforts in an emergency. The six big US banks along with DB are the holders of most these bombs, and since 2008, these too-big-to-fail banks have gotten about 40% bigger. The six big banks in the US carry two-thirds of all our loans with a derivatives book of around $270 trillion - 28 times their assets. That's right at the 30 leverage ratio limit where Lehman blew up. Enron had a derivatives ratio out of control, but so much of it was in the dark, they don't even know what their ratio was at detonation.

DB's reported derivative book is six times the entire GDP of the Eurozone and 65% higher than that of Lehman in 2008. Some claim a Lehman could not happen now with today's much higher capital levels. But the fact is, back in March, DB failed its stress test and was given a dire warning to beef up its capital structure. In June, their credit rating was lowered to BBB+, barely above junk and even lower than Lehman's downgrade just three months before their sudden implosion. On derivatives, I am an ignoramus, but I defer to the opinions of Buffett and the credit rating agencies.

Another canary for the market is what I sneeringly call the cyclers. I sneer because I have never been a fan of the Elliot Wave counters or even the fractal time counters even though I like fractal in general. When a wave counter tells me "we have a third wave up, then a four wave down unless the two wave morphs into a one, then we'll have..." my eyes roll shut and I begin to snore. There is a genre of counters who do fractal time period counts that predict not the amount of a move but the turn points and general severity of the move. Generally, I find them to be useless for day-to-day timing, but now and then I find that their work has latched on to an area of the markets where they are in sync with the month to month moves with astonishing accuracy.

Such a case is David Nichols and the gold market where he called about every major turn for years and called for a major top in gold and silver to occur in March, 2011. Silver topped in April, gold in November. He is crazy accurate for gold, but on his stock market predictions - not quite as good. But he did make a major call back in March 2014 for a fractally-counted SPX topping pattern to set in by mid-2014 when the index was robustly pushing across 1900 for a fresh all-time high, and it looked as though there was no stopping the bull. In October, however, we had the bad selloff, then a badly weakening surge to 2100 in the rollover topping pattern now breaking to the downside. He was right and early. What is he now predicting on gold? He sees a mammoth climb to new highs in 2016, "the big one" gold bulls have been waiting for where gold and silver come "unglued" from banks and currencies.

Another of these fractal time period counter types that has gained some attention lately is Bo Polny. He has been primarily a gold forecaster, a perma-bull who has been calling for an upside explosion to new highs beginning any day now with several missed deadlines for many months. If his fellow cycler Nichols proves correct, he will not have been wrong, just early. He is the opposite of Nichols in that his stock market work is better than his gold work, at least lately. He has been calling the turns of the SPX to a tee for nearly a year now. He predicted a major bull/bear top for July 2015, then a major selloff for August. Then an early September recovery into October. He had been seeing the start of the bear in earnest for November, but issued a revision (he called it a correction of his counts) on December 2, saying that December would begin a major, sharp decline into 2016, where it would get much worse, producing a bear worse than 2008. This all has happened on schedule with the exception of some of it being called a little early. You could say he is just on a lucky streak, but let's consider the odds:

Either he is extraordinarily lucky, or his cycling work is latched on pretty good to the market nowadays. Polny also subscribes to Israel's Shemitah 7-year cycling that received a lot of attention this past September. I explained this phenomena in my October article "A Study In Crashology." Because the last two Shemitah years had some sort of fireworks on the last day of the year (Elul 29) there was a lot of anticipation of a historic crash in mid-September. But Polny was predicting a recovery through September and October, and he was right. Jonathan Cahn is the author of the best seller The Harbinger, which drew everybody's attention to this starting in 2012. He agrees with Polny:

What was missed by most in focusing on only one day, was that the largest and most prevalent of the Shemitah's templates has, in fact, manifested. The Elul 29 day crash is only one of several manifestations, an exception and a minority template. In each of the last seven of the Shemitahs there has been a collapse-but only two of those seven collapses have involved an Elul 29 day crash. The majority have taken place according to a much larger template.

The larger and, by far, the predominant of the Shemitah's templates is that of a long-term collapse, a collapse taking place over the course of several months, or one in which a rising stock market comes to an end, peaks within the Shemitah year, reverses its momentum, and begins a continuous descent

This historically more typical "template" is exactly what appears to be transpiring before our very eyes as we go into 2016. Polny is going by what is perhaps more significant about this particular Shemitah year - it is the seventh seven year cycle or what the Bible designated as the Jubilee year, the 50th year after the 7 X 7 years. This was a more extensive debt restructure in ancient Israel. Historically, this year sees some huge turn point in the life of Israel. The previous Jubilee year was 1967, and Israel won the miraculous Six Day War and took over Jerusalem for the first time in 2000 years. The Jubilee year before 1967 was 1918, during which the Balfour Declaration gave a homeland to the Jews and began modern Israel. To get the next Jubilee year, you go from Septembers and the fact that the 50th Jubilee year is also the first year of the next 7-year cycle:

Polny anticipates our current Jubilee year, 2016, as the curse side of this cycle, a credit collapse with a stock market collapse as well.

And now for something totally different from the chicken scratching of technical analysis, parsing lead group behavior, fractal cycling, and divining ancient Hebrew numerology. We have a remarkable recent invention by James Picerno that involves a quantitative approach in predicting market crashes. Back on June 24, he posted at his website, The Capital Spectator, the result of his extensive research, where he settled on an eclectic mix of 10 key metrics that have been precursors of the major bear markets. He calls this the CRI for Crash Risk Index. If you've read much of his work here at SA, you know that he is mainly an economist who does fundamental analysis. His list of the 10 metrics does, however, include some key technical conditions.

The above is the result of applying this list of 10 metrics to the last 19 years. Each of the 10 factors is given equal weighting and is a binary 1 or 0 value. When the list goes over 0.5 (the red line) half the metrics are flashing red, and an early call on a major bear market is given. Notice this indicator has had no false positives in 19 years with the only two crossings of the red line resulting in the two major bear markets during that time. And it has just now crossed over to "the dark side" as James called it in his recent SA article.

The methods of all the above are all quite independent of each other. ECRI's methodology is proprietary, but presumably fundamental in nature with only key measures of the economy's numbers. The lead group analysis is technical, but attached to the basic notion of certain areas of the markets typically following other areas. The counters are purely technical. The 7-year cycling is, well, just plain weird. The CRI is a well studied combination of fundamental and technical measures. All of these methods come with very good historical prediction records, and all are in agreement on 2016 - not only down, but way down. The canaries are dead, the elephant is just fine, and the mine is a very dangerous place right now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.