This article presents a new mathematical approach for identifying a significant top in the US stock market. It is an update to a previous article "US Stock Market TOP Is Now In Sight" published October 24, 2014 which can be found here.
- In June 2014, the DJIA (Dow Jones Industrial Average) index signaled that a significant US stock market top was near and would be reached within a few months up to perhaps a year.
- In July 2014, a new market timing tool calculated that the market top was most likely to occur in specific windows of opportunity, either late July 2014, Oct/Nov 2014, year-end 2014 or the 4 month window from May 2015 to August 2015.
- Analysis of previous market tops and market bottoms shows that these windows of opportunity are close to 100% accurate.
- The market timing model predicted that the resulting market drop for the DJIA was likely to be at least 12% and could be as much as 33%.
- As predicted, the major US stock market indexes have recorded significant highs in the period May 2015 to August 2015, and in addition, the DJIA has already recorded a 16% drop exceeding the 12% prediction.
- The current rally from March 2009 is one of the five longest rallies recorded over the 130 year history of the DJIA (1901, 1929, 2000, 2007 and the present) and the previous 4 rallies did not end well. At least a 40% downturn is anticipated.
- US indexes are NOT in a bubble, however, a number of US stocks are in a price bubble and are currently suffering serious losses.
- The resulting US stock market downturn could last 2 to 3 years.
- The Chinese stock market bubble burst in mid-June 2015 and stock market bubbles in Argentina and Venezuela will burst soon.
US STOCK MARKET TOP SIGNAL FOR THE DJIA
In mid-June 2014, the Dow Jones Industrial Average (DJIA) index signaled that a significant US market top was near, using a proprietary market timing model developed over the past 10 years. This DJIA market top signal only happens, on average, every 6 years, and has been recorded 21 times since the start of the DJIA index in 1885, over 130 years ago. The signal occurs at major US stock market tops, and was triggered in 1999 before the 2000 market top and again in 2007 before the previous market top in October 2007.
The signal is 100% accurate, since all 21 instances of the signal have led to significant market drops. The signal also occurred prior to the 1929 stock market crash during the US Great Depression and prior to the 1987 US stock market crash. There have been no false positives.
Analysis of the 21 previous occurrences of the signal provides the following statistics. The average delay between signal and DJIA stock market top is 39 weeks (about 9 months). The minimum DJIA drop after the signal was recorded is 12%. The average market drop is 33%. The worst market drop was 90% during the US Great Depression. So at the current time we can expect a drop in the DJIA of between 12% and 33%, perhaps more.
The market timing model cannot pin-point the exact moment that the market top will occur. For this reason, a second market timing tool, based upon the identification of non-linear price wave-forms, was built to provide a more accurate likelihood of when the market top would occur.
The new market timing tool, developed in July 2014, was used to determine a number of possible windows of opportunity to pin-point the timing for a significant stock market top. The first four windows calculated by the tool are :-
 A two week window in July 2014
 A seven week window from early Oct 2014 to mid-Nov 2014
 A four week window from mid-Dec 2014 to mid-Jan 2015
 A four month window covering May 2015 to Aug 2015
Below is a chart showing the four windows of opportunity (numbered red boxes) as they were first calculated, during the summer of 2014, shortly after the market top signal was recorded in Mid-June 2014. Although not shown on this chart, a further window 5 was also calculated covering 3 months from March 2016 to May 2016. The US stock market has lost momentum during the second half of 2015 and it is not anticipated that a new DJIA all-time high will be recorded in window 5, but instead most likely a lower high.
A significant high was recorded by the DJIA in December 2014, and this looked a likely candidate for a US stock market top. However, a particular pattern that normally forms at market tops for the DJIA was absent. The chart below shows the significant high recorded by the DJIA in late December 2014, in window 3 :-
CURRENT MARKET TOP SIGNAL FOR 2015
A significant high was recorded by the DJIA index in window 3 in late December 2014, and this looked a likely candidate for a US stock market top, however, in early March 2015 the DJIA recorded a higher high so it was now more likely that the DJIA would continue to rise further into window 4 (May 2015 to August 2015).
The issue with window 4 is that it is four months long, which is unusual for windows calculated by the timing tool. Typically, the windows of opportunity only span about 2 to 4 weeks.
As a result of the large size of window 4 it was necessary to try and narrow down where in Window 4 the DJIA might likely form a new all-time higher high. In this case, the market timing tool was re-run using daily data (previously it was run using weekly data only) to gain better insight into the topping process.
The chart below shows two new windows A & B (shown in blue) calculated from the daily chart data. Window B overlaps with the first half of window 4 and indicated, at the time of calculation in March 2015, that the following May or June were likely targets for a DJIA US stock market top.
As we moved into Q2 2015, it was still possible for the market to record a higher high in window 4. This did indeed happen and the chart below shows the significant highs recorded by the major US stock market indexes in window 4. The DJIA and S&P500 indexes both recorded all-time closing highs on the same day in May. The Russell 2K recorded an all-time closing high in June and the NASDAQ Composite (COMP) and the NASDAQ 100 (NDX) both recorded new all-time closing highs on the same day in July. Note that only the NASDAQ 100 (NDX) went on to record a slightly higher all-time closing high more recently in early December 2015. The other four US indexes formed lasting all-time closing highs in window 4.
The chart below shows each of the key US stock market indexes topping out in window 4. The DJIA dropped 16% from its top, exceeding the prediction of 12%. Also the average delay after the stock market top signal up to the stock market top is 39 weeks (see section above), and in mid-2015 we see in the chart below a delay of 48 weeks, a little above the average of 39 weeks but nonetheless inline with expectation.
This work was initially presented in 2015 at the May General Meeting of the NYC Investor Meet-Up in Manhattan. A video of the meeting can be viewed on YouTube here.
Analysis of previous significant market tops and bottoms, over the past 130 years of the DJIA, indicates that 95% of previous market tops and bottoms have occurred during the calculated windows of opportunity, and that the remaining 5% have occurred between two closely aligned windows, rendering this technique very accurate.
A LOOK BACK AT THE MARKET TOP SIGNAL FOR 2000
This section covers the DJIA stock market top in January of 2000. The chart below shows the initial market top signal recorded in December 1999, and the three windows of opportunity calculated to cover December and the first five months of 2000. The new market timing tool has been used retrospectively in this case.
A LOOK BACK AT THE MARKET TOP SIGNAL FOR 2007
Similar to the previous section, this section covers the DJIA stock market top in October of 2007. The chart below shows the initial market top signal recorded in May 2007, and the three windows of opportunity calculated to cover the six month period from July 2007 to December 2007. The windows have been calculated retrospectively.
UPWARD PRICE MOMENTUM FAILING IN A PERFECT STORM
An additional reason why a US stock market top might have been expected in Q2 of 2015 was a breakdown of the upward movement in price momentum which all came to a pinnacle in mid-2015. In combination, the upward price momentum for the DJIA on the daily chart, weekly chart, monthly chart and quarterly chart all completed cycles between late 2014 and mid-2015.
The chart below is a quarterly chart, showing the DJIA from 2007 to the end of Q2 2015. The chart was initially presented at the May and June 2015 General Meetings of the NYC Investor Meet-Up in Manhattan. Specifically, the chart shows lines that represent a momentum pattern which completes when the arrow head is reached. The patterns for each of the four time frames (daily, weekly, monthly & quarterly) all complete at about the same time, indicating a 'perfect storm' scenario in the middle of 2015, leading to price weakness and a move downwards.
SIGNIFICANT DOWNTURN SIGNAL FOR THE DJIA
The Santa Rally fizzled the last two days of December 2015, and the levels reached by US indexes at year-end indicated the possibility of a weak 2016 for Equities. The weakness in the Santa Rally did not look particularly significant, nevertheless, the damage done the last week of 2015 has been felt in Q1 of 2016 and will perhaps be experienced long after.
Specifically, the DJIA ended low enough on December 31, 2015 to trigger a signal that only happens a few times each decade. The signal usually coincides with a US recession (as defined by NBER) or serious market correction (as in 1929, 1987, 2000, 2007).
SIGNIFICANT MOVE DOWNWARDS IN THE RUSSELL 2000
Another significant signal is building within the Russell 2K, which has now completed 8 of 9 downward moving candlesticks that form a phase 2 pattern on the monthly chart. The pattern is due to complete at the end of Q1 2016, and if there is no significant rally in March for the Russell 2K, there is a strong likelihood that the full pattern of 9 candlesticks will complete, leading to a significant move downwards in 2016. The chart below is a monthly chart for the Russell 2K showing candlesticks 1 through 8 that are complete and a possible candlestick 9 that might perhaps complete the pattern of downward price momentum.
Although not shown here, a look at the weekly chart for the Russell 2K shows that the month of January was also a down month, which reinforced the downward movement on the monthly chart covered above.
Finally, its is important to point out the repercussions of the chart above. Once phase 2 completes there is a significant likelihood that a phase 3 will follow on, lasting potentially a minimum of 13 candlesticks and perhaps up to 26 or more candlesticks, if phase 3 completes successfully. Since these are monthly candlesticks, there is a possibility that this downturn for the Russell 2K could last another one to two years before a bottom is reached, and that would mean a bottom for the Russell 2K sometime between Q2 2017 and Q1 2018.
HOW LONG MIGHT THE DOWNTURN LAST
The US Stock Market is extremely overbought at the moment. As mentioned earlier in this article, we are now at the tail-end of one of the five longest rallies of the DJIA in its 130 year history. The previous four rallies all ended badly with a drop of between 40% and 90%. There is enough evidence to expect a similar drop this time in at least the range 40% to 50%.
In addition, from a mathematical point-of-view the current overbought price pattern for the DJIA has only been seen once before over the last 130 years and that was at the US stock market top in 1929 just before the onset of the US Great Depression. To unwind this current pattern the stock market has to fall for about two and a half to three years. In contrast, it took three years from 1929 until 1932 for the DJIA index to reach a bottom during the early part of the Great Depression.
The difference here is that the DJIA was in a 'price bubble' in 1929 which had to burst and fully deflate, hence the 90% drop in DJIA index during that period in history. Right now in 2016, the DJIA is NOT in a price bubble formation, and hence I am not expecting a crash in the index, nevertheless, I am expecting a period of time to fully unwind that is similar to the period 1929 to 1932.
Finally, I want to add that this process of unwinding the price may not happen right now in 2016. It may be next year or the year after or the year after that, but it has to happen soon, and when it happens it will take about 30 to 36 months to complete, from a purely mathematical point-of-view. Since we are at the top of a massive rally, with a bubble bursting in China, it is looking more and more likely that the process of unwinding will happen now rather than later. Another issue suggesting we will see a significant downturn is the presence of price bubbles currently in individual US stocks, and this is covered in the next section.
BUBBLES IN US EQUITIES
A new approach has been commissioned to identify and track price bubbles. Specifically, a new mathematical model has been developed by the author to predict, identify and classify stock market bubbles.
The mathematical model works for all national and international stock market indexes (such as DJIA, S&P 500 and China's Shanghai Index etc..), for all individual stocks (such as Apple Inc. and Facebook etc..) and also for commodities (such as Oil, Gold & Silver etc..).
At the current moment in early 2016, the US stock market is NOT in a bubble, far from it. The stock market is very over bought and it must at some point unwind, but it is not in a bubble. However, there are multiple stocks in the DJIA, S&P 500 and NASDAQ 100 that are themselves in a price bubble.
Within the DJIA, there are bubble formations in Apple (NASDAQ:AAPL), Boeing (NYSE:BA), Home Depot (NYSE:HD), American Express (NYSE:AXP), United Healthcare (NYSE:UNH), Visa (NYSE:V) and Disney (NYSE:DIS). Across the other US indexes we can see bubbles in Google (NASDAQ:GOOGL), Facebook (NASDAQ:FB), Netflix (NASDAQ:NFLX) and Amazon (NASDAQ:AMZN) plus many more.
The following chart shows the bubble in Apple and is from an article published by the author in February 2015 "A TOP Formation In Apple Inc. - Crash Condition Signal Recorded" which can be found here.
Once a price bubble forms (whether it be an equity index, an individual stock or a commodity) there will be a price drop of at least 30% to 50% and perhaps more. The bubble must fully deflate before the stock price can form a bottom and grow again, and full deflation will only occur when such a drop of at least 30% in price is recorded.
The following chart shows the bubble in Apple and the drop in price since its high during the first half of 2015. The price of Apple stock must fall below the dashed horizontal black line, as a minimum, before the bubble can fully deflate.
Currently, we see global equity markets at or past all-time historic highs and commodities at or close to all-time lows. We see bubbles in equities both home and abroad suggesting that equity markets are in an unstable state and need to re-set significantly. That process is already underway.
For those who study long term cycles in the economy, some believe we are at the tail-end of a multi-decade Kondratiev cycle. Hence, a huge re-set is upon us and there is little that governments and central banks can do about it, except prop up the markets as best they can.
BUBBLE TROUBLE IN CHINA, ARGENTINA & VENEZUELA
The stock market in China (Shanghai Stock Exchange - SSE) started to grow exponentially from late 2014 into early 2015 and formed a price bubble that topped out in June 2015. The bubble in China is currently deflating (at the time of writing this article in February 2016) and still has some time to go to fully deflate and reach a bottom.
The following chart shows the bubble in the Shanghai Composite index with a score of 96% recorded in June 2015 by the price bubble model, indicating that a market top was very close at that time.
The stock market in Argentina (MERV index) continued to climb higher from early 2013 through to late summer 2015, and the growth in the bubble that has formed has been so prolific that the status of the bubble changed quite early on in September 2014 from a 'Super' bubble to a 'Mega' bubble, now the largest type of bubble that stock markets reach before bursting.
This classification approach has been devised by the author to differentiate between the various sizes of bubble that form. About 80% of price bubbles are all very similar in size and are classified simply as price bubbles. About 15% of bubbles grow larger in size and are called 'Super' bubbles. Finally, about 5% of bubbles grow much further beyond 'Super' bubbles and are then classified as 'Mega' bubbles, the largest type of bubble.
Over the summer of 2014 Argentina's index completed an upward momentum sequence of phase 1, phase 2 and phase 3 with phase 3 count #13 being reached the last week of September. This formed a new all-time high at the time followed by a sudden drop during the first few trading days of October 2014 as investors looked to book profits. The downward momentum stalled and the index rose again into late 2015 to form a new all-time high. Again, the index completed an upward momentum sequence of phase 1, phase 2 and phase 3 with phase 3 count #13 being reached at the end of November 2015. For a second time, investors booked profits and the index fell sharply into early 2016, but has risen one more time. It is not known whether a new all-time high can be reached again.
The chart below shows the huge bubble formation in the MERV index, and a score of 98% recorded by the price bubble model, so a top is now very close if not already recorded.
Remaining in South America just a little longer, the stock market in Venezuela (IBC index) is also in a 'Mega' bubble state. The IBC index reached a new market high in August 2015, climbing above the previously recorded market highs, and is currently in February 2016 above the high of August 2015 recording new all-time market highs almost each day. The economy in Venezuela is being hampered severely by the low price of oil, since oil export is a major industry and revenue stream for the country. Also, Venezuela is suffering from very weak currency exchange rates when compared with other key world currencies, making issues at home in Venezuela much worse.
The chart below shows the huge bubble formation in the IBC index, and a score of 95% recorded by the price bubble model, so a top is now very close.
US TREASURY 10 YEAR BOND YIELD
The yield on the 10 year US Treasury note continues to head lower with consistent downward momentum. Evidence of the move lower is present on the $TNX yearly chart. This is despite signals from the US Federal Reserve Bank FOMC Committee that the FED funds rate will rise over coming years during a period of rate normalization.
Turning back the clock to early 2014, a prediction was made by the author that we would see a lower low in the yield of the 10 year US Treasury note, below the all-time low of 1.39% recorded in mid-2012. Despite the fact that many believed the low in 2012 was in fact the bottom.
The reason for the prediction of a lower low was the identification of a downwards momentum pattern that was almost fully formed on the yearly chart of the yield of the 10 year US Treasury note $TNX. The chart below shows a completed phase 1 and an almost complete phase 2.
In order to complete phase 2 successfully, it was necessary that a final ninth candlestick be recorded for 2015, and that this would likely lead to a double bottom or a lower low in 2015 or perhaps 2016. The chart below (created April 2014) is an extension of the chart above and shows a prediction for 2015 with an extra candlestick 9 added to the right of the chart.
In order for candlestick 9 (representing 2015) to complete phase 2 successfully it would need to close below the close of candlestick 5 (representing 2011) and this would likely lead to a double bottom or lower low.
Now moving forward to the current time (February 2016) we see in the chart below that candlestick 9 did not close below candlestick 5 so the full pattern for phase 2 did not complete successfully. It appears that the small rise in the FED funds rate in December 2015 (and all the press coverage leading up to it) might have been sufficient to keep US bond yields moving higher during the final few months of 2015 and break the phase 2 pattern.
Despite the failure of phase 2, it is still possible for the next candlestick after 9 to be a strong down candlestick reflecting the strong downwards momentum building over the previous decade. Indeed, in the chart below we see that the low recorded for 2016 is very close to the all-time low of 2012, and it is still anticipated that we may see a double bottom or lower low over the next 12 to 24 months.
Hence, a continued move lower in treasury yields through 2016 into 2017 and perhaps beyond, would be consistent with a "fear trade" brought on by the threat of a US recession and/or a major downturn in the US stock market. Indeed, the threat of a global recession would push many investors towards Gold and Silver and in particular US government bonds as a move towards a safe haven, forcing bond prices higher and their yields lower.
This article has presented a new mathematical approach for identifying a significant top in the US stock market. The approach developed in 2014 predicted a stock market top in a number of possible windows or time-frames from mid-2014 to mid-2015, and in mid-2015 five of the key US stock indexes topped out in one of the predicted windows of opportunity. The technique relies upon the identification of non-linear price wave-forms, and can used for stock indexes, individual stocks, commodities and bond yields.
Over the 130 years of the Dow Jones Industrial Average (inception 1885) there have been 21 instances of the market top signal. Examples of the US stock market tops of 2000 and 2007 have been presented. Currently, there are no false positives for the technique, so there is reasonable expectation that we have experienced a major US stock market top and we are now entering a significant downturn.
Analysis of previous rallies suggests that the downturn may last two to three years with a bottom expected somewhere between Q2 2017 and Q1 2018.
The technique predicts a minimum price move downwards of 12% which has been exceeded by the 16% drop in the DJIA in August 2015 and again by a similar sized drop in Q1 2016.
In addition to the new mathematical model that predicts the timing of a stock market top, there are other key signals recorded over the last few quarters that provide additional evidence that the US markets are head lower through 2016. A key signal was recorded by the DJIA during the last week of December and this signal only happens a few times each decade. The Russell 2K index is also showing a very strong downturn which could continue for another year or two.
There are significant price bubbles in well know US stocks which all have to deflate fully, and hence which threaten to cause a serious downturn in the US markets as the deflation process completes.
In addition to price bubbles in US stock there are also bubbles in international indexes. China is in a price bubble and has partially deflated since the peak in June 2015. Price bubbles also exist in Argentina and Venezuela, which have yet to burst and return to a fully deflated state. All price bubbles burst with spectacular effect and deflate back to a price consistent with a point where the bubble started to grow exponentially. There are no exceptions.
The yield on the 10 year US Treasury note has continued to head lower with consistent downward momentum. The reason behind the move lower has been presented using yearly charts of $TNX. A prediction was made in Q2 2014 that the yield on the 10 year note would re-test or go lower than the all-time low of 2012. This has almost been realized and if there is a significant drop in th US stock market (and global markets) there will likely be a further move into US government bonds for safety. The move to safety will take yields lower and cause a problem for the US Federal Reserve Bank as it continues a policy to slowly increase the FED funds rate in the face of collapsing bond yields.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.