US Stock Market: Slave Of Destiny?

The Master Chart indicates that a gut check IS looming out there. Here’s how to spot it coming.

“Whereof what’s past is prologue; what to come, in yours and my discharge.”
- Antonio in William Shakespeare’s The Tempest

Technical Analysis is peculiar in that it is completely devoid of moral judgment. Much like weather forecasting and horse race touting, it simply notes past behaviors and posits that, in similar situations, those behaviors have a certain probability of repeating themselves.

Doesn’t matter if the behaviors under study are wise or stupid, creative or self-destructive - TA just attempts to note the frequency with which certain patterns follow certain setups. It is, in essence, a graphical form of statistical analysis. As such it answers questions best when applied to large groups of actors over long periods of time.

Right now, the question we all want answered is: “How far the current rally has left to run.”

Too Much Overhang?

Economically speaking, it ought to be dead in the water by now, what with all the overhang from such threats as “falling wages, falling revenues, brutal cost cuts, imploding state budgets, contracting credit lines, rising unemployment, rising credit defaults, rising construction loan defaults, rising government debt issuance, and rising consumer savings.”

(Yes, I cut and pasted that from Justice’s column, but it’s as good an elaboration of these threats as any, and as Justice mentioned, we are both getting tired of typing these depressing lists over and over again.)

And yet, the market stubbornly refuses to roll over and die. Instead, we have seen eight consecutive months of share price increases.

Washington’s Very Visible Hand

Most all of that price increase is the result of both gross and specific manipulation. “Gross manipulation” in the form of trillions of dollars being force-fed into the economy. There’s no question about this, no stealth or secrecy: Washington has boldly declared its intention to print dollars until our eyes bleed and our bank accounts collapse.

“Specific manipulation” in that much of the rally’s actual “gains” have come from such bankrupt government-owned entities as AIG, whose shares can gyrate 10% or 25% in a day because they have no inherent value to slow them down. They simply trade for whatever price sellers can stick a rube with.

Morally bankrupt? Oh yeah! Self-destructive? In the long run, no doubt what so ever.

Does TA care? Not a whit. It simply notes that the market has done this. And perhaps more importantly, that it has done something remarkably similar in the past.

The Prologue

View Larger Image Here

Here again is my “Master Chart” of the S&P 100 (^OEX) - the hundred largest U.S. traded stocks displayed in monthly candlesticks. Let’s take a good look at 2003.

By 2003, the markets had been in the toilet for two years and the economy wasn’t much better. Unemployment had doubled over the past few years and Washington was trying to print its way out of trouble.

All the Same Markers

The specific numbers vary a bit - for instance, Washington would kill to get unemployment down to 2003’s 6.25% - but the overall set-up then is similar enough to now to be worth copying and pasting over our current market situation.

In 2003, we hit trend bottom and cornered. This corner was intimated when price broke through the seven-month average, and confirmed when the 13-month average was broken. From there, price rose fairly directly to the 50% line of the falling trend before dropping back to the 61.8% marker for a “gut check.”

So far this year, we have seen four of these five moves play out in almost the exact same fashion. We have seen the corner set at the bottom of the long-term falling trend. We have seen resistance at the seven- and 13-month moving averages broken. And we have seen price move to the falling trend’s 50% marker.

Another Losing Year?

Does this mean that the next year will yield a 10% drop, just as we saw in 2004? That the markets will rise for four years after that? Or collapse again once we reach the top of the falling trend?

Are we merely predestined puppets dancing on history’s strings? Quite frankly, TA can’t answer those questions any better than, say, a “magic eight ball” for two reasons.

One is that it cannot take new events into account. For example, in 2004 we were concerned that perhaps we had reached the top of the curve where oil supplies were concerned. Now we hear tell of BP (BP) discovering enough oil in the Gulf of Mexico to virtually sideline OPEC’s sheiks for decades to come. TA’s other failure is that it cannot anticipate changes in behavior such as the massive falloff in energy demand that is currently keeping oil prices pegged at or around $70/bbl.

Slave of Destiny? No, Just Habit

Indeed, Shakespeare’s famous line is oft misquoted. It does not say that we are slaves to prologue, but rather that the past sets up our future choices. It’s just possible that we could decide to do something different for a change.

But TA works and works really well for one reason: Change is the least likely thing of all. We are creatures of habit, especially in large groups, and therefore it is far more probable that we will follow in the footsteps of the past.

In the long run, we most probably will keep printing money until it is too late and inflation disrupts the rally at the top of trend. The herd most probably will buy the illusion that we actually grew our way out of the hole. And the wise hands who remember these endless repetitive cycles are most definitely buying gold all the way up.

Practical Tactics

As for the short run?

I wouldn’t necessarily dump off stocks right here and now. That would be like standing in front of a fast-moving truck driven by a drunken madman. Morally, the correct thing to do. But still somewhat painful.

But that gut check - be it a mere 10% or more - is looming out there somewhere. So I sure as heck would take a page from the wise-hands book and hedge myself each step of the way with generic short market positions (in WaveStrength Options Weekly we are deploying Diamond puts), and long gold/short-dollar positions (here we are focusing on calls against a short dollar fund).

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