Wednesday, September 23, 2009

How do we Know the Market Will Tank? September, 23, 2009

Here is a question asked by a reader:

Hi Todd, how do we kow from a tecnical point of view that the stock market is ripe to fall off a cliff? Could you pls expand on this

The answer to that can be quite long and in-depth, but I'll try and sum up with the following bullet points. The technical reasons are addressed in the first two bullets, and I followed them up with fundamental reasons as well:

- the market previously declined in 5 waves (see right side of blog "Long Term S&P Futures Chart"), so the larger degree trend is down. This means it was either an A wave, or wave 1, which means once the correction is over then either a C wave or wave 3 will occur. Both waves' characteristics are that of fierce strong moves. (I will post an updated version of that long term S&P chart soon).

- optimism is at an extreme higher than at the October 2007 top. Sentiment measures, such as the Daily Sentiment Index is at a level that is higher than where it was at the 2007 top, yet the market is 500 S&P lower than where it was then. Bull markets climb a "wall of worry", and with less than 10% bulls surveyed, there is no wall of worry. Plus, just watch CNBC for 20 minutes everyone's doing cartwheels over the market. The most bearish person you'll find on their says the market will pull back 10%. But no one questions the rally or whether the March lows will be tested. This type of blind optimism is what formed the October 2007 top, and it will form the wave 2 top here soon as well.

- the market is undergoing huge credit deflation established over the past 30 years. Asset prices collapse during this period as the only thing driving the market and economy higher (credit) dries up and becomes almost non-existent.

- the housing market mania is over, and most likely for the much foreseeable future. So consumers can no longer use their homes as ATM machines, putting pressure on consumer based businesses. Despite the spin put on recent housing data, the housing market for the average American family has had next to no recovery.

- unemployment is not easing and there are no real industry leaders to hire the unemployed. So where's the employment going to come from? With their home equity gone, and their jobs lost or at risk of being lost, how much are consumers going to spend? Who's going to push this economy up?

- where's the recovery? outside of government stimulus, which stimulates nothing, there has been virtually no recovery based on fundamental data. Firms have been able to squeeze out good earnings and outlooks due to price slashing and downsizing. But these are short term solutions based on a recovering consumer, which as I stated above looks unlikely to occur soon. When investors see that there is no recovery and their highly inflated speculated wave 2 rally is all "fluff", they will sell massively, giving way to wave 3. Most housing bought was done by speculators and investors planning to flip the homes, not new families moving in, and most of the houses bought were done at foreclosure sales with drastically reduced prices.

- banks are bankrupt. Most banks are technically bankrupt due to rotting worthless loans that they just continue to repackage in order to create the window dressing of a successfull financial institution. The fact of the matter is that they are failing miserably and their rotting assets are not turning higher. Despite the Fed's efforts to capitalize banks to open the credit markets for them to lend, most banks have not done so and instead of decided to hoard the money on their books.

There is plenty more to fuel the thesis that the market will crash soon, but above is the core of it. In the end, EWP analysis rules the day, and with 5 waves down since October 2007 it is screaming at us ellioticians that either a wave 3 or C will destroy this market soon.

I welcome any questions and/or critiques.



Anonymous said...

Hey Todd. I have a question, one no EW theorist can explain to me. What I'm wondering if the following: the majority EW counts I see on EWI and blogs such as yours claim that we are in for a P3 or C down which seems to target somewhere in the sub 4000 DOW or sub 400 SPX. This seems to be based on the idea that a supercycle wave III topped in 2000. If one does NOT subscribe to the supercycle top theory, is it not possible that based on the monthly chart of the DOW, that 2000-2009 was the completion of a secular bear market and the low at 666 is the ultimate bottom? Can the last 9 years in the DOW be an expanded flat (a-b-c pattern), with 2000-2003 being a down, 2003-2007 being "b" up, and 2007-2009 being "c" down {there were 5 clear waves from 2007-2009}. How come this cannot be the primary count? In expanded flats, according to EW theory, wave "c" does not extend much past the end of wave "a", which on the monthly DOW the market has completed. Why can't this be the most likely count and the bear market be over?

Todd S said...

It’s a good question and one I’ve asked for a long time as well. The market CAN be doing what you’re saying (and what I once thought) in that it just completed wave C of a flat correction. However it’s not a primary wave count because the fundamentals, technicals, and the current rally structure from March 2009 do not support that. EWP alone may allow for the flat correction to be a possibility, but it does not account for the choppy non-impulsive nature of the rally since the March lows. It also does not coincide with the collapses and wave counts in real estate indices, gold, silver, credit contraction, the impending major dollar rally about to start, etc. etc., nor does it account for optimism measures already reaching extremes that accompanied the 2007 top. If the bull market has resumed, it is doing so without EWP and the fundamentals and technicals that should support it.

So my best explanation is for you to do what I did when I had to answer this question. Take a step back and look at the whole picture, not just the wave structure up until March of 2009. You will see that the fundamentals, optimism measures, and wave count since the March 2009 lows do not conform to what the start of a new bull market should be composed of. I cannot create an impulsive 5 wave rally from the March lows, no matter how creative I get. And of course, all of this is just my analysis and best idea of what’s happening next. I’m in no way claiming I know all and have the correct count. This is just my best guess, and the reason why the flat corrective scenario is not my primary count.

Hopefully that helps. If not, let me know and I’ll try to further explain my position.

Anonymous said...

Thanks Todd! The March rally definitely does not look like 5 waves, I agree. I do not believe the lows are in either, but I am trying to find a count that makes the most sense without having to allow for a sub 100 SPX target. The best one I could find is the following (please tell me where I'm wrong, as I am an amateur to EW theory). If I assume that the secular bear market (2000-present) AND the most recent 2007-present decline are both NOT over, then I see a 5-wave decline from the 2007 top that is currently in a corrective wave 4 ABC zig-zag. I have primary wave 1 down ending in March 2008, wave 2 up ending in May 2008, wave 3 down ending at the March 2009 low, and presently in the process of carving out a wave 4 up (likely an ABC zigzag) with a target in the 1000-1100 area, but even as high as 1200 or marginally higher. This would seem to indicate the final wave 5 of this bear market will bring about a target of 500-600 SPX. This makes the most sense to me as I don't believe the lows are in, and there is a huge amount of century-long support in that exact area that I can see. What do you think? Am I incorrect in such an interpretation? Thanks and keep up the good work.

Todd S said...

Your EWP analysis does not violate any rules, therefore it's a possibility. However it does violate EWP guidelines for the "right look" and social mood characteristics, so it would be an alternate wave count in my opinion.

The reason is that wave 2 and what you propose as wave 4 are not proportional, i.e. wave 4 is too strong and long compared to wave 2. Wave 2's are normally sharp and wave 4's tend to be flat or sideways. But this is just a guideline, not a rule. But more importantly, wave 4 is far bigger and longer than wave 2. This does not give it the right look.

Lastly, wave 2's accompany a social mood of euphoria similar to where it was right before wave 1 down started. Most people think that wave 1 was the end of the entire decline, and so wave 2's tend to be real sharp because no one wants to miss the big bull market to new highs, which never come by the way. Whereas wave 4's are just a pause in the larger trend. The social mood, as proven by metrics and indicators on sentiment, show that social mood is more characteristic of a wave 2, not a 4, right now.

So in summary, here's why I would place your count as an alternate:

1) Waves 2 and 4 are not proportioned
2) Wave 4 is too sharp and long compared to wave 2 (kinda the same point as 1 above)
3) Current social mood supports that of a wave 2, not a 4.

Hope that helps and makes sense. Let me know if you have any other questions.


Anonymous said...

Thank you. Your response is much appreciated and very informative. From what you said, this certainly does feel like a primary wave 2 up based on the strength of the advance, but that concerns me because that means the market won't bottom until a LONG way down from here, below 500 SPX, which I personally, as a trader, don't mind. However, I have friends and family who are still invested in this market and if not even I can fathom a sub 500 SPX (and I have been super bearish since 2005), then I fear what is in store for them. Thanks again.

Todd S said...

You're welcome! And yes it is scary, and it's also hard to believe. After the rally we've had, a break beneath the March 2009 lows will be devastating for banks and the financial system. It will break many of them and average people's money will literally just disappear.

I tell my friends and family who have retirement to put their money in 3 month T-Bills, savings accounts, cash in a safe in their house and gold.


Anonymous said...

Todd - I am fairly new at EWP and find your site very informative. EWP aside for a minute, I see our government setting in place so many anti-business, anti-capitalism, anti-free enterprise, and pro-tax policies and laws that most days I wonder what keeps this market up where it is. Back to EWP - now that S&P has crossed 1067, actually reached 1070 on 8 Oct, does this alter your view on the large leg down coming?

Todd S said...

You're right about our government, and those chickens will come home to roost one day. As you can see from my blog, I'm predicting that will happen sooner rather than later.

Regarding EWP and the market: no it does not alter the big picture of the market, but it does alter thet timing which is proving very difficult to predict. The market action this week strongly tells me that new highs (above 1080 in the S&P) will be acheived soon. But it's just another delay in the inevitable. The collapse is coming, but as I'm sure you're tired of hearing, the timing is the most difficult. But it's coming.