http://www.financialsense.com/editorials/williams/2006/1017.html<snip>
No one seems to know exactly how, but from one day to the next, summer ends and fall begins: you can feel it in the air. If the current set of measurements on SPX are correct, we should be noticing the difference at almost any time. The market has run a bit higher than we anticipated with the .618 retracement of the Y2k bear market having measured to around SPX 1260. But what may have been short squeezes powered the market higher until the weaker hands had withdrawn. Now it looks increasingly likely that .764 will be the retracement that provides the resistance robust enough to stop the market rally. The fact that oil appears to be forming an important bottom along with interest rates may signal the sea-change that brings on the next trend direction and with it at least a significant correction, but potentially a great deal more.
The Dow hit its new highs while Nasdaq has only retraced .313 of its bear market, which is remarkably weak by any measure. The fact that large caps were the locus of strength suggests that a flight to quality or perhaps a new ‘nifty fifty’ scenario has transpired over the last couple of years. Mid caps hit highs in May but now are retracing just about the same .764 as SPX since the top. The same is true of small caps, implying that the forces that could make new highs across the board unreachable may have already begun to act upon smaller companies. Their large cap brethren may not be far behind, with only their huge scale economies and marketplace leverage driving the longer staying power. With profit margins failing to make new highs for the 1st time since ’94 or so, it suggests that unless 3Q06 promises to show higher levels of earnings needed to surpass the 8.74% peak in SPX, the market may not be able to find sufficient fundamental growth to sustain recent price gains. With inflation data coming out this week, the turning point may be upon us.
The motivators for higher oil prices may be incrementally higher demand, but OPEC just lowered their aggregate global demand forecast implying that the issue is supply. The emergency meeting of the oil Cartel will likely provide loud voices for slowing production in order to diminish over supplies and to drive prices back up to the deliriously profitable levels of the spring and summer. Oil indices are close to highs and oil stocks are robust as well, but we notice a significant divergence in momentum, which could complicate the situation over time. Trying to connect the dots in order to understand the picture that charts represent is a difficult task, one that is subject to surprises. As of now we suspect that the global economy and the US in particular are weakening quicker and further than desirable, threatening to end the expansion on any Fed miscalculations. We have opined that the distortions in CPI brought about by changes instituted by Greenspan understate inflation by 2%-3%, with much the same data going into the GDP deflator calculus, and could precipitate an overly restrictive monetary policy stance. The effect would be to tighten more than necessary because the key indicators used recently like PCE represent inflation long after its initial resurgence and so will report its retrenchment commensurately later than would be needed to make a soft landing possible. Oil prices could be telling us that demand is greater than we realize, but that the combined tax of fuel and interest rates will stall the consumer and therefore the economy. The effect might be the same, yet arrived at through a different set of conditions. At least we will know soon.
Consumers are losing their much-needed relief from high fuel costs. The reality is that conservation is difficult at best and requires considerable time to fully implement, making fuel costs stay stubbornly high despite a lowered standard of living. Interest rates further exacerbate this situation by driving away refinancing that could save many households from substantial financial duress. After the last 3 years of massive refinancing activity, the majority of mortgages based on floating rates or hybrid structures are coming up for resets. If unallayed, this will drive costs a great deal higher for affected consumers. While fuel costs are highly visible and very annoying, the decision to continue driving or heating is realistically not up for much debate. As prices climb higher, consumers are forced to find the money from other sources. Compared to mortgage resets, fuel costs represent a small fraction of total annual costs for households. Accordingly we suspect that Xmas will be the first time in memory that parents are compelled to cut back on spending in order to stay afloat. The more realistic of the hybrid mortgage holders will choose to sell their homes event at sharply reduced profits because they recognize the need to stay liquid and to live within their means to avoid serious financial problems. The less prudent will find their mortgages in default and their homes subject to foreclosure. The forced sale of millions of homes may set off something akin to a margin call across the real estate marketplace taking prices down sharply and thus setting off another round of forced liquidations. This cycle could be a key contributor to what we are concerned will be a coming recession.
Retail Sales data show a marked downtrend since early summer and when charted with food and energy, the drop has been precipitous. With inflation being propped up in the PPI by tight wage markets around the country, an uptick in Core PPI or CPI could foment a major surprise in the market: a rate hike just when consensus thinking was betting rate cuts would begin early in ’07 to facilitate a soft landing. With all the noise made by the talking (Fed) heads lately, it should come as no surprise that a rate hike is being seriously considered. Still the market can look at strikingly negative data and placidly ignore it while pushing the Dow to another record close. As long as bears are active in the market right now, the vicious short squeeze that has taken the market higher going back to 9/11/06 when short interest grew to outsized proportions and invited raids by professional traders and bulls. Once the buying pressure is largely completed, the firepower to sustain the upside in the market will be tested by the few bears with remaining ammunition. If they succeed in moving the market lower, then we can expect several waves of panicked selling to replace the short squeeze, giving the bulls a taste of the same medicine that cured many bears of any desire to test the market’s mettle. We think that on the heels of an oil rally starting out of a nice wedge reversal pattern and rates moving into another bullish wave higher, the market may finally be at a point where buyers can no longer support it, setting off a correction but one that could easily turn into much more.
The market pattern is one of an extended retracement rally from the ’02 lows, one that usually stops at 50% or 62% of the lost ground. This time, however, the market has run substantially further and made it to the 76.4% retracement level, which represents the last major resistance zone before new highs. Our count of the wave structure is one of a corrective nature with 3’s rather than bullish 5’s, but these counts can be misleading until they are complete which keeps the uncertainty high until just before the trend terminates and reverses. Our discipline will not turn bullish until a fast move has taken the market back through supports in the near term and on heavy volume and confirming momentum. It is this way we try to avoid whipsaws like May/June proved to be for many in the marketplace. So far the pattern reads to us as a corrective 3-3-5 formation that is typical of retracement rallies. It is reasonable, however, to count this bull-run as a bullish 5 wave affair and may be necessary should the market surprise us and make new highs across the entire market capitalization of stocks. That is in our opinion of the (dare we say defects) idiosyncrasies of Elliot Wave analysis.
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