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Friday, September 17, 2010

The Big Picture: Technicals and Macro

This will be another rambling post (probably). I want to talk about the big picture again, and why I still think the counts are much more complicated than most are thinking.

Let me go back to Ponderings:

Okay, as you know I have been doing a lot of thinking about the wave structure recently. I have a few posts that talk about the 'incongruities' that I am seeing:

1) There is no clear impulsive count down so far. This is the closest thing to a 1-2, 1-2 and frankly it is becoming less compelling all the time: Spurn. On top of that, the FTSE made a higher high than the August high (see Spiel). Because the FTSE and the SPX have been moving in tandem, with the FTSE slightly leading, this really hurts the 1-2, 1-2 case for the US indices.

2) The current LD count going around makes me want to barf. It is not a wedge. It is vaguely wedge shaped, but that's it. The trendlines are not converging. The more I look at it, the more I am convinced that the count is not right: See this chart from Spiel.

3) So is the count corrective down? I have been pondering a triangle option, Spurious. But there are a few major problems: the triangle is highly disproportionate to the down move and there is not a valid triangle on the INDU and FTSE (they are sporting wedges).

4) Could we still be in P2? ... Possible, but I seriously doubt it. Based on all of the macroeconomic and fundamentals problems I really don't buy that case. Plus April was a sentiment extreme: Everybody is a contrarian indicator!! What is the actual sentiment like?. The April top really looked and felt like a capitulation top.

.... So where does that leave us?

With no clear answers, that's for sure. But MTU has a great post up that might provide some clues: MTU Weekend Ed. - Moment of Truth (9/10/10 Close).

A proper LD that we are still in the middle of.

When you consider the fact that the FTSE has already bettered its Aug high, then the odds of a 1-2, 1-2 down for the US indices are greatly diminished. So I think all of them are still in a Minor 2. Even if the US indices do not better the August high (making a truncated C wave) I am now thinking it is still in the context of Minor 2 (not Minute 2). But there are far too many problems with a cleanly impulsive down count from the April high (I know, this is what I was pulling for, but the amount this wave is dragging on is forcing me to reconsider).

Lets revisit these. Because I think there are a lot of incorrect assumptions being made about the wave structure.

First, the obvious:

The 1-2, 1-2 count is dead for pretty much every index (which I had abandoned a few weeks ago: Spiel). Also in my opinion the 1-2 (Minor) count is dead. Whether it be an impulse down ending on May 25 with a very lengthy triple-three Minor 2 (which looks *ridiculous*), or the highly implausible LD count with the LD ending in early July (see this chart for why I completely disagree with that count). The Minor 1-2 does exist in a less obvious form, though (IMO). More on that in a minute.

Second, the macro:

I was questioned (accosted?) recently by a commenter with a smarmy (and unfortunately common) attitude regarding macro analysis and technicals. I agree that there are times when the macro and the technicals can move severely out of whack. The common assumption being that the stock market is "foreseeing" a recovery or move in the business cycle (which I call BS on: http://caps.fool.com/Blogs/market-still-deluding-itself/446288). But I concede that there can be significant countertrend moves between cyclical technicals and the macro environment.

But that time is not now. Here is why I think so:

i) The rally from March 2009 to April 2010 was an oversold bounce / fear-panic reversion / cyclical bear market rally in an overall secular bear market. It was not a meaningful valuation bottom in any historically significant sense: Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?

ii) The reason for that rally was completely driven by monetary events. 2008 was primarily a Deleveraging, and more importantly, a Liquidity Crisis. Flooding the market with Dollar Swaps was by far the biggest factor: Bigger Fish to Fry, and update to Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR

iii) Through 2009 and early 2010 there were increasing fundamentals when compared to Q1 of 2009. This was due (primarily) to massive government stimulus which drove (secondarily) an inventory rebuild cycle.

iv) Yet the "cycle" never took hold. The way an inventory cycle usually works is that businesses begin an inventory rebuild, consumers respond to the supply and real final sales pick up, businesses respond to the increase in demand and continue production, increase hiring, increase capex, etc. Throughout this "cycle" there has been a tepid increase in real final sales and the trend has been dropping significantly the last couple quarters.

v) This is precisely why businesses are not (by and large) hiring or going forward with capex projects. They are nervous regarding consumer behavior. They are also nervous regarding the business environment (taxes, regulations, etc.)

So here is where we get to equities and especially now why the macro and the technicals are very much linked at this point in time

vi) GDP could fall off the face of the Earth and it wouldn't matter (which is not true, just using some hyperbole) to equities because what the market cares about when pricing stocks is valuation. i.e. what are the earnings justifying the underlying stock price.

vii) Since Q1 2009, earnings have been up. Which means that equities go up. Government stimulus spurred enough "aggregate demand" to increase earnings from their panic levels.

viii) Earnings have been continuing to increase. But there are two primary ways for earning to increase: a) organic growth based on a recovery (sustainable) and b) cost cutting / margin expansion (unsustainable). Notice what I said above, real final sales the last 2 quarters have been slowing considerably. Which means there has not been much of a). In fact most of the earning growth the last 2 quarters has been because of b).

ix) But that doesn't explain now. Analyst estimates are increasing. What that means is that analysts believe that the unsustainable portion of earnings will go away and be replaced by sustainable earnings

THIS IS THE RUB!. This is why the macro environment and the technicals are completely linked right now. Because there is an extreme disconnect between leading macro indicators and coincident and lagging macro indicators. By this I mean that there are a large set of leading macro indicators that are forecasting weakness at best, or another recession at worse.

- More On The ECRI Leading Indicator
- Market still deluding itself that it can escape the inevitable dénouement
- The Unfortunate Math Behind Our Economic Plight
- A Simple Explanation of the Great Recession and Why It Has Years To Go
- John Hussman: Valuing the S&P 500 Using Forward Operating Earnings
- What is the Consumer Metrics Institute Growth Index saying?
- Rear View Looks Fine, But The Macro Forward Outlook Is Deteriorating
- John Hussman: Recession Warning (Unthinkability is Not Evidence)

My point and contention is that the leading macro environment is forecasting weakness. This means the reason for the the increasing estimates from market analysts and the high valuation of the market (if one uses more reasonable earnings estimates) is misplaced. I think the market is overpriced and needs to correct significantly.

There are two parts to this observation: Did we top? and When will we correct?

So for this second main observation, yes I do believe we topped in April. Not only was it the peak of the inventory rebuild, I believe it was a capitulation top on a number of indicators: Sentiment.

This means that I believe that the April top was a major top. Whether it was Primary 2 or Cycle Degree X or a Primary subwave within a very large Cycle X, I believe it is a major top. This is precisely why I am not entertaining large count options that are forecasting another large run above the April high. BECAUSE I BELIEVE IT DOESN'T MAKE ANY SENSE MACROECONOMICALLY (and per my argument above, I think at this juncture the macro and the technicals are quite linked)

Third, the not-so-obvious

So from observation 1 above I don't think we are in a straightforward impulsive down count. And from observation 2 above, I don't think we are still in the cyclical bull market. I think the trend has changed back to down.

So what does that mean?

It could mean that the count is corrective down. This would stink because it would make this a very difficult large (Primary) wave to count, analyze and trade. But it is not without precedent. If you want to see a major world index that is in a very clear secular bear market, and whose wave structure is clearly corrective, look no further than the NIKKEI: Back at Support

There are a lot of very valid comparisons that can be made between the US situation and Japan. So this course of analysis is not without merit. In fact, I think it might be right on.

But before I go down that path, I want to stick with my preferred count, that we are in a Cycle Degree C wave down with the April top marking Primary 2.

Based on all the incongruities that I have stated above (no impulsive option that I buy) since the April top, and assuming that the April top is a major one (that no retracement waves will challenge it) what option is left withing the framework of Intermediate 1 of Primary 3?

A Large Leading Diagonal. And like I said above, I am *not* talking about an LD that ended early July (which I have said repeatedly is invalid).

Here is what that count would look like:

What this would mean (if this count is correct) is that for over 2 years, we will be in a trading range between 900 and 1200. This is my technical assessment but it also fits with a possible macroeconomic assessment.

Think about what this would mean: We have a failed inventory rebuild cycle. Yet we have been proclaiming the end of the recession / start of the recovery for months. Investors, as a crowd, are largely optimistic, and will not relinquish the perception of a recovery easily. As the over-estimation of analysts becomes apparent the next several months the market will correct to reflect this new reality. But we will be getting our results from mid-term elections, and I think it is quite likely we will see a lot of changes take place in the House (and maybe Senate). There will be a "second honeymoon" from an investor sentiment point of view, coinciding with an intermediate bottom at major support (900 on the SPX).

I think a 2 year trading range is precisely the type of confusion the market represents right now. (Like the 1 year trading range we are in now: Nowheresville). There is honest bewilderment amongst both bulls and bears.

In the past I have tried to rush counts. This one is a better representation of the confusion that exists in the market right now (IMO) and contains the idea that this confusion is likely to persist for some time without a clear "crash" or another gigantic rally.

... So that is my take on what I think the big count has in store for us.

Of course I will be wrong and have to revise this in a couple of months :). But when I look top-down at this point, these are the type of conclusions that I come to.

I hope the explanation of my analysis, if not the outcome of it, was useful.

For more discussion of some macro and fundamental thoughts (and why I see the macro and fundamentals as bearish for the next few years) see:

-- Long Term View
-- Bond Market and Yield Spread Update
-- What the Bond Market is Trying to Tell the Stock Market: A Look at the Yield Curve and Expectations
-- US Dollar Count Updates
-- Bigger Fish to Fry, and update to Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR
-- Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR
-- Of Modeling, Risk, Financial Innovation, and Liquidity Crises
-- Another Impulse Wave Study: A Look at the 1974-1975 Low and Rally
-- Not All Five-Wave Moves Are Impulses: A Short Treatise on Elliott Wave
-- Connect the Dots Before Financial Depressurization
-- Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?
-- Debt Saturation
-- Global Macro Investor August Report - This is a Must Read
-- The Big Interview with David Rosenberg
-- What is the Consumer Metrics Institute Growth Index saying?
-- Rear View Looks Fine, But The Macro Forward Outlook Is Deteriorating
-- John Hussman: Recession Warning (Unthinkability is Not Evidence)
-- Buying dimes with dollars is bad business, government-funded or not
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