Tuesday, 3 November 2009

Dow 3,000 On Its Way

Everything I look at tells me the bear-market rally in global and emerging market equities is over. Any rallies should be used as an opportunity to get out, or better still, get short.

Anyone expecting an economic recovery or even hyperinflation in the US is about to get very confused as we enter the next leg of the US$43trn debt pyramid collapse.

Elliot Wave Confirmation – The Primary wave 2 (P2) bear-market rally appears to have been completed following an ABC correction since March, and a five wave advance since June. We are in the early stages of a primary wave decline at the beginning of a Supercycle bear market. The wave 3 decline will be at least as big as the wave 1 collapse seen in 2008, and as Robert Prechter states ‘third waves are wonders to behold’.

The EW pattern is even clearer in emerging market stocks, with the MSCI Emerging Market etf (EEM) having been rejected at the 61.8% retracement level– the hallmark of P2 bear-market rally.

Panic-Driven Gap Filled – The gap in the S&P at 1,100, created at the height of fear in October, has now been filled. As the chart shows, this was the case in 1930 when the bear-market rally in the Dow topped.

Volume Is Picking Up – After 7 months of declining volume, September marked 1st sequential month of rising volume. Again, this is consistent with the beginning of a third wave.

The Fear Gauge Is Back Up – following several months of sailing through the eye of the storm, the VIX has burst through support signalling the end of the low-vol fuelled carry trade. This is perfectly consistent with the beginning of a P3 decline.

Dow Theory – While the Dow made new highs in September, the Dow Transports failed to confirm this, and despite today’s Warren Buffet-fuelled rally, the uptrend is no longer in place.

Market Breadth – The sell-off has not been confined to a few indices. Everything from the Brazilian Bovespa to the New Zealand dollar look like they are past their peak.

Optimism Is At A Peak – Consistent with a market top, hope and optimism are at a peak. The trailing PE ratio is at an ALL TIME HIGH, and analysts are pricing in a perfect recovery in earnings.

Sentiment – try telling someone you are bullish on the dollar and see if they don’t look at you like you are mental. With sentiment so heavily skewed in favour of the reflation trade, there is simply not enough profit to reward all these people with the same outlook. This makes for a sharp and sustained reversal.

The Fundamentals

Despite the US economy supposedly growing in Q309, it is undoubtedly in worse shape: Thanks to the government’s ill-advised Keynesian policies, private consumption has actually risen as a proportion of GDP; Federal debt (involuntary and unproductive private debt) is much higher; Structural unemployment is higher; the Chinese economy has gone from being in a position to mount a long-term sustainable recovery to help drive global growth to the verge of a banking sector crisis. What is more, the Fed, who got us into this mess, has gained more control over the economy. In sum, the imbalances that caused the crisis have grown larger.

Deflationary Depression Just Begun
While the recession may be officially over, the depression is only just beginning. This is a once in a lifetime credit contraction. While I can see where inflationists like Peter Schiff, Jim Rogers, and Marc Faber are coming from, I think they are barking up the wrong tree. While they are likely to be proven correct eventually (the fiscal deficits and foreign central bank reserve diversification will catch up down the line), that’s no consolation for being wrong now. After all, timing is the difference between salad and garbage.

The above chart shows the extent of the credit excess seen over the last Supercycle, and almost guarantees that we are facing deflation and not inflation. We live in a credit money system, not a fiat money system. The banking system creates the vast majority of money in our economy, not the government – the conventional money multiplier model implies the tail wags the dog. No matter how much money sits on reserves at the Fed, if the banks don’t want to lend, and consumer don’t want to borrow, this money might as well simply not exists. For the hyperinflation threat to play out, the Fed would need to create cash to the tune of $43trn in order to replace our debt-based system with a fiat based system. Those looking for hyperinflation should be aware of this.

So there you have it: Technicals, Sentiment, and Fundamentals. The coming wave down will be epic.

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