It's Still A Bear Market on Wall Street

US Treasury bonds firmed up last week in the context of a fourth quarter correction. The chart bias turned bullish coincident with renewed bearish bias in the Dow chart on Friday, as the Dow bears pierced nearby bullish support at the Nov 13 low of 8298 intraday, which is the last highest low in the not quite three month countertrend bull leg that began on my birthday no less. Bulls were able to close the Dow 6 points above that level at 8304 nonetheless, and edged it back up to 8342 by Tuesday Dec 31st. It's true, they could be hanging on by their fingernails, but nonetheless, hanging on is what they're doing.

The bears are still in control of the primary and intermediate trends in Wall Street's stock market averages, but have let the bulls lead stock prices higher in a countertrend sequence since October, resulting in what was either a real reversal in the Nasdaq, or a fake one. That has yet to be determined. Speculative markets are prone to random volatility, however, which make chart analyses often less reliable.

Our read of the November breakout in the Nasdaq indicates a fresh wave of speculative froth at best, and without confirmation from any of the broader blue chip averages, we are skeptical it is going to hold up. In other words, we're confident it was a fake move, or bull trap.

A break down through 1319 for the Nasdaq composite, 8298 for the Dow Industrials, 872 for the S&P 500 index, and 465 for the NYSE composite would represent the surrender of the near-three month countertrend sequence by the bulls, which would confirm our hypothesis, and open up the possibility for new lows. Bulls might be satisfied if it were only going to be a test of recent lows, but the fact remains that the bears still control the main trends, and there has been little the bulls have done to alter that technical condition so far. Most of the averages barely made it back up to their 200-day moving averages despite the added Fed stimulus in November. Even the Nasdaq's would-be reversal didn't include a crossover to the bullish side of the 200-day moving average.

It's still a bear market, and so, investors should be open to the possibility of new lows in the averages. Bulls have factored an earnings recovery for the fourth quarter of some magnitude, but they fall short on premise as well as the realities evident almost everywhere but the housing and mining sectors. More importantly, they have yet to factor in a potential market driven rise in bond yields resulting from the "inflationary" factors that surface during any currency devaluation.

Perhaps one reason is because the Fed has recently promised us it will keep a lid on longer-term interest rates if it has to (Bernanke). Oh yeah, by the way, good luck doing that while the dollar's falling. The last time they did fix long term interest rates was during the fifties, after the prior secular bull market in bonds gave way to a thirty year bear market. Whatever the reasons then, a) it didn't work for long, and b) the dollar was on a fixed rate regime. That means today, it would work less long.

I wonder if, under such circumstances, Kudlow would be rooting for the Fed, free market enthusiast that he claims to be. It's just a passing thought at any rate. I know he supports the Treasury when it rigs bond market demand.
Outside of these policy machinations and fresh bear tracks on Wall Street, the bonds probably also saw a bid from additional bad economic news during the week as well as war rhetoric.
I'd like to offer some speculations.

The first regards US dollar rhetoric. When someone's got a lot of stock to get off, they hire a promoter to talk up a good story while exiting through the back door. It's no different in other markets. Any large owner of dollar reserves, whose aim is to reduce them in favor of at least a greater diversification of currency reserves, is going to turn up the volume on how great the dollar is. If Japan wanted to sell a portion of its gigantic dollar reserve, it wouldn't tell you. Its politicians would undoubtedly be waving the American flag on the one hand, while selling on the other. Of course, just because that logic is valid, it doesn't mean that if you hear the rhetoric, it isn't sincere. So our first speculation is that it isn't sincere, and thus, that the dollar will continue to fall.

Our second speculation involves the Loonie, and its implication for the momentum in gold prices. While the European currencies are off and running, the Loonie is threatening to fall to a new record low. The dollar index has continued to sink, but the weakness in the Loonie coupled with a consolidation in the Rand and renewed weakness in the Australian dollar are cause for concern if you're bearish on the dollar, as we are.

Without trying to figure out what exactly ails the Northern Peso in this editorial, our second speculation is that the Canadian dollar gets nailed soon. This is premised on its chart behavior, which has been conspicuously weak despite the broad weakness in the US dollar this year. In fact, it has been the weakest performing major market currency all year long, outside of the Latin American currencies. If the current activity results in new lows, the break down could send gold bulls a shock. In other words, a breakdown in the Loonie could be the curveball we've been worrying about, even if it were to be just a minor setback.

Our third speculation is that the Dow is going to 6000 in the first quarter, and that gold prices are going to surpass $400 somewhere in the first quarter, forecasting further trouble for the US dollar, and despite a weak Loonie.

Valuations Must Submit to Rising Prices, Rates
Our main argument for lower equity valuations is that a declining dollar will result in price increases for various factors of production, and ultimately, pressures for bond yields to rise. There are three main opposing variables to our case.

• The first is the effect of the Fed's rhetoric about fixing long term yields
• The second is the specter of an earnings recovery, and
• The third is that the "odds" favor the bulls

Bulls would claim the mere fact that the bear market has lasted three back-to-back years (a post 1932 record) as indicating the decreased probability of further declines, and they would add to that the implications of a coming presidential cycle, as well as a whole whack of other superstitious mumbo jumbo, such as the fact that this bear market has been the deepest one on record since 1977. We have to congratulate CNBC on communicating these odds to investors. They did a poll after reporting on them, and 61% of respondents claimed to be bullish on equities for 2003. Sell!

We'll say one more thing to that. The nineties bull market was a market that established new bull market records, and we expect the bear market to also produce new bear market records before it's all over. But just in case those odds still hold today, in this new economy etc., we've worked out the following scenario. Dow 6000 in the first quarter, or lower, by way of a bear market capitulation/panic, followed by a sharp reversal and the onset of a bear market rally as we approach US election posturing.

Maybe the market even finishes up on the year, which would require only a 2500-point bounce into the end of 2003 for the Dow, off of the 6000 handle. This way, CNBC's viewers might be right, even if they sell before they are. The point being that our bearish scenario could still fit in with the alleged probabilities this way.

A meaningful rally off of these levels, however, would require actually improving earnings prospects. Moreover, the Fed would have no mandate to fix yields in the case of a recovery, so the earnings would have to be good enough that investors could tolerate buying stocks while yields are rising. This is the one place we could be wrong... that earnings come in surprisingly strong. Certainly, that would be a surprise.

We just don't see enough room to run from here for stocks, but that might be different at Dow 6000, once yields have had a chance to rise and investors have discounted that prospect, specifically its effect on stock valuations.

In light of developments in gold and oil prices during December we'd be looking for poor fourth quarter results from the banks, or at least poorer than currently anticipated, assuming that recent settlements have already been factored for the quarter. Undoubtedly we haven't heard the end of this kind of litigation as the Spitzer settlements open the door for investors to sick their own lawyers on the investment banks guiltiest of cheating their clients.

The future write-offs related to such settlements, foreign country debt fallouts, further stock market weakness, soaring gold & oil prices, and potentially rising interest rates are fertile ground for establishing a bearish argument for bank shares. I'm sure we've missed a few, but these are good enough for us to stay bearish at the moment.

Alert

Oil prices might be about to complete a major bottom. Note the 2-year head and shoulders bottom in the chart for Brent. The Brent chart formation is less bullish than the NYMEX Crude chart, but we couldn't get the right parameters for NY Crude. If the recent breakout holds, bulls will have reversed a two year bear market, confirmed the bull market signal in gold, and set oil markets up for a primary jaunt to the $60 range, perhaps even by next year if geopolitical tensions provide a catalyst. Yes, fourth quarter earnings better be good on Wall Street, indeed, or the bulls are going to simply give up trying to pick bottoms. And that's fertile ground for a real bottom.

Ed Bugos