On Wave Counts and the Previous Secular Bear Market
As the stock market creeps closer and closer to the level where the bearish '1-2' wave count would become inoperative, we want to relay a bit more anecdotal evidence that has caught our eye and that continues to suggest that the air is getting thin. Before we discuss these let us briefly consider the wave count problem again.
A good friend who is a colleague of Mish's has reminded us recently that anyone counting the Elliott wave structure of the 1970's bear market would have been stumped all along the way if he had not very early on in the game – beginning with the 1966 high – determined that a highly complex corrective structure was going to unfold over the ensuing 18 years. Many of the impulsive looking rallies and declines failed to produce follow-through, while corrective looking moves often occurred at what were seemingly the 'wrong' spots.
As our friend noted, people counting these waves in real time must have had great trouble interpreting the unfolding structure. It was relatively easy to reconstruct the proper wave count in hindsight, but fiendishly difficult to do so while it evolved and base real time trading decisions on it.
We say this because if one looks at the SPX today, one would as an e-wave practitioner theoretically have to abandon one's bearish stance if the '1-2' wave count became inoperative:
The blue and red rectangles show the proposed areas of waves 1 and 2. The red dotted lines show which level must not be exceeded if this wave count is to be maintained – click chart for better resolution.
The question thus is, would one actually have to turn bullish if the proposed bearish wave count turns out to be incorrect? We believe that would be a tactical mistake.
To be sure, there are always periods during secular bear markets when it pays to be tactically bullish. However, it rarely pays to be so during times when market sentiment is extremely stretched and the market has become extremely overbought by many technical measures.
Below is a chart that shows the moves that occurred during the 1960's and 1970's in the SPX. With hindsight, it is obvious that a secular bear market in the form of a complex corrective wave of cycle degree occurred. Something similar appears to be happening since the year 2000, as the market's structure becomes ever more similar to that observed in the 1970's. The important take-way is that neither 'breakouts' nor 'breakdowns' led to a further move in the direction of the trend at one lower degree.
The S&P 500 index from 1961 to 1979 – the dark gray rectangles show impulse waves, the light gray ones corrective (a-b-c type) waves. Note that not a single one of the impulse waves led to a follow-through move in the direction of the primary trend. This can be easily explained in hindsight, as A and C waves often are impulses within a larger corrective structure. But without knowing the character of the unfolding structure beforehand, it would have been very difficult to ascertain this at the time – click chart for better resolution.
As a result of these deliberations we would warn to interpret a breakout over the May 2011 high as representing confirmation of a new bullish trend. On the contrary, given the current sentiment extremes, we think such an event would likely prove to be a so-called 'bull trap'. From a fundamental standpoint, it seems likely that the ECB's LTRO 2.01 in late February will provide enough juice and confidence to keep the markets floating a little while longer. Alas, thereafter we believe trouble is going to reemerge quickly and with a vengeance.
The Latest Anecdotes
We came across the following interesting tidbits yesterday. The WSJ ran an article entitled 'VIX snooze – No Timetable for Awakening', commenting on the recently fast asleep implied options volatility gauge. On the same day, the WSJ had another article asking 'What's Next for the Bears?', commenting on the fact that even though the market was down in 8 out of 11 sessions in late January, the DJIA still managed to rise by 125 points over this span. What's interesting to us is the article's conclusion:
“There’s a Wall Street adage: if you sell and sell and the market doesn’t go down, you better turnaround and buy. Basically, if the market doesn’t decline despite what seems like good reasons, there must be better reasons to rally.
Maybe it’s the fact that fourth-quarter earnings haven’t been as weak as many expected, or because the labor market has shown real signs of improvement, or because the Federal Reserve is still working to cushion the economy and market’s downside. Or maybe, investors are just tired of worrying about Europe’s sovereign debt troubles.
For whatever reason, selling isn’t working. So perhaps the only sane thing for bears to do is give buying a shot.”
Naturally, 'hasn't been working' is not the same as 'won't work in the future'. One could have written an almost identical paragraph in mid July of 2011 and as a buyer would have found oneself knee-capped by a mini crash almost immediately. The worries about Europe didn't have any effect then as well – until they suddenly did.
The other point we highlighted above concerns earnings. It turns out that aggregate SPX earnings do by no means tell the real story – because they have been massively distorted by a single company's results. The company in question is of course consumer tech juggernaut AAPL.
“Record profit from iPhone and iPad maker Apple Inc. is masking weakness at other Standard & Poor’s 500 Index companies during the fourth-quarter reporting season, according to UBS AG’s Jonathan Golub.
The degree to which S&P 500 earnings beat the average analyst estimate drops by about two-thirds when Apple is excluded, New York-based Golub in an interview today on “Bloomberg Surveillance” with Tom Keene. He is the chief U.S. market strategist at UBS.
The world’s largest company by market capitalization said on Jan. 24 that profit in the quarter ended Dec. 31 was $13.1 billion, 36 percent more than the average analyst projection, while revenue beat forecasts by $7.3 billion, the most ever. The Cupertino, California-based company single-handedly erased a drop in S&P 500 earnings for the October-to-December period, turning a 4.2 percent decline into a 4.4 percent gain.
The S&P 500’s fourth-quarter income growth rate was 1.6 percent, excluding Apple, Golub wrote in a Feb. 2 report.
“Now that those things are rolling off and becoming effectively headwinds not tailwinds, and then you take out the Apple numbers, you just see how weak the underlying trend is,” he said.”
This puts the constant drumbeat about how great corporate earnings are into perspective. Without AAPL, they are really nothing to write home about.
Next we took note of another report containing the phrase 'most since 2007' in its headline. We have come across countless headlines of this sort in recent weeks ('highest' or 'best' or 'most' since either 2007 or 2008). These constitute medium term warning signs in our opinion – they are not proof that things are suddenly fine, they are proof that we are back at the same levels of excess. The headline in question concerns takeovers. As on the topic:
“Most Takeovers Since 2007 Seen Spurred by Data Torrent”
Cisco Systems Inc., the world’s largest maker of networking equipment, estimates that by 2015 the data equivalent of all movies ever made will cross Internet networks every five minutes. How to manage all that data is what will be driving technology mergers and acquisitions in 2012.
In a bid to transform that torrent into profits, a cash rich industry is poised to surpass 2011’s almost $200 billion volume of announced mergers and acquisitions as companies such as Cisco and International Business Machines Corp. search for deals that will boost their capacity to provide new storage, analytics and security services to enterprise customers.
Big data, mobile and cloud technologies will drive “bold investments and fateful decisions,” market researcher IDC said in a recent report. The volume of digital information may balloon from 2.7 zettabytes this year — the equivalent of filling 2.7 billion of Apple Inc. (AAPL)’s priciest desktop iMacs to capacity — to 8 zettabytes by 2015, according to IDC.”
Obviously, such 'bold investments and fateful decisions' are not really dependent on technological progress. They never happen when share prices have declined and are near a major low, regardless of how much technological progress has occurred. These decisions only come after stock prices have risen a whole lot and this happy state of affairs is then extrapolated indefinitely into the future. 2007 was a record year for stock buybacks and takeovers. It was also one of the biggest stock market tops in history.
This tendency to buy at the wrong moment is one of the reasons why research has invariably shown that most takeovers and mergers fail to deliver on their promise. The simple fact of the matter is that companies routinely overpay in these transactions, because so many of them occur near major stock market highs.
Mind, this does of course not mean that a major top is necessarily imminent. However, it is yet another data point showing us that risk has increased a great deal.
Finally we should perhaps point out that even 'Dr. Doom' Nouriel Roubini has recently turned bullish and suddenly believes that the 'rally has legs'. As far as his timing goes, it could have been better. To us it is yet another piece of anecdotal evidence that screams 'danger'. It is quite funny that people – even well-known quasi-permabears like Roubini – routinely turn bullish after prices have risen a lot and risk has therefore greatly increased.
Charts by: StockCharts.com
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