Sunday, 6 June 2010



Since the day Lehman Brothers collapsed in September 2008, the world's governments and central banks have been attempting the greatest financial high-wire act in the history of economics.  They have tried to give a depression - for that's what we're living through - the appearance of a recession, and so maintain confidence in the chances of an imminent recovery.  So far, they appear to have pulled off this remarkable feat.  But for skeptics the question on everyone's lips has always been, when's the critter going to fall off the wire?

Despite my conviction (which I've stated and you've suffered here ad nauseam, dear reader) that this spectacular stock market advance was not the beginning of a new long-term bull market but only a major rally within a long-term bust, I decided not to sulk on the sidelines as the market roared on but to trade my way to the top.  Since October of '09, I've been happily sharing those trades with you in these columns with verifiable success.

On May 23rd, as I promised in last month's Investment Outlook, I posted an update reversing my April sell signal and switching to a green-light buy for stocks, as sound technical studies suggested that a low had been put in after a substantial sell-off.  As of this weekend, the FTSE100 had risen a modest 1.2%.  

But now, having done further research, I am convinced that stocks will soon turn down meaningfully and the recent lows will fail.  

One of two scenarios is then set to play out: 

  1. A sharp decline, which retraces 38% - 62% of the move since March '09, then bounces back to these levels later this year or by early 2011 
  2. A major - possibly monumental - crash   

In this month's special OntheMoney post and Investment Outlook, I'm going to tell you why I'm so sure, what the implications could be for your investments, and suggest how you might profit, protect yourself, or both.


  • Stocks very likely peaked for the year - and perhaps for many years - on 26th April 2010

  • Stocks may attempt a recovery over the next few days or weeks, but before they reach new highs the decline will reassert and accelerate 

    • The move will retrace, at a minimum, 38% of the advance from March 2009; if a crash scenario unfolds however, it would unwind 62% or more of that advance

    • If a crash is avoided, late 2010 to early 2011 should see another attempt to recover and break out through the recent top 

    • If my forecast for the economy is correct, the April high - Dow 11,258 - will prove an insurmountable barrier for years to come 

    • Even if my forecast for the economy and markets is incorrect, the April top will nonetheless hold for another one to two years 



    My reasons are a combination of the technical and the fundamental.  Almost always, however, technical information in charts is a distillation, an expression in trading language, of what is simultaneously going on in the world of political and economic fundamentals.  So let's start by taking a look at those pesky candles.

    Exhibit A:


    In March, I made a comprehensive case for believing that a top could be near based on readings from a reliable measure of market momentum called the Rate-of-Change.  Looking right back to the 1920s, only a very few readings had come close to registering the stupendous level this indicator set in December 2009.

    Rate of Change & Dow Jones Industrials Average 1977 - 2010

    I've learned to trust this kind of technical signal above almost anything else.  In fact I showed in March how - even though I hadn't yet fully got my head around all the intricacies of the banking crisis - I was able to warn friends a potential crash loomed in October 2008 two weeks before it happened, purely because of an unusual pattern I uncovered in the stock charts.  To appreciate more of the rationale behind technical analysis, please refer back to my March post here.

    Reasons I'm confident the reliability of the 'Rate of Change' signal is rock-solid include the historic extremity of the momentum, the rarity of the signal across almost a century and the sheer consistency of its results.  

    Each and every occurrence led to the same kind of market behaviour - a swift pull-back in prices, a run up (or attempted run up) to new highs, then a major and long-lasting sell-off.   

    Each and every occurrence saw one to two years of negative returns, involving either a substantial decline or a bona-fide, investment-decimating, pension-destroying, market crash.

    Let's first take a look at our current situation as at the end of May, then compare it to the seven precedents stretching back to 1928:

    Please click and enlarge in a new tab or window

    Reducing the pattern to its basic features*, we see that

    1. momentum (blue line underneath) peaks
    2. the index hits a minimum two-month high (a level higher than any in this or the previous month - turquoise arrow) 
    3. the index declines on waning momentum and forms a two-month low (yellow arrow)
    4. the index attempts to recover and runs up to a new high, while momentum does not - then begins a significant decline (red arrow)

    *A simple explanation of candlesticks is contained on this chart.

    Now let's go back and check each previous occasion when momentum became this extreme, or came close, and see what happened subsequently.

    JUNE 1999

    Again we see a momentum peak, followed by an initial high during August and decline to a two-month low in September; markets then got a second wind and pushed higher into January 2000, although momentum stayed weak.  This marked the peak of the great bull market run which began in 1982. 

    Over the next three years the Dow dropped 40%, the FTSE100 fell 49%.

    JULY 1987

    Again a momentum peak was followed by a price high in August and a decline to a two-month low.  Markets attempted, but failed, to reach a new high as momentum drooped.  A break below the August closing low ushered in a fully-fledged crash on 'Black Monday', Oct 19th.  

    The Dow fell 42%, the FTSE100 fell 34%.

    APRIL 1983

    Again, momentum peaks and a price high forms leading to a brief sell-off and a two-month low.  As price rose to a new high in November, momentum declined.  A modest, orderly correction followed, which was a hint that the preceding strength was sustainable (we were, of course, kicking off the greatest bull market in history).  Nevertheless, stocks did not finally breach their November 1983 high for another year and a half.

    During the six months following that second price high in November, the Dow fell 17% 
    (the FTSE100 didn't exist until '84).

    Before that, we have to go back into the mists of pre-history to find such extreme momentum - the Depression era.  Here is a longer term perspective, followed by an analysis of each instance:

    Rate of Change & Dow Jones Industrials Average 1920 - 1946

    JANUARY 1939

    Unusually, price peaked before momentum, then fell to a two-month low in January itself.  Prices recovered but were unable to make a new high, and, as in 1987, a break below the January close led to a heavy decline.  Although stocks did subsequently rebound into 1940 they soon fell, and were unable to break to new highs for five more years.

    From that peak in January 1939 to the low three years later, the Dow fell 41%.

    JANUARY 1936

    Once again a momentum peak formed, followed by a price high which led to a swift pull-back that same month, forming a two-month low.  As stocks recovered and surged higher, momentum sagged until a significant correction began in March of '37.  That high was not seen again for almost nine years.

    From the peak in March to the low a year later, the Dow fell 50%.

    APRIL 1933

    This massive surge in stocks followed the end of the horrific three-year crash from '29-'32.  Unsurprisingly it shows greater momentum than all other occurrences, yet the price pattern is essentially the same: a high followed by a two-month low, a recovery to final highs several months later, then a significant correction.  Despite seeing the greatest price momentum in recorded history, that price peak set in February '34 was not exceeded for more than a year.

    Between the February peak and the trough in July, the Dow 
    shed 25%.

    NOVEMBER 1928

    A by-now-familiar pattern: momentum tops, prices rise to a high then fall to a two-month low; a final rally lifts the market to a top despite lethargic momentum.  The high in September 1929 was not seen again for 25 years.

    Between the market top and the lows set in July 1932, the Dow fell 90%.


    • Every precedent retraced at least 38.2% of the prior long-term advance.  A 38.2% retracement (though no more) would represent a natural process consistent with an ongoing bull market, so need not necessarily indicate a coming meltdown.  Using the peak in April '10 and the low of March '09 as top and bottom of the advance, such a retracement of the Dow would see it fall to 9430, 5% below its current level at 9932.  Damage to the FTSE100 has been greater so far and were it to come under pressure from the US markets it would very likely fall further, possibly to 4650, almost 9% below here.  These are minimum targets.

    • there is potential good news: those precedents shown above which bottomed at 38.2% - the relatively mild corrections of 1933 and 1983 - led ultimately to a powerful recovery, so those levels will be worth watching over the next several months 

    • the other instances, which retraced 50% or more, led to greater weakness into the future; three examples unwound 50% to 62.8% of the previous advance and twice, the entire move up was wiped out (after 1929 and 1937)

    Exhibit B:


    I follow 20 varied technical indicators on a daily and weekly basis which are designed to keep me on the right side of the market.  I've learned not to second guess them.  As of June 6th, 16 are on a sell signal, 2 are neutral, 2 are on a buy.  

    One of my most trusted indicators, which I use to measure 'animal spirits' among market players, shows the world's investors falling out of love with risk...

    Many measures of momentum have broken down, plus there's a little problem of 'overhang'...

    Oversold bands underneath suggest a bounce is possible here, but there's huge  resistance above these levels

    And the most commonly used measure of stock valuation also suggests trouble ahead. According to the highly regarded former Merrill Lynch chief economist David Rosenberg, whenever the Shiller p/e ratio has risen above 20.6, this has triggered a correction over the next 16 months which averages 31%. In May the ratio reached 21.  This measure looks back 130 years and there have been no exceptions.  

    Further, future stock returns when the valuation measure has risen this high have historically been extremely poor.  

    According to research by Societe Generale, money being invested in stocks now is unlikely to see better than a 1.7% annualized return over the next 10 years.

    Exhibit C:


    Last year, Morgan Stanley undertook a study of the way stock markets worldwide behaved in the aftermath of major financial crises and credit shocks.  There were 19 examples yet, amid the superficial variations, a clear and consistent pattern emerged.  This is the schematic:

    'X' marks the spot last year when this snapshot was taken, when European markets had risen 57%.  By April 2010, the Dow had gained 74% from its lows, more than might be our due. According to this analysis, a substantial correction is now in the cards - the average from 19 previous comparable instances is 25%. Alarming as such a haircut may be, that is actually not the real story here.

    The real story, friends, the clincher as far as I'm concerned, is that subsequent rallies do not, on average, lead to major new highs in the market.  

    Take a good look at the chart, folks - stocks tend to move sideways for six-and-a-half years.  History is telling us it is most likely that the peak we just saw will set a ceiling on our stock returns deep into the next decade.  

    History is telling us we're at the TOP.

    Exhibit D:


    Last year I posted a chart showing how mutual funds, the basic vehicle of American investors (what we in the UK call 'unit trusts') were down to their last few shekels of spare cash, and that this was an ominous sign for the market.  Here's the latest:


    It's still ominous.  Since 1950, levels of reserves under 4% have consistently led to falling markets, for two reasons:

    1. There is little left in the tank to fuel new stock purchases
    2. If investors start selling heavily, low cash levels mean there's only one way fund managers can refund their clients - by selling more stock.  Prices fall, clients clamour to sell more stock...and lo, a vortex.

    This prospect is made more probable by the state of investor psychology: there is a continuing flow of investor cash out of stock-based mutual funds and into bonds.  The stock market cannot continue its advance without the retail investor - Joe and Jane Schmo - funnelling in cash through their savings and pension plans, but it just ain't happening.  It's not hard to conclude that a decade of double boom and bust has taught millions of Schmoes the market can't be trusted with their retirement savings: so who says the average investor is dumb?

    Exhibit E:

    ANALOGUES FROM 1938 AND 2007 

    A surprisingly rudimentary type of analysis used by many sophisticated traders looks back over history for market 'analogues' - similar patterns of highs and lows in not- dissimilar market environments - to suggest a rough template for future price movements.  This can work for short periods because, in extremis, investors behave instinctively (and therefore similarly) no matter what decade they're in. 

    For example, eagle-eyed traders who spotted that the Nasdaq index in 2004 was following an analogue from 1992, were able to make the all the right moves over more than a year.

    Some examples seem almost too obvious.  For instance, it's hard to ignore the similarities between the exuberant lead up to the top in 2007 and the last few months' market action:

    Subprime crisis, what subprime crisis? (early 2007)
    Sovereign debt crisis...? (early 2010)

    And some of you may remember me writing, in an email written a few days before the beginning of this rally in March 2009, that markets were closely following a script from 1937.  Incredibly, they still are.  

    Cool-cat trader Tim Knight at labelled this chart from 1937/8 with its significant highs and lows.  These have matched beautifully with the current market's progress, below.  If the analogue holds, we are - as of June 4th 2010 - at or approaching point 19...

    These analogues don't apply precisely or necessarily match week-for-week.  But until they break down - and eventually of course they will - they can help alert us to some of the dangers and opportunities coming at us down the pike.

    Exhibit F:


    ECRI's leading indicators - the same ones which told me we were certain to fall into recession in January 2008 while most economists were publicly scoffing at the idea - are falling back to the zero line.            

    The housing market, both in the US and the UK, is showing clear signs of distress after the recent hiatus / bounce.  If prices slump even further, banks' capital situation will deteriorate substantially as they still have $£billions in bad real estate loans sitting on their books (and, in the US, a vast backlog of foreclosures).  

    Indeed, while foreclosures depress prices, serious mortgage defaults are a leading indicator of foreclosures.  Here's the current trend.
    Source: HS Dent,

    And the US consumer, long the mighty engine of world growth, who had seemed to be rebounding from the sudden shock of 2008/9, is now - according to this fascinating leading indicator from ConsumerMetrics which tracks internet purchases - about to surprise pundits by pulling back on spending.  Spending remains by far the most significant driver of western economic growth, and if it is now failing - which has always been my baseline prediction - our recovery is quite simply holed below the waterline.

    Exhibit G:


    You might think I'm a voice in the wilderness, but I'm not alone.  Some of the smartest money managers in the world, as measured by decades of verified success, have sensed the turning of the tide. 

    A couple of months ago I mentioned in Outlook that Philip Gibbs, long-time manager of UK's AAA-rated Jupiter Financial Opportunities Fund, was shifting over 50% of his holdings in the banks into cash.  

    Fund managers almost never take this kind of risk - because if they are wrong and stocks keep powering upward, their fund's performance suffers badly, investors bail and switch to their competitors.  It is especially significant in this case, because Philip Gibbs did exactly the same in 2007 before the banking crisis hit.  He earned the eternal gratitude of his investors as banks crashed and competitor funds got creamed.  Why is he selling?  Because he believes investors have underestimated the risks to banks of the sovereign debt crisis.

    In the US, Dan Sullivan has edited an investment newsletter called The Chartist, offering stock picking and market timing advice, for more than forty years.  Over the 25 years since his service has been independently monitored by the Hulbert Financial Digest, of the hundreds of newsletters the service tracks, he is rated number one for stock market timing.  The old fox has lost none of his powers.  He completely swerved the carnage of 2008 and bought back in to stocks in April 2009.  

    In mid May this year, he switched to 100% cash.

    Exhibit H:


    Over the past few months I've been sounding off on the developing threats from Europe's self-destructing debt-bomb, the unwinding carry-trade time-bomb and China's real estate super-bubble-and-commodity-bomb.  Surely the idea of all these booby-traps going off simultaneously and blowing the stock market to smithereens is inconceivable?  

    Incredible, yes; unbelievable, hell yes; but inconceivable?  Think about it: the impact of any one of these bombs detonating could easily be enough to set off the others. 

    Libor (in red), the rate at which banks lend to each other, has soared in recent weeks, echoing 2008

    The cost to many European governments of selling new debt is once again creeping higher, as bond buyers lower their risk tolerances post-Greece.  And no wonder: Spain recently had to bail out one of its regional banks which still has a ton of rotting property loans festering on its books while Hungary is - according to its own Prime Minister - now dangerously close to defaulting on its debt.  

    Yes it's 'only' Hungary but folks, the question isn't who's the daddy - it's, who's holding the baby?


    Last month, faced with rising panic in the markets, the EU magicked-up $1trillion dollars to act as a kind of 'bailout mega-fund' - a huge pot into which troubled governments (mainly Greece) can dip at reasonable interest rates when the bond markets will only lend on punitive terms.  The subsequent stock market relief rally day.  Why?

    Because it took investors a day to realize it was a trillion dollar sticking plaster.  It achieved only one thing - allowing the banks that hold Greek debt a temporary reprieve.  They could avoid the immediate writedowns and restructurings which would otherwise have begun a swift and ugly chain reaction.  This seems to have bought everyone time, yet the end game is already clear - it's just that nobody wants to face it.  

    Greece itself is, from an economic perspective, doomed: it can only pay its debts by growing the economy and seriously cutting back spending, but if it seriously cuts back spending, it cannot grow its economy.  

    In fact such draconian moves as it's being asked to make could well push it into a depression.  Without a major restructuring of its debt, involving all the banks taking losses, a death spiral towards default is inevitable.  The alternative for Greece is leaving the euro, going back to the Drachma and devaluing its currency - but if it does so it will forego all the EU bailout money and be left at the mercy of the pack-dogs in the bond market who, as everyone perfectly well knows, will eat it for breakfast.  

    Greece debt crisis Kipper Williams

    Efforts by the other 'PIGS' (Portugal, Ireland, Italy, Spain - and let's not forget we Brits are also throwing on our hair-shirts) to get government spending under control in an orgy of self-flagellating austerity could, especially if US and Asian economies are slowing, swiftly lead Europe into another recession in 2011.  This would trigger further problems for debt-ridden European banks, threatening a financial crisis which could cause the contagion markets fear most.

    This exchange on BBC Newsnight recently exemplifies the current air of denial and unreality: Paxman finds himself asking the blindingly obvious questions, hedge fund shrewdie Hugh Hendry is the lone Cassandra, while the other pannelists hum, haw and shift uneasily in their seats.  

    Please follow the above link to youtube

    Meanwhile China is, we're told, attempting to 'tap on the brakes' and let the air out of its property bubble 'in a controlled manner'.  What a deliciously totalitarian conception. Have you ever tried to deflate a balloon...'in a controlled manner'? Have you ever tried slowing a car with one foot pressing hard on the accelerator and the other tapping lightly on the brakes?  

    Japan tried that trick on its own property bubble in 1989 and, whoops, look where it got them.  A boom is one thing - and of course China's breakneck climb out of rural poverty into 21st century urbanized prosperity is a genuine boom which perhaps parallels that of the US in the nineteenth and twentieth centuries.  But America had to endure the bursting of many bubbles along the way.  It seems that the end might already be in sight for Chinese real estate.

    Indeed, as fund manager GMO has shown in extensive research, there is no case in modern history of a statistical bubble which didn't burst and fall back to its long-term trend.  And Chinese property is one mutha of a statistical bubble.

    So how could this combustible mixture be sparked?  Let's indulge in a little idle speculation.

    Scenario 1

    • Immediate worst-case scenarios are averted but, due to the impact of Europe-wide austerity measures, the continent falls back into recession in late 2010 

    • China, which sells 20% of its exports to Europe, slows dramatically, throwing huge numbers of its citizens out of work, triggering the bursting of its property bubble

    • construction in large parts of the country is halted, sending the world price of iron ore, steel, copper etc. into a sharp decline

    • the carry-trade, in which institutional traders around the world use borrowed dollars to buy up commodities and assets in appreciating currencies, goes into reverse as they rush to sell these free-falling commodities, pushing up the value of the dollar and reinforcing selling dynamics in the US stock market

    • Companies exporting to China are dealt a severe blow, especially miners, steel producers, oil producers and construction companies across the world, many of whom prop up the UK stock market and are the cornerstone of British pension funds

    • The crisis ends when the Chinese central bank sends helicopters over Beijing to drop freshly-minted banknotes onto the streets...

    Ok, that last part didn't happen.  Still it would be a nasty scenario even if, compared to 2008, rather benign.  But how about...

    Scenario 2

    • News leaks that a major French bank with exposure to deteriorating Spanish property debt is to get a government bailout

    • Suddenly, many Euro banks come under suspicion and the cost of interbank loans soars further, with banks refusing to lend and unable to borrow

    • Bank shares plummet, sparking a wider stock and commodity sell-off and sparking a carry-trade unwind

    • Investors cannot tell which US and UK banks have exposure in the fallout and sell their shares, as the inter-bank freeze-up goes worldwide

    • Fear grips the business community and world trade slows again; China's exports are decimated, sparking mass layoffs and a collapse of the property market

    • Europeans, remembering how near banks came to closing their doors in 2008, are quicker this time to sense the danger and rush to previously untouched institutions like Santander and ING to withdraw their savings...

    I could go on, but there may be children reading.  

    Maybe I'm being overly pessimistic.  "Hey, Jeremiah," I hear from the back, "governments saved us the first time around and they can do it again."  Sure, first time around governments succeeded in bailing out a bunch of banks loaded with toxic debt.  

    Problem is, this time around the governments are the toxic debt.  



    So friends, we're about to find out if I've been wrong all along.  If the proponents of a V-shaped recovery are right and a self-sustaining economic expansion is underway, the stock market should turn back up soon enough, break through the highs of April 26th at Dow 11,258 and keep on chugging higher.  If that happens, I will happily throw in the towel and admit I was flat out wrong.

    There are, however, two other realistic scenarios according to historical precedent, which are shown in Exhibit A above - and in one of them I could still be wrong.

    • markets take an extended breather, falling further but not too far, eventually recovering over a period of one-to-two years.  A subsequent sustained break through the recent highs then indicates that a major recovery is at hand.  

    • or... markets drop here and, even if they recover their mojo somewhat, fail to break to new highs.  Stocks then either enter a new long term bear market, or crash with little warning.

    In both cases, however, cash invested in stocks now will either be dead money for at least a year, or dust.   


    Last April I posted this chart in an email update whilst musing on the shape of what seemed to be a big rally in the making.

    What we got was, as it turned out, a miracle.  

    The stock market gods (thank you Bush, Paulson, Bernanke, Obama) have blessed investors who failed to get out before the great crash of October 2008 with a bubblicious 74% rally, second only in magnitude to the great rallies of the early 1930s in the midst of the Depression.  

    So fellow investors and pension holders, if you are wondering whether you should stay on at the party let me pose you this simple question: 

    Put aside the fundamental economic headwinds; put aside the glaring sovereign debt problems; given the technical evidence alone, do you want to bet your savings, and potentially your retirement, on the overturning of a century of stock market history?

    Whether one might, for example, need to make more in the stock market to top up a pension is neither here nor there.  The market will follow its own logic, not our needs.  What the market is unquestionably telling us is that the risks of hanging on in and hoping to eke out more gains are greater - far, far greater at this point - than the potential rewards.  

    For all the reasons outlined today, I am finally confident we've seen the best of the stock market in 2010, and possibly for many years to come.  

    As of this weekend, June 6th, I'm liquidating my last long positions and beginning to establish short positions in anticipation of a lasting move lower.  Everything else I have is in cash.


    I'll be back on Independence Day, July 4th, with what should be a revealing update.  Meantime, in this month's Investment Outlook, I'll take a look at ways to protect yourself from the coming downdraft and make some suggestions as to how you might profit in its wake.

    Have a great month!