Thursday, 14 June 2012


Amidst the storm of news, hype, hope, panic and confusion which continues to batter investors on a seemingly daily basis, it's all too easy to become sidetracked by what is ultimately unimportant and lose sight of the really big picture.  

So I decided it might be useful to pull the focus way back and view the global stock market puzzle in its broadest perspective.  And, since major turns in stock markets are also proven leading indicators of economic downturns and recoveries, any clarity into the future direction of stocks might just help us gain a little more clarity about the general direction in which the world economy is headed.

It turns out that, when viewed from 30,000 feet, the puzzle is not so difficult to solve.  To solve this puzzle you don't need a detailed understanding of economics or eurozone politics.  You don't need to be a wizard on market fundamentals, or to be an expert stock-picker, or to be a macro guru.  Valid and useful skills though these may be they are notoriously, and often absurdly, subjective.  

In this case there is only one discipline which can cut through the jungle of conflicting opinions and part-truths to discover what is really happening; one which completely ignores what people say and what they think, and analyzes only what they do.  

What investors actually do with large sums of their own and other people's money is the only true tell, and the study of this behaviour is what proper technical analysis - the objective study of market price action - is all about.

The good news for non-techies is that grasping the current situation requires next to no knowledge of technical analysis either - just a basic appreciation of the meaning of this, the most widely-recognized and traded chart pattern of all.* 

Source: Federal Reserve Bank of NY

The measuring rule for this classic pattern is simple: 
An initial price range is measured from the Head down to the Neckline; if the Right Shoulder subsequently breaks below the Neckline, that initial price range is subtracted from the
breakout point to identify a minimum target price.

For a more detailed discussion of the Head and Shoulders formation, its success rate and its nuances, Thomas Bulkowski's research is a good starting point. The classic reference book for all chart patterns is by Edwards and Magee; and more statistical evidence of the H&S pattern's effectiveness can be found in this paper from the Federal Reserve Bank of NY.  For a recent example, I identified the 2011 top and crash in this post, after noting another Head & Shoulders pattern in the S&P500.


For avid chart watchers managing a global portfolio, what I'm about to show you may come as no surprise.  But for everyone else, let me suggest you pour yourself a stiff drink, find a quiet place to sit and take a long, hard look at the following series of charts.  For obvious reasons, I'll call them the Nine Horsemen of the Eurocalypse.

I've taken a snapshot of nine ishares ETFs, each of which replicates the broad MSCI stock index representing a specific country's equity market.  Each shows daily data stretching back beyond the last bear market.  

As you scroll through, I invite you to look to the left, compare today's price behaviour in each to that of five years ago and imagine what action - if any - you would have taken had you been presented with these same charts in 2007.  



2.    FRANCE

3.    ITALY


5.    JAPAN


7.    BRAZIL

8.    CHINA

9.    CANADA


  • They do not mean that a global market crash is either certain or imminent.  

  • They do not imply that global economic collapse is either certain or imminent.

  • The minimum price targets for each would range from just above to far below the March 2009 lows; however, even if every chart pattern were triggered (none may trigger, or all may trigger and then fail to follow through), this would not mean that stock prices will necessarily plunge all the way to their projected targets.

What the above charts do mean, however, is that each of these three scenarios - a major crash, a global depression and a return to the lows of 2009 - which until now have been dismissed as inconceivable by the vast majority of investors, have moved decisively into the realm not just of the conceivable, but of the probable.

You will of course have noticed that the US market is not among my nine horsemen.  Unfortunately we can't take a crumb of comfort from that fact because, as I showed in a detailed post last month, the American market (S&P500, also the Dow & Russell 2000) is locked into a 'Three Peaks and a Domed House' pattern which is if anything even more deadly, with an even higher success rate, than the Head & Shoulders.

Speaking of which, those familiar with that pattern might like to take a look at my latest update, which sees us caught between two probable scenarios.

Three Peaks and a Domed House updated, June 2012



As I say, when it comes to major investment decisions I am not interested in anyone's opinions about what may happen long term - not even my own.  I watch charts.  I see where hundreds of millions of investors are putting their money, and invest based on an analysis which is, as far as I can possibly make it, objective and unbiased.  I do not invest based on hope.  I can't afford to.

We cannot hide, then, from the fact that these charts are universally, unequivocally...ominous.  I only hesitate to say they are bearish (even though every fiber of my being tells me I should be screaming it from the rooftops) because most of these patterns are yet to trigger.  

They could reverse before they trigger.  They could trigger then fail to follow through.

Thomas Bulkowski's research, looking at more than 600 head-and-shoulders patterns in stocks, found that 55% reached their target price.  While you may be quite happy to take your chances with those odds, remember that a substantial percentage more will have triggered and found support somewhere above their target.  Taking a look at all the charts above, I struggle to see evidence of any meaningful support above the 2009 lows.  

The logical takeaway is therefore that in most of the above cases, any break below the neckline which fails to stage an immediate, powerful reversal would be extremely dangerous, increasing the odds of a swift collapse.  


The US Treasury market is sending out the same message as world stock markets:
the forces of depression are at the gates.  US stocks remain the lone hold-out.


For those complacently relying on the Federal Reserve and the world's central banks to prevent such a scenario from happening, remember: these organizations are hard-wired to be reactive, not proactive.  In 2008, Bernanke began pumping in liquidity soon after the Lehman collapse, announcing a series of rescue programs over the ensuing months which finally culminated in QE1TARP.  During this period the market continued to vaporize, losing another 30% of its value.  It took six months from Lehman's demise for stocks finally to turn.  

Fed moves in 2010 and 2011 (QE2, Operation Twist) occured only after two huge market shocks stirred it into action.  The ECB under Draghi has shown willingness to act with its LTRO program, but did so last fall only after the banks were on their knees and the bond market barbarians were rattling the gates.  

Although they can surely be relied upon to step up when shit hits fan, these two great monoliths will always need cover for their actions (the Fed especially in an election year).  Neither are nimble enough or politically independent enough to act (for investors) in any way other than 'too late'.


As investors and traders we are first and foremost in the business of risk management.  There are times when we need to take seriously that chuckling old jokesmith Warren Buffett's two golden rules -

  1. Never lose money.
  2. Never forget rule 1.

Denial and disbelief are not a strategy.  Until the current danger is firmly in the rearview mirror our thoughts should, in the face of a very real threat, turn towards defence.  

Consider using any rally back towards the spring highs as a chance to seriously lighten, or hedge, your exposure.  My question to you, again, is: what action, if any, would you have taken had you been presented with these chart patterns in 2007?  

Keep in mind that we cannot deal in certainties here, only probabilities.  There is a chance that concerted action by the authorities on both sides of the Atlantic, and/or an unexpected bout of better economic news, will propel US stocks to new bull market highs.  Were that to happen I would consider cashing out completely, depending on whether my technical indicators and the 'Three Peaks' pattern fire off sell signals.  Should they not oblige, and markets push higher on increasing technical strength, I may yet turn into a rip-snorting bull.  

Rely on me to post any significant developments here.  In 2011 I was one of the very few who gave specific, prior warning of the August market crash, but it's likely that only those who subscribed to the blog via email (free) would have had time to act on the advice.  Fortunately I now also have a Twitter feed, so you can follow my occasional warblings (and warnings) there if you wish.    

Meantime, I continue to cling to the simple motto which has guided me since this whole desperate saga began: 

Hope for the best, prepare for the worst.