Fear and Loathing on Wall Street

SPX – 1089.41

DJIA – 10,136

June 1, 2010

“I believe in the stock market, and its remarkable ability to discount the future. Right now the general view is that the stock market is being rocked by the oil slick, the problems in Europe, and the recession. I disagree. I believe the stock market is telling us something about the future. It’s a warning that nobody seems willing to accept.”

-Richard Russell, May 26, 2010

It was the worst May for stocks since 1962, complete with rising volume and just the sort of beginning that would kick off a particularly nasty bear market. The S&P 500 (SPX) traded as low as 1040.78 last Tuesday, slightly beneath its February 5 low, the starting point of the bull market’s last intermediate-term advance, yet another confirmation that a primary bear market is underway. From high to low, the SPX was off 14.7% compared to 13.2% for the DJIA, 14.7% for the Nasdaq 100 (NDX) and 17.2% for the Russell 2000 (RUT).

Most indices held above their respective February lows, and short covering helped fuel last Thursday’s surge, a 90%-up day, stopping out remaining short positions just above 1092.29 (picked because it showed the completion of the first section down under my wave count) and in combination with a close above Tuesday’s high, also pointing to 1040.78 possibly marking the end of the first section down. A test of that low today should help determine whether the jump was the start of a more meaningful rally or just another one day wonder.

I realize most Wall Street professionals reading this letter use it as part of a mosaic in forming their own market decision, some even asking for more technical specificity. More casual readers complain of too much detail but I’ve included an important note for you this week, so be sure to read the last paragraph of the conclusion section.

Back to stocks, the April 26 high (SPX-1219.80) was unusual, ending not with enthusiasm, but complacency with breadth and most sectors confirming at the top. I think the rally from the March 2009 lows is best viewed a cyclical bull market, short by historical standards and one that the public sold into all the way up, the sort of selling that indicates a secular downtrend was in effect all the time.

As to the intermediate-term trend lasting weeks to months, I expect the first rebound rally, typically retracing one-third to two-thirds of the first section down, to carry towards the upper end of that range and possibly higher amid a mostly positive news flow. Remember, the bear’s job is to go down with as many investors onboard as possible and to that end, it needs to convince the majority that the weakness was just a another correction. I’m not sure what headlines look like six months out but last month’s stock price action virtually guarantees it takes a turn for the worse.

Psychologically, bear markets go through three phases- complacency, concern and capitulation. I suspect last Tuesday’s low likely proves to be the end of the complacency phase. To that end, big money’s attention will be tuned into the character of the next advance, with a powerful, high volume rally rocketing ahead while the crowd waits for a pullback being the most bullish action. In contrast, a stilted advance on light volume with divergences emerging while stocks that do breakout struggle would indicate danger, setting the stage for the second psychological phase (concern) where growth slows and the news worsens. The second phase is generally the longest in a bear market. If the market begins to experience the second phase, the third phase (capitulation) where investors liquidate stocks regardless of value will surely follow.

Back to the present, the Market Trend Indicator (MTI) is signaling DOWNTREND. Each key index is below its respective 18% weekly exponential moving average, 1133.58 for the SPX this week and 10,549 for the DJIA. The New York Advance/Decline line is 1,895 net declines below its 18% average. Net volume hurdle rates that need to be surpassed to signal an uptrend are (70.9) for the NYSE and (71.3) for NASDAQ but these could potentially recycle in the next few days with a lower hurdle rate.

In other markets, I’m looking to establish a short position in long-term U.S. government bonds, but it may be only an intermediate-term trade as flight-to-safety buying probably comes back into play as the bear market unfolds. As for gold, I suspect a moon shot is underway but I want to see prices on new highs on the first rebound rally in stocks. Note the parabolic rise in gold’s monthly chart, the sort of pattern that results in a fast up and fast down movement. I don’t plan to stick around if the pattern breaks and along that line I think it makes sense to raise stop positions on long-term holdings to just above the February 5 lows ($1058.00 2^nd London fix).

Harmonic Preview:

(Higher Probability SPX Turning Point or Acceleration Days)

June 2              (Wednesday)

Jun 11             (Friday)

June 14*          (Monday)

June 25            (Friday)

• An asterisk denotes a dynamic SPX price square in time; different factors account for the other dates.

Counting the April high as day one, the SPX is kicking on Fibonacci days, with the May 25 low 21 trading days from the high. June 14 was already on my list for other reasons but it takes on added importance because its 34 days from the high. These sort of counts work until they don’t.

The most important harmonics are based on pre-Euclidian geometry, the dates tied to dynamic squares in time of previous highs and lows in the S&P 500. The key is understanding which squares are working. These dates are not the key to stock market success, but often help trading and market understanding. You’ll be astounded at how many times the press struggles to come up with a reason for monster moves on these days in the absence of market-moving news. I am fascinated that the stock market, which is nothing more than human psychology in action wrapped around the business cycle, dances to these squares.

I also cross reference my dynamic square projections with anniversary dates of important highs and lows, Bradley days and a few other dates tied to the sky as well as clusters of prior 3-day swing chart highs and lows.

Conclusion:

Prices carried above my recommended stop position last Thursday, and remaining short positions were stopped out. The plan is to put on new short positions once the reflex rally runs its course, holding on through secondary rallies until the market runs its course. For the recovery rally, I would size positions (smaller) for a counter trend move. While small cap issues could still lead the advance, I plan to use ETFs tied to the SPX and NDX.

For non-investment professional readers, particularly baby boomers sickened by the last bear market but feeling better after the recovery, it’s no time to freeze or bury your head in the sand. If you haven’t already taken action, I recommend limiting exposure to stocks and raising cash once the reflex rally runs its course.

The information contained herein is based on sources that William Gibson deems to be reliable but is neither all-inclusive nor guaranteed for accuracy by Mr. Gibson and may be incomplete or condensed. The information and its opinions are subject to change without notice and are for general information only. Past performance is not a guide or guarantee of future performance. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without consent from William Gibson.