Charting Stocks

January 1, 2007

Charting Stocks 2007 Outlook:
The case for a Stock Market decline in 2007

-Contraction of the manufacturing sector: Usually precedes a recession

-Auto production declining by more than 10%: Usually precedes a recession.

-The collapsing real estate market: Public Home Builders report record cancellations. KB Homes 53% of orders were cancelled in 2006. Pulte Homes 36%, Lennar 31%, Beazer 58%. The average is 15%.

-The coming spike in Home Foreclosures: $1 trillion worth of option ARM loans are due to reset this year at higher rates.

-Anti-Americanism Soaring: Fueled by an illegal invasion and occupation of Iraq.

-The collapsing U.S. Dollar: Iran and Venezuela are moving towards a system which pays for oil in Euro rather than US Dollar. China expresses some concern about the US Dollar(They hold $1 trillion of it).

-Extreme media optimism: Usually a good contrarian indicator.

-The Breakdown of Copper: A good proxy for economic activity lies within price movements of copper. It recently broke down and violated a key support line.

-Insider Selling : In the first 2 weeks of December, insiders sold 55 shares for ever 1 they bought. Average for the 12 prior months was about 10 to 1. They preferred to sell and realize a 2006 taxable gain than to wait a couple of weeks.

-PPI (producer Price Index): A measure of inflation. November 2006 reading was the biggest jump since 1974.

-Inverted Yield Curve: Over the last 50 years, the yield curve has inverted nine times, excluding the current inversion, according to monthly interest rate data from the Federal Reserve. A recession has followed within a few months of eight of those inversions.

-Dow Theory: The current bull run in the Dow Jones Industrial Average which began in the summer of 2006 was never confirmed by the Dow Jones Transportation Average.

In Real Terms, The Dow Jones Registered a new LOW in 2006, NOT a new high: Real terms meaning inflation adjusted terms. During a true bull market, the Dow will reach new highs in both cash and real terms. The following charts illustrate this point as we look at the Dow in terms of ounces of gold, barrels of oil, and a basket of commodities. The bubble of excess liquidity and credit has distorted the true value of the stock market.

Here is a chart of the Dow Industrials in terms of Gold going back to 1980. We can see that the Dow violated a 20 year uptrend in 2001 and has actually been declining ever since. In 2006, the same year the Dow Jones made a new all time high in cash terms, it made a new multi year low in terms of gold.At the 1999 peak it took about 42 ounces of gold to buy the Dow. It currently takes 18 or so. The down trend is alive and well. Notice that throughout the great bull market of the 1980s and 1990s the uptrend remained in tact.

Next is the Dow in terms of crude oil. We can see the break down of the 90s bull market occur in January 2000, which was before the collapse in terms of cash. At its peak, the Dow traded at the price of about 812 barrels of oil. In 1990, we see a low of 62 barrels of oil to buy the Dow. In 2006, the market made a 15 year low in terms of oil. The down trend is still in tact. Currently, it takes about 200 barrels of oil to buy the Dow.

Here is the Dow deflated by the CRB (Commodities) Index. We see the decline begin in January 2000. In 2006, we hit a new multi year low. This is a bit more of an optimistic picture as a four year downtrend was broken. We’ll need to watch this one very closely.

The next 2 charts are the Dow Transports. Dow theory, one of the oldest theories in technical analysis, states that in a primary bull market the Dow Industrials, the maker of the goods, should be confirmed by the Dow Transportation Average, the shippers of the goods.–(Formerly known as the Dow Jones Railroad Index at the time Charles Dow developed the theory). Here we see a daily chart of the transports. Not only did it not confirm the new highs on the industrial average, but it’s beginning to break down. Violating its uptrend and now trading below both the 50 and 200 day moving averages. It also appears to have formed a head and shoulders pattern which is bearish.

Here is a longer term picture. This is a 2 year weekly chart of the Dow Transports. Again, we see an uptrend violation. We also see a breach of the support line and a MACD sell signal. The last MACD sell signal in this chart resulted in roughly a 20% drop in the transportation average.

The next two charts have had a 100% success rate in predicting declines going back 3-4 years.

The top half of this chart is the MACD of NASDAQ stocks trading above their 50 day moving average(Just a rate of change indicator of NASDAQ stocks which have been trading above their recent average price). The bottom half is the S&P 500 index. This chart goes back to 2003. Notice that when the faster MACD line (Black line) crosses downward on the slower MACD line (Red line) sell signals are given on the S&P 500 with 100% accuracy in this study. Also notice that the cycles normally last 5-7 months while this current cycle has lasted 9 months. Also take notice that the MACD lines of this current cycle reached the lowest low (back in July) and the current cross over was at its lowest high! (Market technicians view this as a weakening market). We currently have another sell signal recently given.

The following chart illustrates the intermarket relationship between bond prices and stocks.(Bond prices usually lead stock prices) The top half of the chart is the MACD and the price of the Lehman 20+ Year Bond Index (TLT). The bottom half is of the S&P500 Index. Notice that MACD sell signals on bonds (Shown by the red arrows) have followed declines in stocks with 100% accuracy in this study which goes back to 2003. MACD sell signals on bonds have always been followed by a decline in stocks. Here too, notice that the recent cycle registered both lower lows and lower highs on the MACD. Further notice that MACD has registered another sell signal recently.

The following two charts are market sentiment indicators which I like to watch closely.

Here we see the Russell 1000 Growth Index relative to the Russell 1000 Value Index. (It is simply the Growth Index divided by the Value Index). When the line is rising, growth stocks are out performing value stocks, which is usually a bullish sign. When the line is declining, value is out performing growth and is usually a sign of a more cautious market. Here we see a longer term downtrend in tact and a failed short term uptrend. The implication is that investors are getting defensive again.

Next we see the Morgan Stanley Cyclical Index relative to the Morgan Stanley Consumer Index. Cyclicals perform well at times of optimism, while consumers preform well when the market is more pessimistic. Here we see the short term uptrend, which began in August, has been broken. Money has been flowing out of risky and into safety.

Crude Oil: Here is a long term chart of crude oil analyzed by The Elliott Wave Theory. The theory is based on investor psychology as the driving force of financial markets. It is also tied in with Fibonacci Ratios which are found in many aspects of nature, art, and psychology. The theory suggests that markets move in set patterns. Uptrends have 5 waves. 3 up and 2 down. Wave 3 is generally the longest (it doesn’t have to be, but it can not be the shortest). The top part of the chart is the price of oil analyzed by the wave theory the MACD indicator on top. The bottom half is also the price of oil, but analyzing the third wave by Fibonacci retracements.

Here we see textbook waves 1,2 and 3. Wave 3 is the longest. We also see the breakdown and the beginning of wave 4. If the theory holds, we should see a retracement of approximately 38.2% of the preceding wave 3. The bottom half of this chart shows that this 38.2% level was reached and has rallied since. The implication is that oil will experience a 5th, and final wave up in 2007. A peak of $90-$95 a barrel is likely. Notice that the MACD has currently registered a buy signal. I think oil will have one last major move up in 2007 before it begins a steady, multi year decline.

We seem to be at or near a contraction point for both bond prices and stocks. It may not be a bad idea to increase cash positions and wait for this to play out. We’ve had a very nice run since the summer of 2006, but it appears to be losing steam. I believe that a 10+% correction is eminent although my opinion goes against the major consensus. (Which gives me added assurance).

Stock Pick for 2007:

KO: Coca Cola: A stock worth looking at. This is a consumer stock which is defensive in nature. We see a multiyear downtrend violated to the upside. Volume is increasing as the MACD is crossing into positive territory.

Happy New Year!!!

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