Tactical Analysis: Establishing the FLLOC - By Frank Barbera

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Down 200, up 200... clearly stock market volatility remains at lofty levels. Of course, anxiety on a number of fronts has eased in recent days as equities have stabilized and now turned in a strong recovery rally. Yet amidst the better days seen during the last few weeks, there are still many difficult questions to answer. Will the Geithner banking proposal entitled “the Public-Private Partnership Investment Program" (or PPPIP) actually succeed in stabilizing the banks? Or is this just another program attempting to place a band aid on the problem, rather then treating the root cause? Will the Fed ever actually be able to withdraw monetary stimulus without sending the economy back into a steep contraction, and if not, will this breed high inflation down the line?


And what about Quantitative Easing, the so called Q/E, wherein the Bernanke Fed has crossed the proverbial rubicon. Already auctions have run into serious problems in the UK which moved to Q/E ahead of the US. Will the US follow suit? And more importantly, are markets now getting nervous regarding the possibility that Bernanke means what he says? In the past, discussions of “using the printing press” have been mostly discounted on the premise that the Fed would never make a radical lasting move.

Flash forward to the last few months, and especially the last few weeks, and the action in the markets seems to start suggesting that the markets are growing concerned that the Fed will breed inflation to fight deflation no matter the cost. Long term yields are rising, not falling, post the Q/E announcement, gold stocks (especially juniors) have remained very strong, and other inflation hedges have firmed, resurrected from the dead. Even the rally in equities could be viewed as a sign that the market sees inflation ahead. Thus, many important issues prevail and beg the attention of investors to evaluate and assess. Stepping back to look at the big picture, the view from 30,000 feet, it is undeniable that with so many negative dynamics now in place within the broad economy the real question of just how soon a recovery can begin, and then what kind of recovery will it be -- these issues are more issues which are paramount for investors in terms of how and where they deploy capital.

In my view, a good starting point as it begins with a conservative view, is to start off operating on the assumption that major bear markets and major economic contractions of the current ilk rarely let go easily. In a situation like this, the investors most at risk are those who may mistakenly hop on board ‘a new bull market’ mantra, as powerful trends can often have large ‘fake out’ moves akin to the eye of a hurricane, where the sun shines thru for brief moments of time, occupying moments within the context of what could be a long series of new lows.

Thus, the periodic tactical assessment is in order, and it is my view that for investors to make the right decisions, the single most important concept is to seek out and pay attention to the message of the markets. Where investors are concerned, there are two kinds -- successful and unsuccessful -- those that have strong ego based, often implacable views, and those that seek to sublimate the ego, and look to the markets themselves as a guide. The idea of following the market's trend and letting the market tell you what it intends to do has no equal. For most investors, a basic understanding of trend change analysis and trend following will take them farther and with less mental anguish than any set of “hot, then cold” forecasts, for engaging in excessive forecasting involves the risk of the inevitable ‘cold’ streaks.

Dwelling on this subject just a moment more, we would suggest that being a successful investor is perhaps one of the most challenging of tasks as the very process of investing demands a money manager build up a certain degree of ego. It is critical for a manager, and/or a successful investor to be in command of his facts, and that the facts empower the ego. It is important for a manager/successful investor to be confident enough to pull the trigger when the time demands action be taken. Yet, it is death for a manager to become enamored with one type of philosophy, one particular approach, or to become too over-confident in his/her work/analysis. The market cycle is much akin to that of a great white shark, natures perfect killing machine, and the only way of navigating it successfully is to retain a martial philosophy that embodies a high level of flexibility of thought, and much impartiality. Being strongly bullish or strongly bearish is only appropriate behavior at certain points of the cycle. The rest of the cycle, the focus should be on knocking out singles and doubles and trying to maintain a focus on the message of the markets.

To this end, I would posit that at the moment the middle ground analysis of the equity markets would strongly point to the idea that equities are in fairly substantial bear market rally. Bear market rallies embody amplitude and time. In the discussion that follows, I feel like it might be helpful if we spend a moment now dwelling on how several different potential outcomes might develop. In so doing, I am now attempting to forecast anything. I am merely putting some of my past knowledge to work in order to draw up what could best be described as a list of helpful clues. I sometimes joke with friends and call this the Forward Looking List of Clues (FLLOC)
Which are really just notes for the tickler file a couple of weeks down the line.

To that end, let's start with a look at the S&P 500 and what could be described as the “Weak Bear Market Rally” Scenario. Looking back to the bull market highs of 2007, I now believe as do other Elliott Analysts that the Elliott Wave structure completed an important bear market “leg” at the March lows. At the time, I had a hard time deciphering the low, and had actually expected more of a basing process before the rally got underway, so the S&P rally took me by surprise, and that happens from time-to-time. That said, I have drawn in a yellow rectangle on the chart below to represent the 788 to 800 zone which dates back as ‘long range’ support to the 2002-2003 major lows. In my view, it is very consequential just “HOW” the market handles this, what is now resistance zone. A sustained move back above the 800 area could be sending a message that the stock market is finding real bullish traction, while a slump back below 800 into the low to mid 700’s in the weeks ahead would suggest the bear is still largely in command.



More to the point, a deep retracement to the downside in the weeks ahead would be a big marker to investors to understand that the message of the market in this event, is that of a ‘weak bear market’ rally. Bear Market rallies tend to be ‘three-step’ affairs, the Elliott A-B-C structure. The first wave is advancing, Wave A, then B-Wave cuts deeply back against the grain, and is then followed by Wave C up. Wave C will often make a higher high than the high left a the peak of Wave A. Wave B can retrace all – 100% of Wave A, or it may retrace just 50%, or 60% of Wave A. As a general rule, the more Wave B retraces on the downside of Wave A, the more momentum is being sucked out of any upside impetus in the equity market, and the more likely it is that Wave C will struggle to match or exceed the highs at Wave A. What we have ‘sketched in’ on the previous chart is sort of the ‘garden variety’ outcome. This outcome is consistent with a market which is encountering a period of hopefulness, but during which the basic solutions to the underlying problems are really not being addressed, which then in turm leads the market into second, major leg to the downside, Primary Wave [C]. In a primary bear market of high degree, Primary C–Waves to the down side are major bone crushers; they are always five wave affairs, and they can sink many, even in the professional community who fail to exercise risk control on assets under management.


A Primary C-Wave down would imply more deflation ahead and the inability of the Fed
to gain policy traction using quantitative easing. A Primary C-Wave outcome on the downside would also imply a great deal more pain ahead for the ailing banks, and likely in the end a nationalization type outcome. It is also possible that under this outcome, it may take a major dollar devaluation or a currency market crisis to unfold and run its course before equities end the down trend and reverse higher.

In the 1930-1993 Great Depression bear, the bear market ended when the Dollar was devalued by FDR with Gold simultaneously revalued. In my view, a good indication of a “weak bear market rally" outcome would be a market which produces an A-B-C counter trend pattern, with a deep retracement by Wave B, and a C-Wave that leaves the market fully overbought on a number of medium term gauges, while at the same time remaining below the January 2009 peak at 943.85 on the S&P 500. Notice that on the prior chart I also ‘sketched in’ some of the potential swings on RSI. RSI is overdue to become fully overbought. In this instance, I am referring to the 14 day RSI for the S&P which will become overbought above +70. In the chart below, I show the S&P daily going back to 1970. The 14-day RSI is plotted in the middle graph. The horizontal line is drawn in at +70. The bottom gauge is a Time Span Counter that counts the number of days in which the 14 day RSI has NOT been above +70. As of last night, it has now been 475 days without a reading above +70. That’s the second longest streak on record, and that means that the market is still due for more rally in the weeks and months ahead. A very big question for us to collectively assess will be, what kind of progress has the market made at the time the 14 day RSI next becomes overbought at +70 or higher. If the S&P has managed to move decisively above the January highs, and better still, above 1,000 at that time, the odds will be high that things really are improving and that perhaps the lows seen in March of this year may end up standing as the lows for the bear cycle. Even then it still would not preclude a retest of those lows, but it would argue against a material breach of those lows. So, a move above 940, and especially a move above 1000 on the S&P would take the worst case extended bear market outcome off the table.


Above: SPX from 1970 to date, with 14 day RSI (middle) and Time Span Counter – Days below the 50 day lower band (lower clip)

Yet another long dated Time Span now exists on the S&P with regard to the S&P and its 50 day Upper Band. With the S&P finishing Q1 2009 at 798, the 50 day upper band finished today at 893. That band is currently falling about two to three S&P points per day. However, at 369 trading days the Time Span counter is telling us that the current streak is one of the longest periods of time the S&P has seen over the last 30 to 40 years in which prices have NOT moved up to make contact with the 50 day upper band. That means that this event is now historically overdue, and that for some time going forward the market will have an upside bias and will seek to make contact with that upper band. Sometimes where markets are concerned, there is a very rhythmical nature that plays out and what has NOT happened can become just as important as what has happened. In the case of the 14 day RSI, and the 50 day upper band, both of these are arguing that there is more counter trend movement in front of us in the days and weeks ahead.


Above: Close up view of S&P with 50 day bands, last contact with upper band was 10/09/07. over 360 days ago. We are due to make contact (either by the upper band continuing to drop down to meet current prices and therefore prices holding up in this area, or by prices rallying to move up and tag the upper band, or some combination thereof). This is a marker that simply says, more bear market bounce is ahead and we are not ready to begin a major (sustained) stock market decline at this time.


Above: the S&P 500 with 50 day trading bands, and Time Span Counter with 369 days and counting – no contact with the upper band, 2nd longest streak ever.

Another idea that I find of importance at this time is the concept of ‘regression to the mean.’ Whether it is the Soro’s concept of Reflexivity, or some of the concepts explored by Walt Bressert in his Oscillator and Cycle Analysis, markets have a marked tendency to snap-back, to mean revert, when major extremes have been seen. In my work, I am always monitoring the ways various moving averages interact, and which moving average combinations have in the past sent out powerful signals. At the moment the 50 day moving average and 250 day moving average combo are sending out a particularly strong message. Here again, without concerning ourselves about what the ultimate label will be, the message is that a rally phase, or at the very least a counter-trend phase is likely underway and has more time and room to run.

On the next chart, I show the spread between the 50 and 250 day moving averages on the lower clip with a close up view of the averages themselves. More importantly, I then zoom out on the chart to show the 30 to 40 year view, going back to 01/01/70 as a start point. From this vantage point, we see that the current spread between the two moving averages is about as far as it ever gets, and this includes the data from the most recent rally right up to last night's close. The point here is that the 50 day average will likely need to narrow the gap toward the 250 day average before this counter trend rally phase is complete. It is reasonable that the next important stock market top could be seen as this gauge, “the spread” returns toward zero. For now, this implies more time and likely some additional price still ahead in the medium term bear market bounce.


Above: the S&P 500 with its 50 day moving average and its one year, 252 day moving average.

The bottom clip is the spread of the 50 day versus the 200 day average.


Above: Exactly the same chart, just seen from a 30 to 40 year point of view. We are still
in a big outlier.

In this week's update, we have dwelled on some of the outcomes for the equity market with an emphasis on the ‘weaker’ continuing ‘bear market’ scenarios, while next week we will do the same analysis in Part 2 and look at what might be a healthier set of expectations, and a more favorable long-range outcome. In setting up this list of crib notes now for both outcomes, we hope that over the next few months we will be able to compare what actually unfolds to some of these ideas and hopefully glean some insights as to what kind of climate the markets are really trying to telegraph over the longer range. In the end, it is the market's interpretation as to the effectiveness of all these efforts at systemic repair that will be the only thing that matters. In my efforts I am in no way trying to tell the markets what to do, but quite the reverse, seeking to draw up some guidelines now (in advance) from which I hope to gain a better focus on the message that the markets will be trying to tell us.

That’s all for now,

Frank Barbera

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