Market Indicators - Investor Sentiment: A Late 40-week Cycle?

» Normxxx - A Late 40-week Cycle?

1/22/05: From A Usually Reliable Source. . .

At the end of December 2004, everyone seemed ready to believe in the phenomenon of years ending in “5” always being up years, and investors were front-running that trade. January’s mission was to convince the public that the sky is indeed falling, that all hope really is lost, and to plan for a terrible bear market. Most of that work has been done, which means that now the market can get on with the mission of putting in an up year. A few more days’ mopping up operations are needed before the next uptrend can get underway. We do look for an up move to take the major indices to higher highs sometime ahead of the next 9-month cycle low due in June. It may take until another short term bottom due Feb. 7-9 before the up move can really get started. T-Bonds are moving up in spite of rising inflation, and in spite of commercial traders being net short. That condition cannot last, and bonds are in for a rough year, especially lower grade corporates. Gold should bounce to an April top, but it is just a bounce and not a new uptrend.

The term “right translation” is graphics analysis jargon, and is not meant to refer to works as a Republican interpreter. What it refers to is the idea that price tops for a given cycle in the stock market do not usually arrive on schedule, and the timing of their actual arrival provides us with information about the future progression of a graphics pattern.

The 40- week cycle is also known as the 9-month cycle, and the 20-week cycle is a half period harmonic of the 40-week cycle. The 40-week bottoms tend to be the more significant ones, and they also tend to be more punctual. The July 2002 bottom in the SP500 is a rare example of the market bottoming off schedule by a few weeks, but the next 40-week bottom in March 2003 was back on schedule. The 20-week bottoms tend not to be as deep, and they also tend to arrive earlier or later than the ideal schedule.

The actual 20-week bottoms arrive in reasonable proximity to their projected dates, but not as precisely as the 40-week bottoms. The current correction that is underway following the December high in the market is just the current iteration of a 20-week cycle bottom. When we see the high price for an entire 40-week cycle arriving very early in the cycle, that portends bearish things for the market in the months ahead. This is known as “left translation”, and we saw several examples of left translation all the way down from the 2000 high to the 2002-2003 bottoms. Beginning in 2003, we saw the market switch to right translation with the high for the cycle arriving very late in the cycle, and this implies very bullish things for the future. One side effect of right translation is that each 20-week cycle high is also usually late in arriving. The Dec. 30, 2004 top in the SP500 was later than the 20-week cycle’s ideal top date of Nov. 23, and so that implies that we are likely to continue seeing the 40-week cycle show right translation.

That should mean that on the next cyclic up leg out of this 20-week cycle low, we should see the major averages exceed their December 2004 highs. Whether they make all-time highs is a separate question, and not relevant to this discussion. It should be enough for the moment to have an expectation of a move above December’s highs. The next 9-month cycle bottom is due in early June 2005, and so sometime between now and then we should look for a top of the next up move. If that top is indeed higher than the Dec. 2004 top (1213 in the SP500, for example), then that will promise us continued good things for stock prices on the other side of the June 2005 40-week cycle low.

Bulls can take some encouragement from the fairly gentle way that this 20- week cycle bottom has been apparently put in. The major price indices have not really declined all that much. If the market can avoid getting hurt too much during a period when it is supposed to be weak, that is a good sign.

We have not even seen a day when the NYSE has had more 52-week new lows (NL) than new highs (NH) since Oct. 20. With the completion of this month’s 20-week cycle bottom not yet even evident in the price charts, this indicator is already starting to head upward. Having new highs start to make a comeback ahead of prices is something we have seen before at other price bottoms, so this is not all that unusual. It is an encouraging sign for the market going forward.

Bottom Line: Stocks are bottoming now on schedule for the 20-week cycle, and after a bit more thrashing around we should see a rally to another big top sometime before the big 40-week cycle low in June.

As part of a long term bear cycle for gold prices, investors have lost interest and will have to gain some interest back again in order for the next down wave to be able to proceed. We look for a rally of a couple of months’ duration, just strong enough to lure the suckers back in again, but not robust enough to bring about a new high.

We seldom mention them, but Rydex has several sector mutual funds in addition to its leveraged bullish and bearish stock market index funds. The Rydex Energy Fund invests largely in the major oil companies, with its top 5 holdings in Exxon Mobil, BP Amoco, Conoco Phillips, Chevron Texaco, and Total Fina. It is very well correlated to oil prices. The falloff in crude oil hurt that sector, and caused the investors in this fund to lose interest and pull their money out. As a result, the total assets fell by more than half from the October high, even though the Net Asset Value (NAV) has remained fairly stable. This dropoff in fund assets is therefore a statement by these investors that they are no longer interested at all in oil stocks, and any card-carrying contrarian will tell you what that means. Low readings on total assets are usually associated with tradable bottoms in both this fund and in crude oil generally. Based on what gold has said, and what these investors are saying, we expect to see a rally again in oil prices and in the stocks which track oil prices up into a March top before the next decline of significance.

Bottom Line: Oil prices should pop over the next few weeks, and should also mount a bigger uptrend toward year end.

Bonds Still Not Giving Clear Picture
If one were to look only at the price of long term T-Bonds, one might conclude that prices are about to break upward out of a long trading range, and so therefore we should all be as bullish as all get out on bond prices.

But if one looks elsewhere, the picture changes. If we look at the data on commercial T-Bond futures traders’ net positions as reported in the Commitment of Traders (COT) Report (see www.cftc.org), we see that these “smart money” traders usually end up being right in the long run. But they have been net short by a huge degree for the last several months, and bond prices have not responded with a decline. We expect their patience to eventually be rewarded. Prices meanwhile are trapped between a rising bottoms line and a curved rounding top line, each of which has been penetrated briefly during extreme circumstances. Prices cannot remain between them forever, and our expectation is that eventually a down move is going to have to unfold to prove the commercials right. A downward price move may be more apparent in the 10-year T-Notes than in the 30-year T-Bonds.

If we look at the yield spread between the 10- and 30-year bonds, we see it is at its lowest level since early 1992. That means that 30-year T-Bonds have been moving up in price to close the yield gap. When that happens, it is usually a sign of a top in T-Bond yields. But this time it is occurring as T-Bond yields have been falling, which makes this a bit of a head scratcher. The explanation probably lies in the fact that there is a very small supply of 30-year T-Bonds, and certain institutional portfolio managers are mandated by their investment policy committees to be invested in long term T-Bonds. That puts a greater than normal price premium on the few long term T-Bonds which are out there. If the U.S. Treasury ever decides to issue more 30-year bonds, which is not likely with 30-year yields at 4.6% versus 1-year yields at 2.9%, then some relative order may be restored to the T-Bond market. For now, the illiquidity of the 30-year market is skewing the picture for yields and bond prices.

It is our belief that the participants in the T-Bond market are blind to the dangers of inflation that are looming. They are passing it all off as being related to crude oil, which it is partly, but it is not as dismissible as they think. The leading indication for the CPI that is given by gold prices offset forward by 14 months shows that we still have a long way for inflation to go before it is done going up. Indeed, since gold prices topped out in early December 2004, we have to wait until early February 2006 before inflation rates should top out.

We will also have to wait even longer than that before people stop worrying about the “horrors of runaway inflation”, which is going to be the new catch phrase for 2005. Such inflationary pressure is bad for T-Bonds, and so it likely means that the commercial traders are correct in their bearishness.

Bottom Line: Bonds keep going up against all reason, but reason will one day prevail, and catch the complacent unaware. Watch for rising yields.

Some More Market Themes For 2005
Even though years ending in 5 are supposed to be up years, based on a string of successes dating back to the 1870s, not all investment opportunities are created equal. We are projecting a year in which small cap stocks will have a much more difficult time than they have had for the last few years in terms of outperformance over their big cap brethren.

The yield curve foretells the future for small cap outperformance. Usually the real yield curve shows a portrayal of all of the different maturities’ yields, and so we are taking just a portion of the yield curve by comparing the yield on 10-year T-Bonds versus 3-month T-Bills. We set this yield spread indicator forward by 15 months to get the leading indication for the ratio of index values for the Russell 2000 and Russell 1000. The generally rising spread between long and short term Treasuries over the last few years has correctly forecasted the outperformance by small cap stocks.

For 2005 and beyond, however, the yield spread indicator says that large caps are more likely to outperform. The Fed started raising short term rates in 2004, and long term rates have held fairly steady, thereby shrinking the spread. If things go according to the normal relationship, then this drop in the yield spread should start to be especially felt later this year and into 2006 in terms of small cap underperformance. Keep in mind that we are talking here about relative performance, which can be different from absolute performance.

But looking at relative performance can often give insights about actual performance. It frequently gives valuable early warnings about directional movements in the Russell 2000 itself. The relative strength line often breaks its own trendlines ahead of the corresponding line on the Russell 2000, and it recently gave warning of a price turn when it failed to confirm the Dec. 2004 top. One other theme that we believe we will see in 2005 will be an expansion of “credit quality spreads”. Corporate bond yields of all varieties have fallen much more than the higher quality bonds, and the spread between “junk” bonds and high grade corporates is at a multi-year low. We think that this is going to change, with investors increasingly looking for discounted prices on lower grade paper in exchange for accepting the higher risk.

The relationship between the Effective Fed Funds rate and the spread between T-Bond and Aaa corporate bond yields have an usually a good correlation, with spreads rising whenever the Federal Reserve strangles the liquidity supply. So far, there has not been any reaction to the Fed Funds Rate increases implemented by the Federal Reserve. That cannot go on forever, and we suspect that there will be some sort of major corporate bond default (or the scare of one) that jolts this spread back to life again. If our analysis of the transportation sector is correct, then a major company from that sector, perhaps an airline, will be the agent of that jolt.

[Normxxx Here:  Or, perhaps, GM or Ford debt re-rated to junk? ]

The content of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx