Putting the pieces together...

Close-up of Santa

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Seasonals & Seasonals

If we look at the seasonal of the Dow since 1928 there is a tendency for the Dow to top right at the New Year, like last year.

But if we just look at more recent years, the SP500 futures seasonal from 1982 shows that the SP has topped later than a 77 year Dow history:

Since the 11 and 77 week cycles top (presumably) in February as shown in this chart, the rally could run longer.

Near term all the seasonals have a mini-low in the 12/19-12/21 time frame before the Santa rally runs.

Pretty Close...

While cruising the "blognet" today, I came across this chart which was said to be from Bank Credit Analyst's (BCA) December 2005 issue. If so it would be typical of what I remember of that excellent publication from when I had a subscription ~25 years ago. Even before that, back in the  dark ages of the 1950's and 60's, BCA were like the Arab scholars and Chrisitian monks of the middle ages who preserved the wisdom of Greek and Roman antiquity. In their case  BCA  preserved and annually reviewed Elliott Wave analysis of the major markets, long before Bob Prechter even thought of going to Yale to study psychology, or perhaps even to kindergarten.

A. J. "Jack" Frost, who co-authored the Elliott primer blockbuster with Prechter, was one in a line of BCA analysts who worked with Elliott techniques after Elliott's death.

BCA has normalized  SPX from 2002 to now for comparison with the average of all eight prior post bear market bull rally phases. I didn't see BCA's text, so I'm not sure whether by "real" they mean total return with dividends reinvested, or whether they mean inflation-adjusted. But I guess it doesn't matter very much. What we see is that 2002 to now is a good proxy for all eight prior bull-after-bear phases in the first three years from the bear low. Put another way, it isn't "different this time": it's almost exactly the same pattern.

Using a nice little tool called Chart Overlay (www.OmniumSoftware.com), I measure the typical pullback into early 2007 at about 31% of the post 2002 low to 2005(?) high. Assuming that this past week's SPX high 0f 1275.8 holds, this would take us down to ~1120. Actually, based on the seasonal chart odds, I still think Miss Market will dance up until New Year's Eve. But think of a 30-35% retracement of the bull rally, or ~13% decline off the high, wherever it may be. This idea fits well with my own hunch I have outlined over the past month or so.

I mentioned before Bill Hester's article this month at Hussman Funds: "Average Gain in Year Two of Presidential Cycle Hides Important Declines". http://www.hussmanfunds.com/rsi/prescycle.htm Hussman Funds does, of course, have a negative bias over their entire history, which has not, however, kept them from making money. I have some money in their strategic growth fund (HSGFX) to take advantage of their excellent hedge fund approach to controlling risk while making money.

Hester goes over some of the same ground BCA did, but he does it in terms of the secular four year US presidential cycle in which 2006 is year two. It's a short and well-written article, so I won't summarize it here except to say that Hester feels one  needs to take valuation into account as far as the size of the pullback is concerned. When valuations are high, as Hussman folk believe, the second presidential year pullbacks are deeper than when they valuations aren't high.

If you tie this and the BCA chart into the annual "learned seasonal" (from www.CSIData.com) which Hester hints at, you can see that we may be on the cusp of the correction in a week or two. The chart is the Dow learned seasonal since 1928, but the 20 year seasonal for Nasdaq100 and the 55 year seasonal for SPX are quite similar: basically downward from early January to late October, then sharply up for two months.

All three of these "cycle studies" are the stuff of statistical odds which I have gradually gained a greater appreciation for, especially after reading Vic Niederhoffer's "Practical Speculation" which a good friend gave me earlier this year. It is like handicapping a horse race or a football team for betting. You may not always win the race or the game, but it's the way to bet: previous similar places in markets after a bull run, a secular political cycle, and the annual "seasonal" pattern. Then there is all the rest I have written about below....from Paul Kasriel and others.

Where Oh Where Are the Bears?

Today my sentiment work has the lowest bearish reading I have seen since I started doing this work in 1996 (for some of it) and 2001 for the rest. I realize it is treble witching and options "extirpation", but that happens four times every year.  Whether or not we get the Santa rally, this market is skating on thin ice.
 
 
Using plain Jane VIX as a proxy (imperfect) for my stuph, now looks a lot like conditions in December 1993 and December 1995 before the next years' corrections  and subsequent big bull runs on increasing volatility.

 

Bill Hester of Hussman Funds, who does excellent statistical work, has recently posted an analysis of what the markets do in presidential second years, which basically is to reinforce the annual seasonal downward move from January to October. This would also fit with a bi-phasic pullback in 2006, which in Hussman eyes might be deeper than usual because of what they see (house bias) as persistent over valuation.
 
Personally, since I have to live on my money the rest of my life, except for trading profits--and I'm tiring of trading--I have been selling off parts of grossly appreciated sectors of the past year and gradually hedging long term (and hopefully superior) core holdings. For hedging I am using SP futures  (which now gives an interest rate kicker to short positions: three month SDP futures are eight handles ($2000) per contract above the expiring  contract, so you make $2000 being short even if the SP500 stands still for three months. In cash accounts (retirement IRA's) one uses Rydex or Profunds "double down"  or 200% short  funds the same way.
 
I thought last week that gold was done for a while, and my old buddy, I M Vronsky, put up the piece at Gold-Eagle which I had previewed in drat here at the blog. Durong 2005, people who got scared out of Euros and Yen, but eschewed dollars and/or also bought gold, are reversing that  play.
 
http://www.gold-eagle.com/editorials_05/drake121205.html

Gold Eagle First Draft

We have every right to celebrate gold's success of the past six years. Compared to the Standard & Poor's 500 Index (SPX,VFINX on the chart, in red), Newmont (in lime green), BGEIX (American Century Global Gold, in cyan), and VGPMX (Vanguard Precious Metals, in blue)have hugely outperformed SPX and have even surpassed long term outstanding global stock fund SGENX (formerly SoGen Global, now First Eagle Global, in fuscia). On a five year total return basis Newmont Mining has grown at a 25.27% compound annualized rate, and VGPMX, reflecting greater gains in copper and coal, has compounded at 31.18%, while SGENX has "only" compounded at 18.14%. On the same five year basis VFIMX (SPX)has barely returned to its level of December 2000, returning -0.14% annually.

Longer term, the news is not so wonderful. Looking at the same representative funds and stocks since the 1987 crash low, SGENX has a compounded total return of 13.5% annually, VFINX (SPX)11.42%, VGPMX 7.85%, NEM 4.21%, and BGEIX 3.48. (Barrick Gold, ABX, that great growth gold story of the 1980's and 1990's had an 11.9% annualized return from late 1987.)If we take the annualized return of gold from the first market day of 1975 when it became legal to own the metal in the US, the annualized return to the Friday New York cash close of 525.50 is 3.6% per year over nearly 31 years. This does not include storage and insurance, if any.

There are several positives one can offset against this abysmal long term return for gold. Holding a reasonable allocation of gold in a diversified portfolio did reduce portfolio volatility. In the late 1970's and 1980-81, gold contributed positively to overall return when stocks and bonds were in bear markets. From 1996 to 1999 gold was a drag upon overall return. A second positive could have arisen for those investors who persistently pursued a dollar cost averaging (DCA) approach, whether monthly , quarterly, or even annually. There were very few months or quarters when gold traded above $500 as it does today, so an accumulator would have a nice collection of gold coins or bars or shares of a gold mutual fund or major gold stock.

Gold investors have a better understanding than most others of the long economic wave of inflation and deflation known as the Kondratieff Wave. Even though gold's price was controlled at $35 per troy ounce from 1934 to 1969, gold investors know that it rose in little over a decade to $850 and then fell for two decades to $252. Now if we extend price history to a basket of commodities or crude goods or the CPA or PPI, we find that the cycle is actually a bit longer with an average of 26-27 years up and 26-27 years down. But gold's price behavior alone gives us great insight into the basic fact of the long economic cycle which affects nearly everything in economic life. Of course there are other shorter and perhaps even longer cycles which modulate the Kondratieff cycle, but the Kondratieff stands out clearly on long term charts. Gold investors have lived that cycle either personally or through study.

One thing we can say with certainty is that gold will be in a secular bull market for far longer than it has been since 1999. What I have learned from living and investing through an entire Kondratieff wave is that neither the tops nor the bottoms are usually spikes (although gold had one in 1980), and that not every commodity or crude good tops or bottoms at the same time. I learned that 1974 was the average or consensus top year of many commodities as well as interest rates, labor data series, personal incomes and a host of other economic data which cycle together with the economic wave. 1974 was also 54 years from the 1920 inflation high. ~54 years before that was the 1866 US inflation high, and ~54 years before that was the 1812-1814 inflation high. The lows are at about the halfway point and are ground out over five to ten years, as are the tops. 1999-2003 certainly qualifies as a Kondratieff wave low. Having lived through both the 1974-80 top formation and 1999-2003 bottom gave me an appreciation for the difficulty of entering and exiting various markets exactly correctly and "just in time".

Nevertheless, knowing that a Kondratieff wave low is probably forming gives one an enormous advantage for long term returns on capital. Being able to add to long term gold holdings between 1999 and 2003 and re-entering the stock market in 2003 adds immeasurably to returns. Even more valuable is knowing that, based upon a typical Kondratieff inflation half cycle, we can confidently predict that the gold bull still has two decades more to run. This will not be a straight line or parabolic rise, and there will be one or several multi-year bearish segments within the two decades which will devastate highly leveraged investors and producers. When investor sentiment and behaviors become outrageously bullish or bearish, the market corrects them, down or up. But the long term perspective which Kondratieff gives us is "priceless", as the credit card ad tells us.

In previous Gold Eagle editorials of 2000, 2001, and 2003, I analyzed the gold market in the midst of the bottoming formation: http://www.gold-eagle.com/editorials_00/drake080100.html http://www.gold-eagle.com/editorials_01/drake043001.html http://www.gold-eagle.com/editorials_03/drake100103.html

The Elliott Wave analysis I made in 1999-2000 of the entire modern history of legalized gold in the US remains unchanged. I believe it fits all of the facts, the dynamics, and the generally accepted rules of Elliott. My approach is what a trader friend calls "KISS wave": my Elliott interpretive bias lies somewhere in the great middle ground amongst Elliott's own work, the work of Frost and Prechter, and that of Neely. I am long past arguing with other interpretations. If you are comfortable with another "count", and if it consistently makes money for you and gives you the lay of the land going forward, keep it.

My view is that the last great bull market phase had its first wave ending just after US legalization in 1975 at just under 200, its second wave ending at just over 100 in August 1976, its third wave ending at the all time high in Janaury 1980, its fourth wave ending in March 1980 and its fifth wave--known as a "fifth wave failure"--ended at the fall equinox of September 1980. The long decline of the Kondratieff wave for gold is detailed in those previous Gold Eagle editorials, and I won't belabor it except to point out the 13-1/2 year B wave contracting triangle from 1982 to early 1996. One should ponder that very long brutal period as a brilliant example of what can and does happen in long wave formations! In fact, the first low (wave A in my chart) ended just below 300 in 1982 with the 1999 low being only $50 lower. Gold spent 17 years backing and filling before making that final low in 1999.

Although I believe at this point that gold is in the early stages of a multi-decade Elliott impulse third wave which will make higher highs than 1980, that grinding "killer B wave" from 1982-1996 should help us accept the possibility that we could be into another B wave at this time as part of an even larger correction from 1980. We needn't address that issue now. I mention it only to remind in another fashion that we should expect some long and vicious corrections to the uptrend in progress, not forever steady progress upwards.

So where are we? And where do we go from here? In re-reading my last attempt here I am humbled that I missed the top of the wave then in progress up from 2001 by being seven months early before the correction of 2004-2005. I was also off early by one impulse wave. In both cases the lesson to be learned is that things often go farther in price and longer in time than one generally supposes or would like the case to be. Despite my earliness, I was correct in the direction and implications: unless this is just the first wave of a B wave up from 1999 and not an impulse wave, as hinted above.

http://twocents.blogs.com/weblog/ This is a non-commercial (free) blogsite.

My current Elliott wave opinion is that we are near the completion of wave three (3) up from 1999. Wave two (2), from the 1999 high to the 2001 low, was so deep (97% retracement of wave one) that I don't think it is very likely that this current wave three (3) is instead wave C of a larger degree wave B as mentioned above. The "power" implication of such a deep wave B of B does not favor such an extended wave C of B from 2001 to now.

A viable alternative is that wave three either has subdivided or extended or is now in the process of doing so in its own wave 5. However,for the moment I will continue with the "KISS Wave" concept of a relatively simple five wave structure up whose only out-of-the-ordinary structure would be a complex or combined "double three" with labelling of a-b-c-x-a-b-c-d-e. Basic descriptions and implications of such formations are found in Frost's and Prechter's classic book and in Neely's. A strong move generally follows. Thus far wave 5 is about 100 dollars which fits neatly with wave 3's 162 points, and it is about 3 times wave 1's 34 points, while wave 3 is 5 times wave 1.

In writing a long term perspective it is tempting to get caught up in the moment and presume to know exactly where one is in wave structure and what "must" happen tomorrow or next week. Be assured that I do not claim clairvoyance or infallibility, and my 2003 editorial is humbly offered as proof! Nevertheless there are a few times in Elliott structure when outcomes are more certain than at other times. Assuming the outline form 2001 is correct, and we are now in wave 5 of larger degree three, it can only end or extend.

Instead of using Fibonacci projections from wave 1 of larger 3 and of 1 of smaller 5, I thought I'd show some Rule of 7's projections from the same initial moves. The method is described in Arthur Sklarew's "Techniques of a Professional Commodity Chart Analyst", published by CRB in 1980 and reprinted in recent years. One takes the length of the wave "projected from", multiplies it by seven, and then divides serially by 5, by 4, by 3, and by 2. Then each of these four products is added to (or subtracted from in downward markets) the base or origin in the same manner as with Fibonacci projections. In the present case, both waves 1 project 7/2 for 5 of 5 to be in the vicinity in which New York cash gold closed on December 9. If I happen to be right, consider it to be the cousin of winning the lottery: low odds but a large payoff. I can see five waves up from the blue 4 low at about 420, and both the inter-wave ratios and the Rule of 7's are consistent with an end to wave 5 and larger degree 3 (black). Sentiment is also quite exuberant, and rightly so, but that's when impulse moves often end: when things look really good. I don't see sentiment as wildly exuberant as gold was in 1980, NASDAQ was in 2000, or as crude oil was this past summer, but it's "exuberant enough".

If I'm correct now or in the near future, I would expect black wave 4 to last about two years (exceeding wave 2 from 1999 to 2001) and for wave 4 to retrace approximately one half of wave 3 (black). This would take gold, using current prices, to about 390. This level is well into wave 4 of the previous wave of smaller degree and is also ~150% of the 1999 low. Waves 4 needn't be longer in time than waves 2, but they frequently are longer as they are often complex waves rather than the simple abc's seen in wave 2 position. Frost and Prechter cast waves 4 as "waiting for everyone to catch up" or perhaps leading to early failed fifth waves as some participants "leave the party early".

If this analysis is anywhere nearly correct, the eventual wave 5 high might be under 600, unless wave 5 extends. It it doesn't extend, the ensuing larger degree wave two (or wave B correction), from a completed five wave structure up from the 1999 low, could retrace much of the same terrritory and last for two to four more years. Thus one can see how extended periods of sideways action can develop during secular bull markets just as a thirteen year B wave took up much of the bear market from 1980 to 1999.

This scenario does not mean I am bearish on gold or don't like gold. Quite the contrary. We all know that all paper currencies are doomed over long periods of time, even for the best, because they are run by imperfect political human beings. We have seen gold rise dramatically this year in Euro terms and even more so in Yen terms. And this while the US Dollar rose! Rome was neither built nor destroyed in a day. Decay of great currencies and great civilizations is not linear nor short term. Rebounds and real advances occur. So one must not expect the worst to happen on this watch and get overleveraged and wiped out by committment to an untenable expectation.

For more on the near term market fundamentals and economic technicals, as I understand them from others, please refer to my posts of the past few months on

In the long run gold is a better holding and a better trading vehicle if it does back and fill for a while. Blowoffs and crashes beget longer periods of dullness than KISS wave moves. Accumulate on weakness, since time works for those who accumulate gold during pullbacks. But also remember that the 31 year rate of return for modern US investors in gold is ~3.6% compounded annually, despite the dramatic bull market into 1980.

So Far, So Good

The market scenario I chose last time in "Push Comes to Shove" remains in place. I think the market is working its way toward an intermediate term high which will result in a larger correction than we have seen since March 2003. Furthermore I think that high is likely to be in December or early January. I'll review the evidence.

The biggest piece of evidence is also the most recent. Long before I traded stocks, mutual funds, and stock index futures I was a commodity trader. One of the best of all sentiment measures is comparing the net futures (and futures options) positions of the insiders  with those of the speculators, large and small. Futures exchanges were first set up in Chicago in the 19th century to transfer risk from producers and banks to speculators. Guess who is most often  right about  danger ahead (and therefore putting on short hedges) and who is wrong?

My "pay for" guru on this subject is George Slezak http://www.cot1.com/ But you can read the weekly results for free from the US Government: http://www.cftc.gov/cftc/cftccotreports.htm  The big change is that the knowledgeable players, the commercial hedgers, also known as the insiders, have switched from a major long position at the October lows of six weeks ago to a major short position as of this last week. This is compelling news.

Other sentiment as I measure it, and as measured by others, is into a zone which has sent the stock market down over the past two years. We've had two or three short term tops in both years at new bull market highs or near new highs. So unless "it's different  this time", there should be a decline before too long. What could make it different is what last month I called the "bullish wild card", which is that the markets breakout and run up in a new bulish leg like that one of 2003. Part of my sentiment studies depend  upon interpreting VIX. The CBOE's White Paper on VIX is a good place to start to get up to speed: http://www.cboe.com/micro/vix/vixwhite.pdf

A chart from that White Paper shows the basic usefulness of VIX:

(Click on the image for a larger pop-up version.)

CBOE began publishing VIX in 1993 using options data back to 1990. I think of VIX as a fear index which goes up when market players are worried enough to pay up for hedging insurance, and goes down when they are more confident without insurance. This is a gross oversimplification

but it works for my purposes.

In 1990 Saddam Hussein invaded and planned to annex Kuwait, and later set fire to its oil fields as he withdrew. In addition to changing the course of history, which continues to this day, these events shocked the stock market at the end of the decline from 1987 and the savings & loan implosion. VIX rose to high levels as stock portfolio managers and others rushed to hedge short or sell short.  During the subsequent bull market from 1990 to 1994 the SP500 rose from just under 300 to 480, and VIX "fear" dropped from near 40 in 1990 to between 10 and 15 from 1993 to 1996 with occasional drops under 10. In 1996 the stock market corrected and then  began the great bullmarket into 2000. But unlike 1990-96, VIX began to rise on a trend basis with the price of stocks.

With VIX hovering around 10 recently, what could "be different this time" if the stock market really begins to take off along the lines of the 1935-37 scenario presented in October and November? This is how some analysts, including me, who use sentiment measures which utilize VIX and put/call ratios could get fooled. Sentiment has become very popular, but it could be entering a period of time when it will be less useful than it has been since the 1990's. The current very low sentiment readings, which have characterized stock market highs for two years, could rise but could do so either because stocks break down or up.  Also, if the market breaks upward we could see what is called a "recognition wave" when the majority would be right that the market will rise further, so even polls and other methods of sentiment would get fooled.

For this reason older market analytical methods like the NYSE advance/decline line and other volume and breadth indicators may be more important. We are seeing some of these indicators begin to evidence a slowing of the advance. The advance/decline line has turned down in the past few months. It's certainly not a timing method as many shorts learned painfully in the 1990's, but it's a hint of a change. Likewise the "last hour versus first hour" or "Smart Money Index"  has been falling for a year now which indicates distribution by the "smart money". Notice how the market often opens up in the morning because of enthusiasm, but frequently sells off in the last hour or half hour.

While they aren't infallible, they have been around a long time, and the Lowry Report people have been seeing multiple indicators suggesting a larger pullback in the market. I won't get into economic indicators in detail, but GDP was revised upwards although a lot of other factors are rolling over. Review the post in October on some of Paul Kasriel's indicators, or read some of John Hussman's weekly posts. www.hussman.net/index.html

I have increased short hedges on stock and mutual fund positions and have reduced holdings of some inflation hedges. I'm still net long and hoping to increase hedges gradually into year end rallies. Some neural network folks I know who have been doing this work since 1996, are projecting a decline for the next week or ten days. This would fit with the SPX and DOW seasonal patterns which go back to 1949 and 1928 respectively. These are just statistics, not promises, but the market often declines into mid December and then the Santa Claus rally takes us to year end.

I will begin to see that I am wrong if we have a large advance of several days with VIX rising instead of falling.