Are we going to crash?

So far, 2008 has been a disaster for the stock market. The stock market had its worst New Year’s hangover since 1904! The Dow Jones Industrials had two 200 point down days in the first three days of trading in 2008. The NASDAQ composite index was down more than 98 points for its biggest one day decline since Sept. 17, 2001, when the stock market first opened after the 9/11 disaster. This is important because of the January Effect – where investors view the market’s performance at the beginning of the year and extrapolate for the remainder of the year.

The January Effect has a few versions. They are:

that stocks do better in January than any other month of the year;

what happens in January predicts how stocks will act the remainder of the year; and

small cap stocks do better than large cap stocks in January. Well, as bad as January was in the first week of the New Year, it has been at least equally bad through its third week. The January Effect has been accurate 70% of the time since 1900, however, since 2000, the record has been sporadic – up in 2000, down in 2001, 2002 and 2003, up in 2004, down in 2005, up in 2006 and down in 2007 (and now in 2008). Well, don’t worry about the January Effect – there’s a lot more going on than that.

From their October 2007 intraday highs to their recent lows, the Dow Jones Industrials have lost 15.3%; the S&P 500 has lost 16.8% and the NASDAQ 100 has lost 18.3%. The markets are rapidly approaching the 20% decline level, which happens to be the minimal decline in 85% of the peak to trough declines in the four year cycle. So, the good news is we may be setting up a four year cycle low. On occasion, the four year cycle lows are extended as was the case in 1987 and in 1938. The bad news is that four year cycle lows can occur in bear market periods such as 1938. In fact, the four year cycle low in 1938 followed a five year bull market ending in 1937 with the prior four year cycle low in 1932. 2008 follows a five year bull market ending in 2007 with a prior four year cycle low in 2002 – very interesting.

In fact, there are a number of similarities going back to that time period. The most impressive long term analog I recall seeing happens to cover a 14 year period from 1924 to 1938. It involves the Dow Jones Industrials from 1924 to 1938 as compared with the NASDAQ Composite from 1994 to 2008. The general price movement of the analog alternatively from low to high to low is incredible. The explosive run-ups and the crashes coincide remarkably. The analog is in months, so its value in not in fine tuning.

However, it has been an excellent roadmap for quite some time. On the next page, you will see the analog and a chart I have included below the analog that shows the turn dates for the current time period (assuming the analog continues to remain accurate).

You will most likely want to increase the number in the percentage box on your toolbar to 200% or greater as it will make the dates much easier to read. The analog has January as a reversal month i.e. the expectation would be that the market reverses its decline this month. As good as the analog has been, analogs should be a tertiary indicator at best. Following the analog page is a chart of the S&P showing where I feel we are headed. I have had a turning point set for late this week. It appears with the recent market action that we can expect a low this week. I would expect a low to be made tomorrow or Wednesday followed by a bounce and then a test of the low on Thursday or Friday. I would then expect a rally for five to seven trading days or so. Then we should see another thrust to the downside that will, hopefully, complete the first leg down and allow for a rally that lasts for a number of months.

This scenario is the most bullish case. The alternate scenario would follow much more closely to the analog. The alternate scenario is not to be taken lightly. It would call for a more extended rally after the upcoming low. However, it would be followed by a much more severe decline. Remember, the analog is of the NASDAQ Composite and it calls for about a 50% correction from its recent October high. The Dow and S&P 500 may not fall as much, but you can count on severe declines in these averages, as well – assuming the alternate scenario is what occurs.

What is the risk at this point?

In case you hadn’t noticed, “they don’t ring a bell at the top.” That is an old market adage that hasn’t gotten much play lately. The reason is that no one was thinking about a top in this market until fairly recently. The point is that the financial news media doesn’t warn you that a top is forthcoming. They didn’t do it in 2000 at the top and they have never done it at any other top in market history. Oddly, investors are glued to the financial news stations during the day when recent history showed that the commentators at the last top had investors buying stocks all the way down … and then had the audacity to say the market was “obviously” way overvalued in 2000 after the NASDAQ 100 had fallen over 80% from high to low. Clearly, it wasn’t obvious to any of them.

Since we now know we can’t rely on the financial news media during extremely critical times, maybe wecan rely on economists and market professionals i.e. the major brokerage houses, the major banks, etc. Uh, no … that doesn’t work either. A classic example was at a very critical point in our history when not one of the panel of 55 top corporate economists at the National Association of Business Economists correctly forecast a downturn in 1982. Interest rates moved above 20% in late 1981 and one of the country’s worst recessions ensued. For the first time on record, virtually all of the economists saw growth for the next three years (just prior to the recession). Worse yet, after 1982, the consensus each year was that another recession was right around the corner. Those opinions were being given amidst the longest economic expansion in 20 years. Specifically, they were very wrong about 1982 and they continued to be wrong about 1983, 1984, 1985, 1986, 1987, 1988, and 1989 -- and then, for 1990, they finally foresaw no recession occurring in the next three years -- immediately preceding a recession! So, economists can’t be counted on for help either.

Obviously, we must turn to the major brokerage houses and the major banks – surely the answer lies there. Sadly, these are the folks who are monopolizing the front pages of your newspapers because they are writing off billions of dollars of bad debts. These are the world’s top brokerage houses and the world’s top banks … and they are the major victims of the current real estate crisis. These are the people you are counting on to save you if things get worse? These folks are the managers of the major wealth in this country. When things go wrong in the economy, you need an “out-of-the-box” thinker. If you think about it, the major banks and brokerage houses are “the box” – by definition. Let’s get a couple of visuals about what we may be facing.

The above chart shows the first break in the long term trend line from the low in 1982. It includes the serious market decline of 2000 to 2002. We have recently broken the trend line and the implications aren’t good. However, before we draw any conclusions, let’s take a look at one more chart.

I made the above chart on the first trading day of the New Year. The frightening thing about this chart is twofold – 1) it implies we have been in a secular bear market, and 2) it is the institutional index – the point being that institutions run the market. Regardless of what may be happening in other indices, the institutional index is a representation of what institutions have been doing. This shows the peak in 2000, the drop into 2002 and a perfect 61.8% retracement of that decline – just what one would expect in a secular bear market. This is compelling because we are now in position to experience “when the second shoe drops” – the old market adage that refers to the first decline as merely a precursor to the second decline when they take no prisoners.

Are we going to crash?

This brings us to the big question, “Are we going to crash?” Crash happen from lows, not highs. We are certainly at a low area. In 1987, the dollar had been in a free fall against other currencies just as it is now. The Administration doesn’t seem to be any more concerned about the falling dollar now than it was then. Just prior to the 1987 collapse, foreign stock markets took a tumble – just as they are doing now. In 1987, the market had a Black Monday – currently we were saved from a Black Monday due to a holiday – otherwise, the set-up is very similar. In 1987 the economy was not in a recession and not about to enter one. Currently, we aren’t in a recession and praying that one won’t occur. Frankly, we’ll just have to wait and see. The weak dollar is boosting foreign demand for US products. One argument is that the subprime mortgage problem is being exaggerated and things aren’t really as bad as they appear. Of course, the other side of that equation is that things are going to get much worse. One thing for sure, we are in position for a crash to occur. Since I am expecting a low this week, a crash could certainly take us to that point, however, I don’t believe it is any more probable than an orderly decline. We are now quite oversold and we could just as easily find a bottom at or near the recent overnight lows.

Gold and the U.S. dollar

I got a sell signal on gold as it reached its over-extension price as shown by the dashed line in the chart below. This was very similar to when gold made its peak in May of 2006. On Friday, my weekly numbers confirmed the sell signal and implied that gold could have a decent correction. Ironically, the daily numbers have signaled a buy as of Friday. When this occurs, we look to market action for clarity. If gold has a weak rally or fails to rally at all on Tuesday, then the weekly numbers should dominate and I would expect weaker gold prices to about February 1st. Initial targets are $825 with a potential to drop to $771 if the weekly numbers prevail.

It is interesting to note that the US dollar gave a buy signal on its weekly numbers at the close on Friday. This confirms the gold signal, but is somewhat surprising as it appears obvious that the Fed will be dropping rates. This should be interesting to watch as the US dollar has acted well in the very short term.

Final Note (written the morning of January 22nd): This Alert was written over the weekend. I anticipated that the Fed might make an early move to reduce the result of a panic driven market, so I waited until this morning to e-mail this Alert. The Fed acted by cutting interest rates by 3/4 of a point. This is viewed as a bold and overdue move. I will stick by what I stated in the Alert. I think it is important to remember that we have had five years where buying the dips was the most logical approach. Selling the rallies will now take center stage.

I would like to point out to any new readers that we pegged the top in July to the exact day in Special Alert #45 dated 7-17-07 and called for a top on July 19th. In Special Alert #46 dated 10-5-07, I stated “I am expecting a top next week”. The market topped the following week.

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