From the August 01, 2010 issue of Futures Magazine • Subscribe!

Are we at the beginning or end of a bear cycle?

The major bull market peaks over the past 60 years were 1973, 1980, 1987, 2000 and 2007. Learning to recognize these peaks prior to their arrival has obvious benefits. My analysis of the Long Wave cycle with a proprietary set of technical indicators allowed me to forecast each of those market tops.

The recent decade was the worst performing decade in U.S. history due to the severe bear markets of 2000 and 2007. The Institutional Index (XII) is incredibly useful in analyzing this period (XII is a capitalization-weighted index of 75 stocks most widely held as equity investments among institutional portfolios). Clearly, it is the institutions that dominate the markets, so it is important to know what they are doing. The XII is a more honest representation of reality (see “No confusion here”). For example, it shows the long-term market top was in 2000 and that the 2007 top was a recovery rally in a secular bear market that began in 2000. Our analysis indicates this, though the financial news media and the industry at large believes the top was in 2007. It is interesting to note that XII made a perfect 61.8% Fibonacci retracement at the 2007 high. All real valuations peaked in 2000, not 2007. The S&P in terms of gold topped in 1999 and double topped in 2000, confirming the "real" top in 2000. It was 2000 that had the extremes in valuation. The P/E ratio for the S&P 500 was 44 at the top while the dividend yield was 1.11% and the market was selling at 9X book value for the S&P Industrials. All those factors point to 2000 being the beginning of a long-term bear market that is still in play. That is quite a different distinction from equity market bulls who seem to have already forgotten about the 2008 credit crisis. For whatever reason, the XII seems to portray that reality more than most of the commonly followed indexes -- and therein lies its value.

chart

Another useful tool is knowing the long wave cycle. This allows us to know where we are in the cycle and by knowing where we are, we can ascertain what comes next. Like seasons, each phase of the cycle feeds the stage that follows. The next stage is bankruptcies and liquidation due to deflation, unemployment and high debt level. This is followed by debt default where individuals, corporations, municipalities, states, etc. belly up on debt. This ultimately sets up a stock market bottom brought on by total capitulation, where investors dump stocks, causing them to fall to levels of extreme undervaluation. Finally, you have an economic bottom where banks close, debt is restructured and you have remonetization -- and possibly, a new currency. By knowing these steps, technical indicators can confirm (or deny) where we are. This analysis shows two major turn dates this year: May and August. Both could be tops as was the case in 2007 -- also separated by three months. The May expectation actually topped on April 26 and could be tested in late July.

The XII chart provides valuable information. We are in a 10-year-old secular bear market. A confirmation of that is the 2009 low was lower than the 2002 low; 2002 was the first time a prior major low was broken since 1932. This lets us know that we are now entering the period where “the second shoe will drop.” This is confirmed by the Elliott Wave count that implies we are approaching the nuts and bolts phase of the bear market where everyone is aware that we are in a bear market. That realization changes sentiment which, on balance, has been very bullish for a long time. That change in sentiment brings on an overwhelming bearishness that feeds those final stages previously mentioned with the psychology necessary to ultimately bring about capitulation.

Simply put, we are at the most dangerous period of the cycle in the past 80 years. The winner at this stage of the cycle is the person who can successfully protect his portfolio. However, the "safe money" investments of earlier stages of the cycle are not likely to be the "safe money" investments of this stage. Money market funds, for example, may be much riskier than in the past.

In analysis of the S&P 500, we expect a C wave rally off of the early July lows, potentially testing the mid-June high, so that by the time you see this the major indexes likely will be at a higher value to short. As noted above, they could potentially test the April 26 top, but beware of August as that is our major turning point.

Garrett Jones is a partner with Peter Eliades of Stockmarket Cycles Management, Inc. Jones is a recognized expert in gold, technical analysis and the long wave economic cycle. He can be reached at garrett111@comcast.net.

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