Deflationary Dreams, Reflationary Reality

Deflationary Dreams, Reflationary Reality

(originally published 09/06/10-09/12/10 for BullBear Trading members)

In the last BullBear Weekend Report I called for an important bottom and a sharp rally and we did get just that. We are now long from SPX 1048. Technicals indicate that the rally has further to go both in the short and intermediate terms. There are significant indications that a long term bottom has been put in place and that at a minimum a revisit of the April highs is possible. So far there are little if any indications that a bear trend will resume any time soon.

I am sure that upwards of 80% of those who read this analysis will allow an ingrained bearish bias to doubt it, disdain it and disregard it. Others who perhaps accept it will still, in fear, be unable to pull the trigger and buy.

Keep in mind that your own mentality reflects a larger reality. It is important for bears to realize that they are no longer the outsiders standing at the fringes shaking their fists at The Man. The bearish view is now the official, accepted, mainstream dogma of the majority. It took over ten years for this to happen but it has happened. And it has happened at a significantly higher low in the market indices. It is this divergence of sentiment and technicals which always marks significant market turning points. The emotional and mental resistance to this that we experience is a part of that process.

A lot has happened since the last secular bear market from 1966-1982. The price bottom came in 1974 and the final, orthodox, psychological bottom came in 1982. Due to many factors, not the least of which is the information technology revolution, time frames may now be significantly compressed. We are faced with the possibility that the price bottom for this bear market came on March 2009 at SPX 666 and the psychological bottom occurred recently at SPX 1010.

My personal, philosophical disposition is to favor a deflationary view in which the powers of Keynesian Monetarism are rendered impotent, irrelevant and discredited, ushering in, after the Great Debt Destruction, a New Age of entrepreneurial capitalism and sound money economics. In this dream, the laws of Free Market Capitalism overpower the will of Central Planners, Ron Paul is President and I am the official White House yoga instructor, or sometimes Head Chef, or (my favorite) the guy responsible for firing 50% of the gummint bureaucrats (it varies), and Bernanke, Greenspan, Paulson and Geithner all share a 6X6 cell with Bernie Madoff. And the lion lies down with the lamb.

While it's a nice dream, I have learned that markets don't really give a damn what I think, prefer or dream. As a BullBear, I can change my position--mentally and financially--at any time. When the market gives cause to do so, I will. At the moment I think the right side of the market is with the contrarian, minority view, which is bullish. Naturally I have no intention of being on the wrong side for any significant market move, so I will be monitoring the situation for any shifts. All long term moves begin as intermediate term moves. By positioning myself on the right side of any intermediate term move I set myself up to be on the right side of a long term move should it develop. Ergo, I currently favor the long side of the markets.

Sometimes dreams do come true, but I get all my tradable opinions from the market. What is the market saying now?

All major indices, save the Dow Industrials, are challenging the downtrend from April.

A variety of world markets are breaking out, closing above prior highs and challenging important resistance levels.

Canada has caught fire as agriculture and metals lead world asset prices to the upside:

Korea looks set to break out to new highs soon:

London has already taken out it's August highs on a closing basis:

Australia has taken out the August downtrend and the 200 EMA decisively:

The Emerging Markets ETF appears set to break out of its year long diamond pattern. EMAs are in a clear bullish configuration:

From the above data set we can see that a broad sample of world markets is leaning towards a bullish resolution to the generally lateral price action of the prior 10-12 months.

NYSE showed a jump in buying volume at the recent bottom. Thursday and Friday were subpar volume days, however that may be simply a function of pre-Labor Day trading. Also note that the broad market index closed the week well above the 200 EMA.

The bullish scenario is favored by the current available technical evidence. Here, a reverse Head and Shoulders pattern is in the final approach to its neckline in the context of persistent fear, skepticism and pessimism. The wave count has the market in i of 3 of (3) up.

Let's look at the short term action to get a better sense of what we can expect from this encounter with the August downtrend:

The near vertical ascent into resistance has left bears scrambling to cover and bulls desperately buying even the smallest of dips. The short term wave count, due to the lack of volatility in the price action, is difficult. Wave i may already be over or it may have another leg to 1111-1115 (a price level that has been important support/resistance many times over the last year). Where's the pullback? The short term overbought condition could get even more overbought early this week. Most market observers are already calling for a top and this rally has been greeted with skepticism. In this context I would be looking for a sideways abc formation over the first few days of the week. Traders who are out or looking to add to their long positions could buy the a and c wave lows of wave ii ahead of iii of 3 which should rapidly take the market back to 1131 resistance.

There are a variety of bearish scenarios to choose from. This one calls for an immediate reversal of the rally and another probe of the lows in the context of a continuing complex corrective consolidation prior to an eventual breakdown below 1040 support:

I'm not seeing much that lends credence to this scenario, however. The more credible Bearish scenario involves higher prices from here. In this scenario, SPX is in its final e wave of an abcde wave 2 wedge formation and should complete near 1030:

On a larger scale, this formation is but one segment of a year long Head and Shoulders topping formation:

There is a lack of symmetry between the left and right sides of the formation, relative price strength rather than weakness on the right shoulder as compared to the left and the pattern is being widely followed. These factors tend to suggest that the formation will not eventually complete.

After putting in a divergence which signaled a potential bottom, SPX:VIX looks close to leaving behind a bear trap and a close above the August high will be an important bullish confirmation:

The SPX:Treasuries chart is showing a double bottom and breakout. This measure of market performance relative to bonds is arguably the most important chart to monitor at this time. If equities are to rally sustainably the capital to fuel such a move would most likely be drained from bonds.

The yield on the 2 Year Treasury is still making lower lows as investors continue to panic into the "safety" of short term government debt. This may be creating several long term divergences with SPX in relationship to price action at the 2003 and 2009 bottoms and current price levels.

Another indicator of investor risk aversion, the Japanese Yen, is also showing potential long term divergences as well as a near term breakout in the SPX: JPY ratio:

EuroYen is another important indicator frequently linked to world liquidity. It's showing a significant divergence in RSI on the monthly chart:

It's worth pointing out again the long term divergences on the chart of the 200 EMA of TRIN (Arms Index), which was covered in the last report. That indicator has now started to turn down sharply, a bullish signal:

On a less long term basis, VIX has dropped to its August lows. While this may help to occasion a short term pullback, a move to 20 or lower will probably be associated with a significant market rally.

New High-New Low Ratio has FINALLY made a move and each time it has done so in the past has been associated with significant market rallies:

The Nasdaq 100 to Dow Industrials ratio chart has made a nice breakout from a descending wedge formation and has taken out its 50 and 200 EMAs. This action is further confirmation of the recent bull move.

The Aussie Dollar looks like it is setting up for a move higher after a Major Wave 2 correction which has bullish implications for commodities and the world economy.

While the Euro's longer term trend may yet be down, it is set up for a significant C wave rally after leaving behind a bear trap and a failed head and shoulders pattern, which is of course bullish for world asset prices:

DollarYen is hovering just below major support and a break and close back above the 20 EMA could be a major long term buy signal as well as a further bullish indication for world markets:

Grains made the move I called for last week. Hope you got your entry! Fortunately, this trade is still largely "off the radar", but once the wave 3 move gets rolling the media will pick up on it, the momentum players will pile on and it will become (I think), one of the great plays of 2010.

There is a small chance that the recent bottom was an A of a much larger ABC, but I doubt it.

In conclusion, the likelihood of continued upside in defiance of bearish expectations is high. Whether this represents an intermediate term blip or something more significant is as yet unknown, although there are some long term divergences and indications that point towards a longer term bullish conclusion.

Good luck and good trading!

Questions, comments and observations are welcome.

Current position:

Long SPX, JJG, DBA, MOO

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