D.B. Hi Ike, how are you doing?

I.I. I am doing well, thank you.

D.B. Since the last time we talked, on 4-18-04, the popular indices have lost on average about 4%-5%, which represent a rather mild pull-back. On the other hand, many indicators such as the put/call ratio, the McClellan Oscillators, and Summation Indexes, the Arms Index, just to name a few, have reached levels that match, or, exceed the ones reached at major market bottoms in September of '01,  in July of '02, and in October of '02. If past history repeats itself, the markets should rally quite strongly, correct?

I.I. It all depends on the "historical precedent" that is  actually applicable!

D.B. What do you mean?

I.I. Technical analysis is consisted of two parts, first comes the collection and study of the raw data, and second and more importantly, comes the correct interpretation of the data based upon the prevailing state of the market, which may be different than other times when similar readings have been observed. In other words, you need to put things "in context" otherwise, you are not comparing apples to apples. One of the most common reason  people misinterpret technical signals is because  when they first discover technical analysis,  they think they found the "Holy Grail" and they approach it with a "one case fits all" type of mentality. For example, they learn that an RSI reading below 20 signifies an oversold condition, and they automatically assume that every time the RSI gets below 20, the market is a "buy."  If it was that nice and easy, everyone would be buying when the RSI fell below 20, and everybody would be selling when it went above 80, and everyone  would become fabulously wealthy, but that is not the case, is it? The exact same numerical  readings mean different things, if the environments in which they occurred, are materially different. I'll give you one more example, by comparing two identical McClellan Oscillator readings. In the first case, the NYSE has been declining for several weeks, and all of a sudden we get an upside reversal, which is followed by 6 consecutive up days, while the McClellan Oscillator in the same period goes from -50, to +250. In case  two, the NYSE has been moving sideways to higher for several weeks,  while the McClellan Oscillator in the same period went from -50, to +250, moreover, the NYSE has gone up six out of the last six days. The readings are identical in both cases, (+250) are they saying the same story?, should we draw the same conclusion? 

Of course not! In the first case, more than likely, the action by the Oscillator and its corresponding high reading, indicate an "initiation thrust" to the upside,  which means despite the highly overbought condition of the market, any pullbacks will be minor, and higher prices will be the most likely outcome, and thus, we ought to be long and looking to add to our positions. In the second case, more than likely, the action by the Oscillator and its corresponding high reading, indicate  a  highly overbought condition,  created after several weeks of sideways to upside action, with the last six days representing the conclusion of the move. Consequently, going forward lower prices will be the most likely outcome, an thus, we ought to be in cash, or, short, and looking to add to our positions.

Therefore, the exact same reading (+250) when it is  put in the proper context, it  leads not just  to  simply  different conclusion, expectations, and course of action, it leads  to a diametrically opposite conclusion, expectation, and course of action! 

I hope the example I just gave you, illustrates clearly that looking at indicator readings only in terms of their raw numerical value without putting them  into proper context, can be misleading and a recipe for disaster. So, if someone told me that many indicators are currently at the same levels they were, following the decline after 9-11, instead of automatically concluding that the markets "must  therefore be"  at a  bottom, to be followed by a similar  25%-30% advance, I would  want to know if the similar indicator readings have taken place within the same context, if they haven't, then, we are comparing apples to oranges, which is illogical. 

So, to finally answer your question, let's take a look at the overall market conditions between now, and then. Which indicator do you want to discuss first?

D.B. The Eliades New 10 Trin, it is  near the same levels it got after 9-11, and in July of 2002.

I.I. It fell  marginally below -1.75 in the middle of May, after six consecutive down weeks, during which the NYSE fell just 504 points (7.5%) from its high of 6715 on 4-5-04, to its low of 6211 on 5-17-04. During the same period most SP companies reported  earnings that either exceeded expectations, or were in line. The economy as measured by things such as employment, capacity utilization, help wanted ads, etc., continued to improve, and analysts have been raising earnings expectations. Although the U.S. is involved in a war, it is happening in  a far away place, and it hasn't affected consumer sentiment in any dramatic way. There has been no terrorist attack on U.S. soil, and investors -once again- are pouring billions of dollars into mutual funds, reaching a new record in January of 2004. Interest rates are expected to move gradually higher, while commodity prices have risen steadily and oil prices have remained stubbornly around $40.00 per barrel, creating fears of "inflation." 

The last time the Eliades New 10Trin gave a similar, if not identical, reading was on 7-12-02, after the NYSE had  fallen for 19  weeks from 6492 on 3-19-02, to 4423 on 7-12-04, losing 2,069 points (31.8%) During the same period most NDX and SP500 companies reported  earnings that either missed expectations, or were actually losses. The economy as measured by things such as employment, capacity utilization, help wanted ads, etc., continued to show signs of deterioration and analysts were lowering earnings expectations. Allegations of  rampant corporate fraud had  taken its toll on investors' confidence in the markets, and consumer sentiment had reached one of its lowest levels in years. Investors had been pulling  billions of dollars out of mutual funds, .  Interest rates were  expected to move lower, and the FED was becoming increasingly pre-occupied with deflation fears. The NYSE rallied 53.19% from its lows before topping out again on 4-5-04.

Prior to 7-12-02, the Eliades New 10 Trin, reached a slight lower level on  9-21-01, after the NYSE had fallen for 17 weeks from 7014 on 5-24-01, to 5223 on 9-21-01, losing 1791 points (25.5%), including 802 points that were lost in just five days following the re-opening of the markets after the 9-11 attack. The country had suffered the worst terrorist attack  ever, which took a heavy toll on the national psyche, obliterated consumer confidence, and dealt a devastating blow to the economy and to its  chances of recovery. During the same period most NDX and SP500 companies reported  earnings that either missed expectations, or were actually losses. Corporate chieftains refused to give guidance, and analysts had no other choice but to lower earnings estimates. Lay-offs accelerated, while  industries such as the airlines and hospitality teetered on the brink of bankruptcy.  Fear, uncertainty and doubt were the order of the day. Interest rates were  expected to move lower, and deflation had once again become the topic of conversation and concern. The NYSE rallied 23.5% from its lows before topping out again on 3-19-02.

Now, let me ask you this; does the current environment  have any similarities with the market environment that was prevalent during the previous two times  that the Eliades New 10 Trin fell to the same levels? 

D.B. Coming to think about it, no!

I.I. From their lows in March of 2003, to their highs in March-April of 2004, the NYSE gained 53.8%, the Dow gained 43.3%, the SP500 gained 48%, and NASDAQ from its lows in October of 2002, to its highs in January of 2004 gained almost 100%!  Given that the Eliades New 10 Trin, is at the same levels  from which in 2001 we were rewarded with 25% rallies, and in 2003 we were rewarded with 50% rallies, does that mean investors  ought to expect at least 25% gains if they bought right here? 

D.B. Probably not.

I.I. Why not? All these indicators are at the same levels, shouldn't we expect the same type of rally we got the previous two times? Shouldn't NASDAQ gain another 100%, and run up to 4,000?

Chart courtesy of Carl Swenlin and decisionpoint.com

I.I. The point is, in the previous two times that we had similar readings, in order to get there it took a 25% decline, it took a period of 18-20 weeks of falling prices, it took the worst terrorist attack ever, it took major corporate failures such WorldCom, and Enron, it took  the worst corporate earnings contraction in the last 50 years, it took a total collapse in consumer confidence. None of the above is present now, the markets have only lost 5%-7%, the decline has been going on for only six weeks, the economy is growing, employment is improving, most companies exceeded, or, met earnings expectations, deflation fears are gone, and capital spending shows signs of life! The fact that the internals got so negative and so quickly, in the absence of a catastrophic exogenous event, should tell people, that  although many indicators are at the same levels that in the past three years marked important bottoms, the markets are not the same, and thus, these readings do not have the same meaning, and they won't have the same result, the SP is not going to rally another 25%-50% from here, for the next 10 consecutive months!

D.B. So, how do we interpret these indicator readings, and what should we expect?

I.I. To me, it would make sense that first we tried to find if there have been  any periods that match the current market both in context, and in technical measurements, therefore, at the very least we are comparing apples to apples. If we can't find anything in the market's recent history that resembles the current situation, then we can start hypothesizing! 

D.B. Have you found anything?

I.I. In my view, the recent market action is quite similar in many ways with what happened  in the first quarter of 2000. In the fourth quarter of 1999, the economy grew at an record setting annualized rate of 8%. Employment continued to grow thru-out the first  quarter, companies and analysts were predicting record earnings for the rest of the year, not to mention that most companies beat first quarter earnings expectations by the customary and obligatory penny, the FED was raising rates, mutual fund inflows hit record levels during January-February of 2000, and amid all this nirvana the Dow and the SP turned down on  1-14-00, they declined roughly 10% in six weeks' time, NASDAQ followed their fine example in March. In addition, breadth deteriorated rather quickly, and volume started to contract on rallies, and expand on declines, just like now. The McClellan Summation Index reached -1785 on 3-14-00, last week, on 5-18-04 it stood at-1631, closely resembling the action and the readings  during the first part of 2000.  As we all recall, the markets -with the exception of NASDAQ- did NOT collapse,  in fact the SP, and the NYSE made new marginal highs in late March of 2000! The markets traded sideways to higher until October,  it was  the 3rd quarter earnings and guidance  -or should I say  the lack of- that sunk the markets,  further undermined by the bombing of USS Cole, and the election fiasco!  We  now know that between March and September of 2000, the markets were in the process of completing a massive distribution top. The "strong"  price action in the popular indices, helped to hide the enormous deterioration that had taken place in the internal structure of the market.  Once again, we are seeing the same type of behavior now, I pointed that out in a recent article  titled "Fraud And Deception, Are The Order Of The Day." 

I believe, the recent extreme oversold readings indicate that the markets have entered a topping phase which could last a few more months. In the absence of an exogenous event, the extreme oversold condition will continue to provide a floor for the market, and at the same time the poor internals will prevent the markets from doing anything more than perhaps marginal new highs by some of the indices.

D.B. The other day you made a comment that when it comes to the price action of an Index versus its components, true positive divergences occur when the price of the index makes a lower low, but breadth and cumulative volume make higher lows, not the other way around, why is that, and is it applicable now?

I.I. We will take a look at the number of stocks that are above their 200 DMA, and it will become clear.

Chart courtesy of Carl Swenlin and decisionpoint.com

I.I. Notice that all major indices, pretty much held their March lows, which the "talking heads" touted as a sign of "strength"  However, as they made their April lows, fewer of their  component stocks   were responsible for helping the index to maintain its price level. The fewer the components that are responsible for the total value of an index, the more vulnerable the index is. For example, let's say we have one index that is made up of 100 stocks, and each stock contributes 50 cents to the overall value of the index (I am keeping the contribution the same for each stock for the purpose of illustration) So, if we got 100 stocks, each contributing 50 cents, then the value of that index at that point in time will be $50.00. Now consider another index that is also made up of 100 components, and its value is also $50.00 however, just two of its components are contributing $15.00 each, and the remaining 98 are contributing equally $20.00. Well, it doesn't take a genius to realize that in the first case it would take 30 stocks losing 100% of their value for the index to go down $15.00, in the second case, it only takes one stock -one of the two with the large weight- to lose 100% of its value, for that index to lose $15.00. Obviously the second index is much more vulnerable, and a candidate for a sudden collapse. (this is a rather oversimplified example, only for the purpose of illustration) All the charts of the major indices show that as they approach their April lows, a smaller number of stocks were responsible for keeping the index at that level. That is weakness disguised as strength, and only those who superficial knowledge and understanding of technical analysis, and what constitutes strength and weakness, would argue with a straight face that  a price level which  is being defended by fewer and fewer  components, constitutes a "positive divergence." What is happening is akin to removing one by one the studs from the foundation of a house, at some point it will collapse. The above charts, do not illustrate strength, they illustrate structural weakness. 

D.B. Let's change the subject, there is something else that we need to cover. On 4-13-04 you did a "Ratio Analysis"  and you concluded the following:

"The ratio analysis is telling us that  more likely we ought to expect  for the intermediate term, higher oil prices, higher interest rates, lower equity prices, a secular top in the financial sector, and in the short-term, a higher dollar and lower  gold prices"

It turned out that your conclusions were right on the money, consequently, we have received  many calls, and emails from people asking  for a follow up, after all it's been two months.

I.I. That is why I don't like it when I get lucky,  people think you're smart and they want follow ups!!

The ratio between  the bullish percent index and the put/call ratio, shows that the SP is less oversold than people would like to think. The ratio needs to drop to below 35, in order for the downside risk to be substantially  reduced from new long positions.

The Gold/dollar ratio suggests that we should see increased volatility, both in the dollar, and in gold.

The Gold/Xau ratio stands at 4.5, which in our view is not good enough to justify buying gold stocks for anything else other than short-term trading purposes. However, we do anticipate the ratio to eventually move up above 5.5, and in that case, XAU Leaps will provide an outstanding return to risk ratio.

The Gold/Oil ratio suggests that  as long as the current demand/supply dynamics remain intact, in the short-term  (1-2 weeks) it will pull back to support, however, for the intermediate term (3-6 months) oil has more room to run on the upside, and it can easily advance another $5.00 before it encounters any  intermediate term resistance.

However, if  Saudi Arabia decides to ease the price  by increasing production unilaterally, immediately,  the price can drop by $5-$10 per barrel. It will be a temporary drop,  but it can be very painful if you own oil stocks.

The NDX/VXN ratio is closer to its highs than its lows, which means if the NDX rallies, at the most,  it can gain no more than 125 points.

The SPX/VIX ratio is closer to its highs than its lows, which means if the SPX rallies, at the most,  it can gain no more than 55 points.

The financials have made a long-term top. Since they make up such a large portion of the SP, they could very well cause the SP to under-perform the rest of the major indices.

Summary: Based upon the current ratios, we believe that gold can continue to be under pressure, oil could rally another $4.00, unless it gets sabotaged by the Saudis, in which case it can tumble $10.00 in a couple of days, the financials have completed a long term top, and if the  equity indices rally, given their present volatility ratios, at the most, they can only make marginal new highs

D.B.  Should we get into the rest of the charts?

I.I. Sure, we got some interesting stuff to talk about.

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