The Landscape
Now that the Olympics are over and school is getting back in session, it’s time for market participants to get back to work. The next 60 days will have a large number of decisions made that will not only affect the course of the United States, but also of the world.
First, coming at the end of August from Thursday, August 30th through Saturday, September 1st is the annual Jackson Hole, Wyoming Economics symposium. US Federal Reserve Chairman Ben Bernanke is set to give his keynote address on Friday, August 31st at 10am ET followed by ECB President Mario Draghi giving his speech on Saturday, September 1st at 10am ET. Remember, in 2010 Bernanke used this speech to signal to the market that the program known as QE2 was in the works and a bull uptrend started that very day lasting through May 2011.
Similarly important, for the end of the month are the Republican and Democratic National Conventions (August 27th through 30th and September 3rd through 7th, respectively). The United States faces a key decision this year in deciding which party has the better plan for America and market participants are sure to be watching every move to figure out how to position themselves.
On September 12th and 13th, the U.S. Federal Reserve will be conducting a 2 day FOMC policy meeting which should be a continuation of Ben Bernanke’s Jackson Hole speech.
On September 12th, the German courts are expected to rule on whether they want to allow the European Central Bank to buy sovereign debt of its member countries in much the same way that the U.S. Federal Reserve buys Treasury debt in an attempt to stimulate the struggling European economy.
Also on September 12th, Apple is holding its annual media event and is expected to announce a new iPhone (iPhone 5?) and perhaps a new, iPad mini. Also speculated about but not likely would be an Apple TV (iTV?).
October will bring about three U.S. Presidential debates (October 3rd, 16th, and 22nd) and one Vice Presidential debate (October 11th). The FOMC will also meet on October 22nd and 23rd with a statement being released on the 23rd.
Finally, U.S. election day is on Tuesday, November 6th.
Whew. Talk about a busy few months for the market. Digesting all of this information will be exciting as we’re at a pivotal time in our country’s history. Given all that’s going on, has there been a time in history that even closely resembles? Your author is a firm believer that what has happened in the market in the past will happen again in the future (price action repeats itself) because human emotion drives the market. And since human nature will never change, the market will always operate the same way. Let’s see what’s happened in the past that looks oddly similar to what’s happening today…
Precedent Analysis
Below is a chart of the Bull Market that took place from December 1987 through October 1989. You will notice that after going through a “Waterfall Sell Off” in October 1987, which is a market period where prices essentially fall off a cliff, the index stabilized for the next 2 months into December 1987 and then had a solid move up (+36.2%) over the next 7 months. The Nasdaq then moved into the red box that I have highlighted below (July to November 1988) and this period is the focal point of my market discussion today. You will notice that after the index emerged from this box, it went on an 11 month uptrend that took the index 33.9% higher. Also very notable was that 1988 was an election year and the behavior then versus what we are seeing now in 2012 with an election year is strikingly similar. Recall that in 1988 Republican George H.W. Bush was elected to fill the Presidency held by fellow Republican Ronald Reagan. I’m not going to focus on partisan politics or discussion here. The important thing is that an election was happening as the market was see sawing. Let’s dig deeper into exactly what I perceive to be happening in this 1987-1989 precedent and see how it’s relevant to what we’re seeing today…
Looking closer into the red box period as in the chart below (Nasdaq 1988), there are a few important observations to be made. First, a Bullish “Golden Cross” emerged during the uptrend. A Golden Cross is defined as the point where the 50 day simple moving average of prices (take the last 50 closing prices for the index and divide by 50; do this daily to get a “50 day simple moving average line”, aka 50 day SMA) crosses above a similar line generated from 200 days of prices (200 day SMA). This cross with 50 rising above 200 signals momentum to the upside of a market and is a positive development indicating potential price progress in the future.
Next, after this portion of the move topped in early July 1988, the index began selling off in what I’m going to describe as “Wave A”. Within “Wave A”, you will notice that I have traced out 5 distinct smaller waves (1 down, 2 up, 3 down, 4 up, 5 down) which comprise the total move that is “Wave A”. An upward trending “Wave B” followed, taking the index to the point right at #2 of the 1-2-3-4-5 pattern in “Wave A”. You can see this marked with the purple resistance line below. The fact that the index struggled at #2 is very significant psychologically. After selling down off the initial top in #1, buyers entered the market and began to “buy on the dip”. After further selling, these buyers were in a loss position and desired for only one thing: to get back to even or close to it on their position and exit the market. As the market continued further south and then started its rebound with “Wave B”, these individuals (both people and institutions) started to hope that any further price progress higher would allow them to exit their positions. Then, as the index got right up to 390 (the point where these underwater buyers initially bought “on the dip”), the index stalled as they began unloading their position.
As the selling began, more and more sellers joined the mix, fearful that they would not be able to exit their positions at favorable prices. This all happens within “Wave C”. The selling gradually picked up and “Wave C” eventually undercut the low point of “Wave A”, which scared even more holders to capitulate and sell positions that they were holding onto. This is the perfect psychological point to buy “when there’s blood in the streets”, as our friend Warren Buffett likes to say.
One last item to note about the perfect psychological moment is the Bearish “Death Cross” that I have labeled. A Death Cross is the exact opposite of a Golden Cross where the 50 day crosses underneath the 200 day simple moving average (green under red here). Some casual and many more “professional” market participants regard a Death Cross as always a sign when prices are likely to continue lower. Here, the Death Cross occurred after the market had already bottomed. This further creates the scenario that scares the most people into believing prices are going to continue lower. What works in the market is rarely obvious to the majority of market participants.
Another example of this type of pattern comes from the Nasdaq 100 index in the year 2000. From the March 2000 top to May 2000 low, the index sell off created a clear 1-2-3-4-5 pattern within a “Wave A”. The index then rebounded with a “Wave B” and rallied right up to the point of #2 from “Wave A” (see the purple line labeled “Resistance”). Further selling took place right from the resistance point. A key difference between the 1988 chart and the 2000 chart is that the market entered a Bear market in March 2000. The action occurring after “Wave B” is a completely different ball game which I’ll discuss at length when the next Bear market is upon us.
The chart below marks where we stand today in August 2012. Not pictured on the chart is August 2011, which was a “Waterfall Sell Off”, much like the 1987 Sell off described above. Do you remember the debt ceiling negotiations that led to the market falling rapidly for 3 weeks last year? That started a chain of market action that very closely resembles its 1987 counterpart. You will see that an initial uptrend from October 2011 to March 2012 (6 months) took the index 36.3% higher (within 0.1% of its 1987 precedent). We then went through a “Wave A” to the downside with a clearly traced 1-2-3-4-5 comprising the total of “Wave A”. Currently, we are in “Wave B” to the upside coming right up underneath the #2 likely resistance level at 3065-3085.
Our Current Market View
If the 1988 precedent continues to play out, I suspect the Nasdaq will stall between 3065 and 3085 before starting “Wave C” to the downside. For “Wave C” to complete itself in the same manner as 1988, the index would have to undercut its “Wave A” low of 2726, which would imply the index would fall by at least 11.6% to undercut the low. The more likely scenario would be that the index will overshoot this point to the downside and we could see a 12-14% correction before starting a 10-12 month uptrend that could take the Nasdaq 34% higher. This analysis would imply that the selling would likely end in October 2012 and the final bull market top would possibly come in October 2013. A projected level for the bull market peak using this analysis would imply an index price of 3572.
We are closely watching the 3085 level on the Nasdaq as a key area that could provide the resistance necessary to start “Wave C” down. With all of the news coming up over the next couple of weeks, it’s tough to say what will happen. The important thing is that investment decisions be based upon rules first and foremost. Having a view of the market is important to use as a framework, but rules should dictate how one takes action. If the Nasdaq were to clear 3134, the current bull market peak, perhaps our view was wrong. I’m not going to talk about the stocks we are following today (pillar #2), but very few of them have any action that is bullish, which makes this rally suspect. In future posts, I will spend a lot of time on stock selection criteria and provide a full company analysis for you to get a feel for how we evaluate the securities which generate the alpha for our investors.
That wraps it up for this month. With all that is set to happen in the coming 60 days, there’s going to be a lot of information to process. If you have questions on anything written above, please don’t hesitate to reach out to Thomas or I. We’d be happy to clarify any of the points above for you. Have a great weekend!