A Stealth Top

People think today’s market conditions are normal,
because a benign present is always considered normal.
But it’s not normal. It’s unprecedented.

—Bob Prechter, Elliott Wave Theorist, June 20, 2014

On Monday, trader pal Dick Diamond e-mailed: “Boring. Nothing to do but wait…” The intraday chart of the S&P 500 was flat, matching the uncommon stillness of the ocean at dawn that morning when Cindy and I strolled the boardwalk. Traders hate this calm. We make our living in volatile markets, and this past month our rice bowls have been half empty for lack of opportunity.

On Tuesday the condition abruptly changed. The diagonal triangles-exhaustion patterns-that had been forming in the major averages since April had completed and the throw-overs that followed reversed, generating reliable signals that the long advance in the bear market contra rally since March 2009 was finally over. The textbook says, “If there is a throw-over, the ensuing reaction could be breath-takingly fast (EWP, page 194). We shall see.

Throw-over

As is typical at this type of ending, no one thinks anything is amiss. Quite the opposite. My friend Malcolm sends me a link to a market analyst who says the market can continue to rise for ten more years. This forecast matches those of the brokerage firms I survey. All of them make their forecasts based on what they see in the streets right now:

The economy paints a seemingly encouraging picture: car sales are up, home sales are better than they’ve been in years, retailers are not complaining (but have you noticed that the big stores are featuring 40-50% off everything in the store almost everyday?) There is remodeling, demolishing and rebuilding on every street in my neighborhood. So, what’s your problem, Rod?

Simply this: That’s how all tops look. And, to my gimlet eye, there is a great deal of rot beneath the surface. To begin, the entire rally since March 2009 has been technically weak, with narrowing breadth and contracting volume. Margin debt has exploded and both public and professional sentiment exhibits aggressive euphoria here at the top. In every respect, the rally has been a phony, and the buyers have been in denial about the intractable weaknesses in the economy. It adds up to a “B” wave-a reaction to the primary trend, which is down. Investors are in peril.

Most dangerous of  all is the bubble in the junk bond market. The public’s hunger for yield has them snapping up junk bond funds in unprecedented amounts. Demand is so high that junk bonds can come to market successfully bearing record low interest rates. There is no risk premium built into these investments.

During the next wave down-the most devastating part of the bear market-junk bond issuers will default on the interest and the bonds will collapse, leaving large holes in the portfolios of millions of retirees. Reminds me of the tale about the advice the Baron Von Rothschild supposedly gave his heirs while on his deathbed: “Never buy bad bonds in good times.” Apocryphal or not, the crowd is going to be sorry they weren’t privy to that wisdom.

It is time to play defense.

Cheers,

Rod

No one should consider any part of this presentation as a recommendation to buy or sell any securities whatsoever.

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