Stock Market Crash! Blog

Dow 11,400: Failure, Look Out Below!

One month ago, I created a post highlighting the significance of the Dow level 11,400, which we were rapidly approaching. I expounded upon two possible scenarios that were likely to occur at such a critical juncture, either the start of a strong bull market or bear market.

Dow 11,400 was "the level that stopped the 1990's bull market right in its tracks, resulting in a terrible bear market that ended at 7,200. From 1999 to 2001, the Dow attempted to break 11,400 four different times, only to come crashing down again. Another time, in early 2000, the Dow briefly passed 11,400 for a few weeks, then dropped 2,000 points." The following chart shows the Dow and its multiple failures, old and recent, at 11,400. Click on the chart for a larger version:



After several attempts, the Dow finally breached 11,400 in late April, causing many a bull to rear his horns as the market surged to 11,709, only a mere 200 points below the all-time high reached in January 2000. Unfortunately, the similarities with the year 2000 didn't end here, as the market promptly dropped below 11,400, indicating the potential for a bear market. The Dow dropped 600 points to 11,100. If this is anything like the false breakout in January 2000, the Dow might fall 2000 points. Even worse, if its like the false attempt in the spring of 2001, we might see a 3,300 point drop. Scary, isn't it? Its quite scary looking at the charts of the past few weeks:

The Dow Jones Industrial Average, down 609 points or 5.2 percent:



The SP 500, down 75 points, or 5.6 percent:



The Nasdaq Composite, down 220, or a staggering 9.2 percent:



England's FTSE crashed 550 points, or 9 percent:



Japan's Nikkei, down 1,900 points, or 10.8 percent:



Emerging markets experienced the most dramatic slide, some experiencing actual stock market crashes, giving back some of their impressive gains won this year. This correction isn't surprising, given the stellar performance these markets had.

India's Sensex Index, had an actual stock market crash, dropping 2,500 points, or 20 percent within 2 weeks:



Brazil's Bovespa, down 6,000 points, or 14 percent:



The Korean Seoul Composite, down 140 points, or 9.5 percent:



The Hong Kong Hang Seng Index, down 1,550 points, or 8.9 percent:



Singapore's Straits Times Index, down 250 points, or 9.4 percent:



Taiwan's Weighted Index, down 700 points, or 9.3 percent:



A Confluence of Bearish Catalysts

In my first Dow 11,400 blog post, I described several fundamental reasons why we might see a severe correction, upon a false breakout in the Dow. Now that a false breakout has occurred, I'd like to revisit this bearish scenario and publish a more detailed list explaining several catalysts for a further drop in stock prices.

1)The Dow's rejection of the 11,400 resistance is highly bearish, as the failure to breach this level resulted in the 2000-2002 bear market. 11,400 is a psychological barrier, and the failure to break shows the underlying weakness of this market. Such a weak market is vulnerable to dramatic drops upon even the slightest hint of negative news.

The current Dow MAY be experiencing a similar pattern to its sideways pattern that lasted from the mid-1960's until 1982, as the Dow repeatedly attempted to breach the 1,000 level, only to result in four different bear markets. A 20-year stagnation ensued as the Dow stayed flat.

Barry Ritholz, of The Big Picture Blog, created a post comparing the present with 1973-74 cycle, using a chart to show that today's Dow is following the 1970's Dow's pattern with a 60 percent correlation. If the comparison holds true, 2006 is now equivalent to 1973, a year that marked the start of a bear market that finally ended in 1975, with a 40 percent loss. Lets hope we don't see a repeat of that action, as it would imply the Dow hitting 6,700. Make sure you pay Barry a visit, as his analysis is extremely cogent and insightful. Here is his chart:



2)We're late into the interest rate cycle, with the Fed having lifted the benchmark lending rate 16 times since June 2004. Bull markets have tendency to start right after the Fed has a series of rate cuts, while many bear markets have started after a series of rate hikes, causing a slowdown in business conditions. Additionally, during periods of monetary tightening, the Fed has tended to overshoot and tighten too much, often resulting in hard landings or recessions.

A selloff in bonds, and consequent rise in bond yields, portends a decline in stocks, which is what happened in 1929, the 1987 crash and the year 2000 bear market. Now bonds have decline and yields have increased, as I've posted here. In that post, I signaled that we have further to go in the bond decline, and I still feel this is the case today.

The yield curve, or the difference between short & long term interest rates, has flattened lately, a harbinger of slower future economic growth. A steep yield curve, with short term rates at a much lower level than long term rates, implies strong economic growth in the near future.

At one point earlier this year, the yield curve even inverted briefly, a development that has "presaged each of the last six recessions, without a single false alarm," as explained in the article, "Inverted yield curve spurs recession concern." The article further states, "typically, the warnings operate on a lag of about 12 to 18 months and need to remain in place for about a month to be meaningful." Either way, a flat or inverted yield curve isn't exactly the most bullish sign. You can check Stockharts.com's Dynamic Yield Curve, to see the recent flattening. Note that the steep yield curve in 2002 forecasted a healthy stock market rally.

To make matters worse, the Fed has raised the discount rate to 6 percent, a level that has caused severe stock market crashes a full seven out of seven times since the early 1900's, according to Peter Eliades, a well-known market cycle theorist. How severe were these crashes? Let's just say the stock market crash of 1929, the 1974 bear market, the stock market crash of 1987 and the Y2K tech crash were some of the more well-known ones. And here we are again. Take a look at Eliades' explanation of the "6 percent" phenomenon. Here is the chart showing the impact when discount rates hit 6 percent:



3)"Sell in May, and Go Away" so goes the old adage warning of the seasonal weak time in stocks, starting on May 1 and ending October 31. According to Yale Hirsch of the Stock Trader's Almanac, most of the gain's in the stock market tend to be made between November and April, with the summer months tending to be flat or negative as Wall Street heads to the Hamptons for vacation. According to Hirsch, "there were twenty-one losing periods since 1950 from May to October, but only twelve for November to April."

In Harry S. Dent's book, "The Next Great Bubble Boom," he posits that "an investor starting with $10,000 in 1950 would have seen it grow to $467,100 by April 2002 if it was invested only between November and April, but would have had a slight loss to $9,923 if it were invested only from May through October each year."

So there you have it, we are in the stock market's bad season, further increasing the probability of a bear market from this point on.

4)We are due for a crash in the well-known eight year stock cycle. According to Dent, the eight year cycle involved strong declines in 1958, 1966, 1974, 1982, 1990 and 1998, with 20 percent corrections the norm for the SP and Dow. 2006 is eight years after 1998, meaning we should see a strong decline if the theory holds up.

5)The current run in global stocks appears stretched when compared to past bull markets, according to a report by BCA Research. BCA explains that the bull market in global equities is entering its fourth year, now exceeding the median duration and magnitude of past major up-cycles since 1970, suggesting that the risk/reward trade-off is deteriorating. Click on the BCA article to see an excellent chart displaying the duration of the historic up cycles.

6)From what I wrote in my first Dow 11,400 post,

"Higher interest rates which will pop the housing bubble. Once the housing bubble implodes, foreclosures will increase and consumers who use their homes as ATM machines will feel the pinch and curtail their spending. Now the housing wealth effect which has made home owners feel very wealthy, will run in reverse.

The homeowners who will be hurt the most, with the rise in mortage rates, are the ones who let themselves get duped into taking on adjustable rate mortgages or ARM's. With an ARM, monthly mortgage payments rise as interest rates rise. Homeowners who overleveraged themselves with jumbo-mortgages will face dramatic increases in monthly payments, forcing many to foreclose- especially if the job market weakens. According to the Mortgage Bankers Association, ARM's constituted 34 percent of mortgage applications in 2004, a staggering figure indicating many people who think interest rates will be low forever and housing "always goes up." Sounds alot like the other historic bubbles I wrote about for this site.

More worriesome is the statistic from the National Associations of Realtors, saying that 36 % of the home sales in 2004 were second home purchases, ie. mostly speculative buying and "flipping." As housing deflates, these speculators will add more fuel to the fire as they attempt to unload their houses."

This development will lower consumer spending and the overall vitality of our economy.

7)The options volatility indexes, VIX and VXN, are at all time lows, indicating investor complacency that has historically led to strong bear markets. A VIX reading below 20 signifies a dangerous level of complacency. Within the past year, the VIX reached as low as 9.88 and is still at a low level of 17. The chart below from Investopedia shows what can happen when the VIX is below 20:



The stock market may drop until the VIX reads as high as 35 or more.

8)There is a possibility of oil reaching in the low $80 range or even more, as I've written in a post a few days ago. Oil at these prices would roil the stock markets causing a severe crash. A military confrontation with Iran could easily push oil prices to these lofty heights, scenario that looks possible with the ever-defiant Mahmoud Ahmadinejad at the Middle Eastern nation's helm. Goldman Sachs even believes that Oil Could Spike to $105, in a 1970's-style surge. That projection certainly brings more credibility to Barry Ritholz's view that 2006 is equivalent to 1973.

Profit From the Decline

To summarize, there seems to be a reliable confluence of negative catalysts which could lead the stock market down a slippery slope in 2006-7.

How can you profit from this? Unfortunately, the recent decline was so terribly sudden and steep, with the Dow and SP down 5 percent and the Nasdaq down nearly 10 percent within two weeks, making it a difficult market to trade in. With each day's drop, the market is getting more and more oversold on the short term, leaving us overdue for an upside swing, before resuming the downtrend. I wouldn't short the market just yet, as its more prudent to wait for the upswing.

For those not willing to short stocks, there are plenty of inverse market ETF's and mutual funds that will short the market for you, without your risking a margin call. Some are even leveraged to give 2X the return of a simple inverse fund. Here is a list of short funds.

I'll keep posting about developments regarding an upside swing and how to profit from the market's decline.