Uncle Sam The Stock Trader
September 8th, 2008 by Leonard
Uncle Sam the Stock Trader
The Government has now sponsored 5 stock market rallies since August 16, 2007, when 2 Bear Sterns hedge funds bellied up.
The first 4 of these government sponsored rallies have fizzled with the market breaking down to new lows. Failed rallies like these should be of no surprise. Rallies that are based solely on short term patches and fixes for the crumbling financial sector cannot be sustained, unless the economy is improving.
The latest government sponsored rally (number 5) began on July 15, 2008, from a low of 10,827 on the Dow Jones when Congress stepped in to indicate that if needed, Uncle Sam would support the failing GSEs Fannie Mae and Freddie Mac.
Uncle Sam the trader is not necessarily ignorant of how markets function. When Congress and the Treasury made the plans to takeover the GSEs months ago, they sent out the early warning notices mid-July, perhaps as a litmus test, to measure the markets potential reaction. The hope would be that the announcement itself would re-inflate stock prices. It also gave adequate time for counterparties to prepare for the actual event.
Uncle Sam Has Gone Long the Market Again.
So after seven weeks of a low volume government sponsored rally, along with the regular palaver “they have plenty of liquidity”, the rescue is apparently on. Uncle Sam the stock trader is at it again.
If it is not clear to you, that Uncle Sam is timing these interventions, to neutralize severe bear market breaks, then take a look at the chart below. The last 2 days Sept 4 and 5 saw the Dow plunging 495 points to a low of 11,037 challenging the July 15 lows before short covering into the close at 11,220. Oh, what a surprise! Not.
I haven’t seen the details of the “save the GSEs program”, but I understand that Fannie Mae and Freddie Mac are going into conservatorship. A conservatorship I guess, is different from a receivership, in that the GSEs are not being nationalized…..Yet.
Government sponsored rallies have been good things if you were interested in finding higher price levels to liquidate your stock portfolios. It’s an ironic twist of fate, (or is it), that by propping up the banks, and brokerage houses (that the government is trying to “save”), that the hope rallies pushed up by short term traders, allows major institutional players to liquidate their long term holdings in an orderly fashion. Classic distribution.
Touchdown
If you follow my blog, then you know that on Nov 19, 2007, I drew a picture 7 months out into the future, depicting the most likely path that the Dow Jones would take. The picture was one of a simple Head and Shoulders top formation. The price target was 11,940.
The market finally hit the predicted price target on June 20, 2008, slightly later than expected, but no complaints. It was a good call on two counts. First of all the pattern that I drew conformed to a classical predictive path called Gates of Confirmation (part of Novy Principles of Market Flow). Coincidentally the market flow outlined a giant one and a half year old Head and Shoulders topping pattern that remains in force, at least for now.
Denial …………One Year Ago
In lowering the discount rate on August 16, 2007, professor Bernanke took the very first baby step towards awakening the investment community (or at least himself) from a pompous state of denial, that the housing market mortgage problems were contained.
It’s hard to figure out why de-coupling theorists ever had a voice in market analysis, other than to promote the buy side of the markets by habit. One of the clear problems with de-coupling theories is that it seems to apply best to what is convenient to making your case. If you can ex out anything that bothers you, then you can by default, extend denial to infinity, or at least until infinity comes rudely knocking on your door. So far, de-coupling theories have been about denial. Bad things only happen to other people.
With recent reporting from the Fed, it appears that they are more in tune with the overall situation regarding the weakness in the economy and the affect of the housing market on the economy. Cheer leading has been noticeably dampened. Over time, the Fed may be able to gain more credibility being market savvy rather than politically correct.
Welcome to Wall Street
Wall Street became the world center for the trafficking of bad debt. If the DEA were to add the selling of bad debt to their list of illegal drugs, then what we saw was pretty close to pushers on Wall Street buying and selling it. Huge bonuses and commissions created an oversupply of debt. The inventory that is sitting on the shelves of banks, investment firms and financial institutions, cannot be easily sold at this time.
Wall Street tapped into the credit/debt addiction of the masses, who were trying to replace sub standard incomes with fantasy driven speculation. Now everyone is angry.
Survival of the fittest has Wall Street banks and investment firms, wanting to hide bad debt. If they can’t hide it, they want to re-name it, to split it up into parts, to re-sell it, to amortize it, to swap it, to dismiss it, to delay its transparency, and in the end it to pass it on to the public as a tax, as the government intervenes.
Bargaining to Depression, the Real Bear Market
Shifting the market psychology from bargaining to depression means that traders would be ready to concede that government sponsorship and interference (bargaining), with bear market forces is not working. This would be the tipping point, where traders and investors begin to assume that bearishness is the dominant mode (depression), and that all rallies should be sold. Four government rallies so far have failed. The fifth rally has been in progress for about 7 weeks. Volume has been uninspiring low which is not bullish.
The market has tested the underside of the neckline (11,940) of the Head and Shoulders Top. The closest the market has come to the neckline as a point of resistance was on Aug 11, 2008, when the market reached a high of 11,867.
There are of course many variants of how tests take place. The reason for this is that a test of a neckline represents a potential shift in the psychology of the market from a stage of bargaining (testing the neckline) to stage of depression, (a real bear market), or to an upward shift, if the topping pattern is not validated. In that case the market could rally but the Head and Shoulders Top becomes a warning sign that a real top is near.
The Typical Path
Here is the path that usually takes place when a market tests a Head and Shoulders top.
After breaking down through the neckline the market will find a benchmark low at an area of straight line support. The market will try to rally back up to the neckline. It doesn’t have to touch the neckline. The market can stay under the neckline, or stay at it, or move above it. If the volume of trading declines as the market moves up it is generally bearish. If the volume rises as the market moves up then it is generally friendly to building a base. The volume has to be very high.
In the testing area, near or at the neckline of the pattern, sellers begin selling to form a distribution point. If buyers do not begin accumulating, to counter that, then sellers can bring the market back down from the neckline, the same distance, that approximates the distance measured from the top of the head, down to the neckline. In this case, a confirmation of the top, would bring the market down to about 9,690.
Where is the Overhead Resistance for the test?
There are 2 major points of overhead resistance. First, there is the area of the neckline at the 11,940 level. Secondly, there is resistance at the 50 week moving average which is slowly moving down to meet the market. It is currently at 12,520, but has been descending about 30 to 50 points a week.
The test and confirmation of a Head and Shoulders topping pattern is more of a process than a defined market action. It is very often a choppy area, because after moving through denial, anger, and bargaining, the market may have completed a normal bull market correction. If so, the bulls would have an opportunity to gather their resources, charge upwards on high volume and make a stand.
The next stage lower however, would be called depression, and that would represent the beginning of the real bear market. The minimum price objective as explained earlier would be 9,690.
That is the classic outline. The market could of course, move through a variety of twists and turns while following that outline.
What About the Bulls?
In order to invalidate the current Head and Shoulders top formation, any price probes above 12,000 needs to be accompanied by very high volume. There should be massive short covering along with multitudes of fresh bulls pouring cash into the market.
So far, volume on this 7 week rally has not been good with regard to that scenario.
As bearish as the fundamentals have been, we have not yet seen typical bear market action. The bulls have never thrown in the towel or capitulated. If they succeed in creating high volume rallies, then we can only say that the great bull market absorbed a very troublesome credit/debt bubble correction and the market will move on to a new dynamic of wealth creation. At this time that has not transpired, nor has it gotten close to transpiring.
Change does not occur overnight. It took Paul Volcker and the Fed of the 1980s about 8 years to rein in the inflationists. Taking the needle of credit/debt addiction out of the arm of today’s investment community will more than likely put the market in rehab for a while.
Longer Term Bearish Considerations
In order to confirm distribution, the Dow Jones needs to close below the July 15, 2008 low at 10,827. That would project the market down to 9,690 as the minimum price objective of the current Head and Shoulders top.
If the market takes a very long time to turn over, say another 2 to 4 months, then we may see the development of yet another right shoulder duplicating a left shoulder created in late Jan 2006. The completion of a new right shoulder, could occur as far out, as the beginning of Jan, 2009, equaling the amount of time it took to create the left shoulder.
Since the market already has a Head and Shoulders Top formation, the completion of an additional right shoulder could come sooner. We would then be seeing the completion of a complex Head and Shoulders Top that if validated, could send the market down to a minimum price objective of 7,390. I would presume that a global recession would be in force.
Near Term
All eyes are on the US consumer near term, and the global slowdown further out. It is possible that a further slowing of our economy could produce the fourth stage (depression), and the further slowing of the global economies could produce a fifth stage (acceptance). At best this is guess work. I really don’t know what if any other fundamentals would guide the market down.
Real bear markets lose 35% to 50% of valuation, not 24% as this one has. Therefore as unbelievable as it seems, the market still needs to prove that it can take on real bearishness and become a real bear market.
The lack of transparency regarding debt in the financials, makes it difficult for traders to trust, and sustain rallies.
Stay focused on our economy, and the economies of the world. The Freddie and Fannie takeover by the Treasury will probably cause a lot of volatility. Avoid trading on election bets. Thirty years of observing election markets has not shown me any reason to place election bets. It is an exciting time in our history, and in the history of the world. Vote. The elections will be over soon enough.
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On Tuesday September 9, 2008 at 1:30 PST (4:30 EST) I will be giving a one hour presentation on various aspects of Novy Principles of Market Flow that tracked the topping process of the Dow Jones over the last 8 months. I will also display its use in scalping and day trading. It is a free seminar and you can register at http://www.onlinetradercentral.com/.
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This information is for educational purposes only. Trading with this information is done at your own risk. All concepts and writings including the Novy Training/Trading Method NTM© are proprietary and the sole ownership of Leonard A. Novy and may not be reproduced for profits without expressed written permission. Copyright1995-2008
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