"Where?" Part IV: Secular and Cyclical Bull and Bear Markets

We've changed the format a bit on how we're approaching more educationally-oriented content to make the Dreddnomics for Dummies series the highlight. However, in the spirit of leaving nothing incomplete, we feel the need to wrap the "Where?" series up. This will be the final installment.

If you haven't been following the "Where?" series so far, we highly recommend checking out the first three parts of this series, which are available under the "Education" section of the blog on the right hand side. They are:

• Part I: Intro to Inflation
• Part II: Money
• Part III: Inflation, Deflation, Real, and Nominal Prices
  

In the last part of this series, we covered more on inflation, deflation, real, and nominal prices in brief. In reality, it's complicated subject, but there should be enough there to get you started.

In picking up where we left off, we looked at the Dow Jones Industrial Average in nominal terms (as it's priced when you typically see it, in US dollars) and real terms (Dow Jones price divided by gold in US dollars). The result is the Dow Jones priced in ounces of gold instead of dollars. For now, we will refer to this as the real price of the DJIA.

As a refresher, we're including the chart here again. Note that we changed the color of the DJIA priced in ounces of gold (right hand scale), only to make it easier to read. No data has been changed. Click on the image for a larger image.


Note that the nominal DJIA (blue line) has long periods where it generally trends up and peaks at about the same time as the real DJIA (red line). The nominal DJIA then either falls or trends sideways while the real DJIA falls like a rock. Keep this in mind for a bit later while we investigate the standard way of looking at secular bull and bear markets.

Secular Market Trends
Conventional wisdom states that since the forming of the Dow Jones Industrial Average index, the US has been through four long bull markets where the economy was good, stocks rose, and fortunes were made. It has also been through four (counting the current one we're in now) bear markets where the economy was terrible, stocks were lousy, and fortunes were lost.

Wikipedia defines a secular market trend as follows:

• A secular market trend is a long-term trend that usually lasts 5 to 25 years (but whose distribution is more or less bell shaped around 17 years, in the stock market), and consists of sequential primary trends.
  

Take a look again at that DJIA chart again. The general trend is up over time, but there are periods that are generally up and others that are generally dropping or flat for many years. These are the secular market trends. Given that these trends last for a decade or more, it pays to know which secular trend you're in and what to do when you're in it.

This is more obvious in the picture of the DJIA from the Wall Street Journal several months ago.


Note that the chart is divided into secular market periods of growth that last for many years which are defined as secular bull markets, and there are periods where the DJIA is flat or down which are defined as secular bear markets. For our purposes, we will stick with the dates in the chart to define secular bull and bear market periods for the rest of this analysis. [Side note. These are periods defined by conventional wisdom, which will suffice for now. This is not, however, how we believe they should be defined, and we will prove below. For now, this will suffice.]

We have recreated the same Wall Street Journal picture with a little bit more context. Below are two DJIA charts in linear and logarithmic form, respectively. There is no difference in the data itself between the two charts. The major secular bull and bear markets are shaded green and red, respectively. The periods are labeled with beginning and ending date, beginning and ending values of the DJIA, and percentage gain or loss for that secular period. Several historical dates are listed as references.



Note that the DJIA index was put into place on May 26, 1896. Prior to that there were no indices that measured stocks in aggregate. For the purpose of this analysis, May 26, 1896 is the beginning of time, though it was not the beginning of the stock market itself (or even the beginning of the first secular bull market).

A few things about the data are interesting.

First, the secular bull and bear markets are determined by the green, secular bull periods in which the DJIA gradually rises to some "peak" value. The red, secular bears begin when the DJIA crashes significantly from its peak and moves "sideways" for a sustained period of time.

Note that not all crashes beget secular bear markets. For example, the 1987 crash, while significant, recovered quickly and continued the long bear market of 1982-2000. It was not marked by a particularly weak economy of any duration, so it was actually the beginning of a cyclical bear market within a secular bull market. It was a sharp correction, but for savvy investors, it was the buy of a lifetime.

Second, you can see that the bull market periods are generally upswing periods. If you are invested at the beginning of a secular bull market, you can generally just buy the stocks and hold onto them with no trading. That, of course, is referred to as "buy and hold." If you would have invested at the beginning of each secular bull, you would have gained 149.78%, 495.1%, 947.50%, and 1369.76%, respectively, for each major secular bull. All you had to do was "buy the Dow" and come back 14.71 years later, on average, to collect your payola. Easy, eh?

Third, note that the secular bear markets are punishing. Had you invested at the beginning of each secular bear, you would have lost 37.96%, 75.62%, and 21.93%, respectively. Also, keep in mind that this is in nominal terms. As you'll see later, the losses are much larger when adjusted for inflation. Had you invested your life savings on August 30, 1929 and waited it out during the following secular bear market of 1929-1942, it would have been November 24, 1954 before you broke even again. That's over 25 years of waiting to get your money back.

In the secular bear market periods, stocks either fall or generally move sideways for decades. In the end you wind up losing money. Clearly, if you "buy and hold" during this period, you're in a lot of trouble.

This is how we get to Dredd's Rules on Secular Markets:

• "Buy and hold" is for secular bull markets only
  
• Secular bear markets MUST be traded, so understanding timing is key
  

In general, secular bull markets last 14.71 years and secular bear markets last around 14.92 years, using the definitions of secular bulls and bear market periods as defined by the Wall Street Journal.

Some people will argue that the end of the secular bear market of the 1970s (the 1966-1982 period marked on the chart) actually ended when the stock market reached its low in 1974, shortly before the end of the Vietnam war. We wouldn't disagree. That's a reasonable way of looking at the secular bull and bear market periods.

Similarly, Some will argue that our current secular bear market didn't begin until the crash of October 2007 because the DJIA (and S&P) had reached new highs after the dot com crash of 2000. This is also a reasonable argument and legitimate way to divide up the secular bull and bear markets.

However, as we stated before, we're following the conventional bull/bear argument here. We have an entirely different way of breaking up the secular bull and bear markets that we'll discuss later that is based on the REAL price of the DJIA.

Cyclical Market Trends
Note that both secular bull and bear markets are made up of smaller periods where bull markets go down a bit or bear markets rise. Secular bull and bear markets, which are multi-decade phenomena, are made up of cyclical bull and bear markets. The definition and debate on what a cyclical bull and/or bear market is is well beyond the scope of this article. We'll come back to it another time. Suffice to say that in a secular bull market, the bear cycles pull the market back only a bit and provide the long term investor with a good time to buy stocks while the cyclical bull markets within a secular bull market advance the market to new highs. In a secular bear market, the cyclical bear periods are essentially crashes of significant magnitude and the bull markets are periods of sharp, but short recovery.

Where We Are Today
This brings us to the first answer, or at least first superficial answer, of the "where?" question. Where are we? We are in a secular bear market where buying and holding is not going to work. As of today, August 28, 2009, we are in a cyclical bull market within that secular bear (cyclical bull as designated by the Dow Theory and several other key market indicators). This cyclical bull appears to have started in March of this year. For many reasons such as the shape of the recovery from March, the fundamental economic situation, the cyclical period, and even the duration of the total secular bear market thus far, we do not believe that the secular bear market is even close to over, so we know that we must trade in and out of the market to do well. The key will be understanding when the cyclical bull period is ending. That is the primary reason we frequently comment on the market using technical analysis.

Dredd Approach to Secular Bear Markets
Secular bear markets are periods of extreme economic stress and are caused by different external factors. Of specific interest to us are the secular bear markets of 1929-1942 and 1966-1982 because they bear so much resemblance to the current secular bear market that we're in.

Much like today, the secular bear of 1929-1942 was caused by excessive debt that built up during the previous bull market after World War I. The market crash was caused by a forced deleveraging of debt. That bear market really didn't end in the United States until business production was ramped up for World War II. Unlike that period, the global monetary standard was gold, which put limits on the amount of money that could be created by the government.

The bear market of 1966-1982 had many causal factors, but inflation was the hallmark of that period. Much like today, the secular bear of 1966-1982 was a period of rampant money creation that culminated in the ending of the gold standard for the United States under Nixon in 1971.

"Stagflation" is the term coined to deal with the economic climate of the 1970s. It is essentially a description of a stagnant economic period with rising price inflation (which was, in fact, caused by rampant money printing, which we refer to as the real definition of inflation.)

Prior to the formation of the Federal Reserve in 1913, money and credit expansion was limited by the gold standard. Inflation was very low. If you look at the chart, you'll see this period was particularly marked by "sideways" market behavior where the market went up and down for almost 24 years. There was no crash--at least no obvious crash--as compared to the 1906-1921 and 1929-1942 periods.

This is where we start to look at things "differently" than most.

Let's look at the same linear and log charts from above, but with the DJIA priced in gold (real price of the DJIA) on the same graph in red.



Again, the blue line is the nominal price of the DJIA--the one that gets quoted frequently. The red line is the real price of the DJIA in ounces of gold, not in dollars. It's simply the nominal price of the DJIA divided by the nominal price of gold on the same day.

If you view these charts closely, you will see that we have shifted the green and red secular bull and bear market periods to coincide with the movements in the red (real) line, which in our opinion, is the real determining factor for when a secular bear will end.

Prior to the secular bear of 1929-1942, the nominal value of the DJIA and the real value of the DJIA were basically the same (in terms of pattern.) Then something interesting happens. In 1933, Franklin Delano Roosevelt formally devalued the dollar by confiscating gold, declaring a bank holiday and revaluing the dollar from $20.67 per ounce of gold to $35 per ounce of gold, a loss of 70% of purchasing power overnight. Prices rose 70% overnight. Frightening (but probably coming again to a country near you.)

Something else happened that was interesting at this point. The tracking of the real DJIA and the nominal DJIA breakdown, and have been moving further apart ever since. In short, in 1933, inflation in the US really started. Again, in 1971 (when Nixon removes the tie with the gold standard), it accelerates again. We'll see this more a bit later.

Note that we mentioned that some people will claim that 1974 was the real end of the 1966-1982 bear market. Based on the real price of the DJIA, we would disagree. In nominal terms, that may be the case. But in real term, the decline just continued--hidden by inflation.

Similarly, the 2003-2007 period was hidden by inflation. In nominal terms, the stock market reached a new high. But in real terms, the market has been crashing since 2000.

Inflation hides the real effects of what's going on in the economy. The deflationist camp does not understand this effect. You must absolutely understand that inflation must be taken into account when gauging markets. This will become more obvious in later charts.

[Side note: The blue/purple shaded area denotes a period where one could argue that there was the beginning of a secular bull market. It also coincides with the period in which Franklin Delano Roosevelt devalued the dollar. This shouldn't be surprising. People that had money realized money was worth much less and used that money to buy stocks, which is just a formal means of inflating.]


Let's go back to the very first chart with which we started this article.


It's the same chart as the the colored log chart above it, only using monthly prices instead of daily prices. The nominal DJIA (blue) is logarithmic, and the real DJIA (red) is linear so it shows up best visually. Here's the point. In every major secular bear market, the real price of the DJIA will show the end of the secular bear when 1-3 ounces of gold will "buy the DJIA." As an example, if gold stayed right were it is today (let's call it 950), then the secular bear would end when the DJIA reached 1100. Similarly, if enough inflation gets into the market and/or the USDX falls like a rock, we may see the DJIA at 20,000 at the end of the secular bear with gold at $10,000 + an ounce. Which direction it goes depends on the amount of inflation created.

A Closer Investigation of Secular Bear Periods
Since we're in a secular bear, let's break each of the major secular bear periods down for closer inspection in real and nominal terms. We're going to stick with the Wall Street Journal view of secular bulls and bears, just for convenience. First, the 1906-1921 secular bear.



The chart is linear because the time frame is relatively short and the machinations are not major. The red shaded areas are cyclical bears within the secular bear. The white areas are cyclical bulls within the secular bear. The blue line is nominal, and the red line is real. We will be consistent in this color coding schema for the rest of the charts in this article.

Note that the market is very regular and cyclical. This is a "normal" bear market, unpolluted by poor political policies and inflation. The real and nominal prices are really perfectly correlated. You'd have to trade the market to make money, but if you bought and held, the effects would not be devastating. However, if you bought at the beginning of a cyclical bull and sold at the beginning of a cyclical bear, you'd have done very well indeed.

Next, the 1929-1942, "Great Depression" bear market.

From 1913 on, with the creation of the Federal Reserve, the real and nominal prices have varied somewhat. However, they remained very close to one another until the 1933 formal devaluation of the dollar. You can see how the real and nominal market start to "decouple" strongly during this period, but are still tied together at a different exchange rate. They only get more decoupled from this point forward.

In this bear market, there was a long, major crash from 1929-1932, a strong but short bear market rally in 1932, another crash in 1933, the formal devaluation of the dollar that led to a cyclical bull market from 1933-1937, then an increase in taxes which led to another down leg that lasted until the US entered World War II.

You can see the effects of the Fed and government tinkering here already. The "solution" to the deflationary crash was to weaken the dollar. This has been the strategy ever since--today is no different. The currency always becomes the outlet for government intervention.

The devaluation works on the nominal market. Devaluation/inflation will make asset prices rise again, at the expense of the purchasing power of the currency (until it eventually destroys the currency.) However, note that increased taxation wrecked the recovery. Taxes matter.

Here's the 1966-1982 "Stagflationary" secular bear market.

We've had to add to this chart a bit to point out the profound differences of money printing over time. The red horizontal and vertical lines point to bear market periods in real terms while the red shaded areas show the bear periods in nominal terms.

In nominal terms, this market crashed, recovered, crashed, recovered, crashed bigger, recovered bigger, crashed even bigger, recovered even bigger, crashed for a long time, recovered quickly, and then crashed again to end it. Thus, in nominal terms, it looks a lot like the original 1906-1921 market with a very definite periodic response.

In real terms, however, it was one giant decline with a little over a year of cyclical bull market recovery, then a long decline again until the end.

The distortion of money printing is particularly insightful in this bear market.

But what about today?

What we see today is a mix of 1929-1942 and 1966-1982. Basically, it's the combination of a debt-based crash (Great Depression) with a lot of money printing (Great Stagflation).

Here's a close up of the 2007 to present period.

Our primary mission right now is determining when this cyclical bull market period ends. We use technical analysis and a proprietary model based on the historical movement of markets as shown above (plus we look at the S&P, NASDAQ, foreign markets such the Merval, Nikkei, etc).

Inflation adjusted market analysis works equally well and is also very illuminating. Perhaps we will do that another time.

Hopefully you have now realized a few important points:

• You cannot "buy and hold" during a secular bear market
• Gold will maintain its value throughout the cycle.
  
• The secular bear market will end when the DJIA:gold ratio is between 3:1 and 1:1
• The tactic used by the government will be to devalue the money to solve the problem through either formal devaluation or subtle, but effective, inflation. Printing money matters. It will affect your purchasing power and distort what is occurring. Understanding what is happening in both real and nominal terms is critical.

We're always interested in comments and requests. Feel free to shoot an email to us at dredd.every@gmail.com.

Read more...

August 27 Technical Update

Again, not much to comment on other than the dollar just cannot seem to hold ground. Most assets are overbought right now and a rise in the dollar would be bullish in terms of "cooling the heels" of asset markets a bit. Asset prices started today with a sell-off, but the dollar was unable to stay even on the day, and as it sold off, asset prices rose. This should have been a down day, but the dollar cannot stay up. The dollar rules over all asset values taking precedent over overbought and oversold conditions. We may not see the extent of some of those price pull backs that were discussed Tuesday night if the dollar can't even maintain a few days' gains.

You can see the trading range is still intact as discussed a few days ago. What looked like a forming rectangle may actually be a descending wedge or symmetrical triangle--it's still too early to tell (outlined by the blue trend lines). A pattern is not a pattern until it's a pattern, if you get by point. Before then, it's something that may turn into a pattern...

If this trend holds true, we should see the dollar touch the bottom blue trend line on Friday or Monday, and then reverse to the up side. The 50 day moving average is basically forming along the top blue trend line and acting as resistance. This is a classic consolidation pattern forming. If we see a real triangle form, then we could expect that odds favor the dollar breaking down and continuing its down trend. Time will tell.

Until the support line at 77.43 is decisively broken, we're just going to sit around and consolidate...

Read more...

August 26 Market Update

Not much to post on tonight. The situation remains about the same. Of interest is that the 50 day moving average seems to be acting as resistance to the dollar and support for gold. We're simply in a consolidation phase (this is a "bounce" for the dollar).

Read more...

The Dollar Will Fall (And So May Everything Else), But When?

A news brief with Minyanville CEO Todd Harrison touches very nicely on our existing theme - dollar weakness is the fundamental cause of asset price increases in this Yahoo Tech Ticker video.



Harrison's points can be summarized by the last statement in the accompanying article:

"...Harrison thinks there are actually legitimate reasons for the dollar to rally in the near term:

• The creation of all this debt, creates demand for dollars.
• "The dollar is the best house in a bad neighborhood." Meaning, as bad as things are in the U.S. other economies around the globe aren't faring any better."

Harrison is short term bullish on dollar and long term bearish, which is similar to our thesis. However, our interpretation is a bit different.

As we stated last night, we believe the only things that can drive the dollar higher are:

• A return of a crisis, like the credit crisis phase we entered last year which forced the deleveraging of assets
• A structural fix to the economy such that consumers get out of debt, the US starts producing more than it consumes (net of trade deficit currency issues), the government shrinks in size and becomes more favorable to business, we let the banks go out of business as required, etc. This is a long term issue that is not being addressed. Quite the contrary, the Administration, the Fed, and the banking system are "papering over" the real problem by creating more dollars. That will only exacerbate the problem in time.
• A technical bounce that occurs when the dollar reaches specific levels on the USDX chart that have made historically good buy points. This will force the dollar to rise for short periods of time, but not necessarily substantially.
  

We differ with Harrison in the belief that the debt creation will drive the dollar higher significantly. For the most part, we see an increasing lack of foreign demand for Treasuries and more "tricks" associated with "stealth quantitative easing." (That's a topic for another time). Instead, we perceive that this debt creation will only slow the rate of decline of the dollar.

Short term, we can expect some dollar "strength." We refer to this strength as a "technical bounce" since we do not expect significant rises from the dollar without a crisis driving it (in which case, we would use dollars to buy hard assets). In short, the dollar is only the best house in a bad neighborhood if there is a sudden demand for houses. That is, without a crisis move, the dollar can only move up on technical trades for brief (2 month-ish) periods of time.

Here's the rub. Again, the dollar, as measured by the USDX, is really only an indication of capital flows among the US' key trading partners. As ALL countries continue to inflate (and they'll all have to to various degrees), the USDX may remain relatively stable even as prices rise globally. Note that this is the difference between the USDX as a measure of the strength of one floating currency against a basket of other floating currencies and price inflation as a result of all countries creating more liquidity. So the dollar may be the best of a bad bunch of apples, but we wouldn't advise eating any of them. All currencies will ultimately fall against hard assets as this crisis moves forward into its next phase.

Read more...

August 25 - Technical Market Update

Some interesting events today. Notably, crude oil hit its 200 week moving average and rolled over even as the dollar faltered. We are seeing signs of increasing divergence and a possibility of a strong pullback occurring soon.

Market Scenario
As we've shown in our technical updates thus far, a falling dollar implies that assets like stocks and commodities will move up. The opposite is also true. If the dollar were to start rising, assets will fall accordingly.

Right now, there are no indications of an impending return of the "credit crisis" which would lead to panic selling. However, from a cyclical basis, we are within a period of time where we must be vigilant in watching for such a return based on our market model. We will, of course, immediately send an announcement if we see indications of an impending return of a liquidity problem. If you'd like to get an automatic notice if this occurs, please send an email to us at dredd.evry@gmail.com with a contact email address.

Note that it is possible for the stock market, based on fundamentals, to start to decline without the dollar rising if the rate of the dollar decline exceeds the rate of decline of the stock market itself (this would be similar to the October 2007 - July 2008 period). In summary, if the dollar rises, assets will fall. The dollar will only rise on a technical bounce (like we're seeing now), if the credit crisis returns, or if the economy is structurally fixed. We do not see anything other than a technical bounce at this time with a duration of maybe another couple of months. We have several proprietary indicators that should alert us to any impending credit market issues.

US Dollar

We're still in an overall bearish territory with a longer term target of 72 (we'll most likely have another rally/bounce again at 76). However, we are seriously oversold and the dollar will, at minimum, need to tread water for a while, which is exactly what it has been doing for a few weeks. The question remains: how far can the dollar rise? Of course, this is a difficult question to answer, but we can look at the short term charts and get a sense of the likely areas where it may move.

Note that we're trapped in a tight range where the dollar is "bouncing" around between the 79.51 level on the upper end and the 77.42 level on the lower end. Essentially, we're pivoting around our old friend 78.33. Note that we may be setting up a rectangular consolidation pattern from which the dollar will have to break up or down. The longer the consolidation lasts in this range, the more likely it is to break down and move toward the 76 level.

Crude Oil
The long term oil charts are bullish, but overbought. Today's divergence between crude oil and the dollar occurred when crude ran up against its 200 week moving average. Short and mid term, we expect a pull back to the 65 range (maybe only 67) while the dollar treads water and then a run back up to challenge the 75 level. Assuming we breach the 75 level, we will likely move toward the 95 price point over the next six months.

Again, and we cannot stress this enough, a sudden and sharp move up in the dollar may disrupt this pattern. As the situation evolves, all factors in various markets must be taken together in context.



Equities (Stocks)
Stocks have been acting a bit bearish. They appear overbought and tend to sell off near the end of the day. It's likely we're finally ready for that pullback. Similar to oil, stocks are overbought short and mid term, but longer term have the opportunity to run up significantly--well beyond what fundamentals would imply. We would not add to positions here, but will likely hold what we have and wait to see the behavior of the stock market on any pullback before committing new funds.


On a separate but related note, we think Chinese stocks are a cautious buy here.

Summary
We are in a period where our model indicates that we could see the beginning of another stock market move down. If this window of opportunity closes and the markets are in good shape, we will be very bullish on stocks for another move up. But for the next few weeks, the risk of a significant pull back or beginning of another crash is elevated. We advise caution over the short and mid term. Traders should look to take profits here. Commodities, aside from gold, may exhibit the same behavior.

Though we didn't cover it specifically tonight, we have repeatedly stated that gold looks as if it may be preparing to launch forward.

The credit crisis does not appear to be making a return in the immediate future. The implication is that assets with good fundamentals, notably commodities and stocks of commodity producers, will likely do well after any consolidation period initiated by the general stock market sell off.

Read more...

Big News of the Day - Bernanke Reappointed

We were going to post a video, but what's the point? The news is straightforward enough: Bernanke is being reappointed as Chairman of the Federal Reserve for another four years.

In our opinion, this is positive for the stock market and negative for the economy.

Why?

Well, in a nutshell, we're confirmed believers in the "There's no free lunch" concept.

Bernanke has pulled some amazing stunts to reliquify a market that was crashing because the banking system was so strongly leveraged to over-the-counter derivatives that were imploding. What started as the "subprime mortgage crisis" has shown the reality of the problem--the banks themselves have such massive risk associated with individually structured derivatives contracts that if those contracts were allowed to execute, the entire banking systems of the world would collapse. It's the equivalent of you borrowing all of the money you can against your assets, borrowing from your friends and family, and placing it all on "red 22" on the roulette table. Actually, it's worse than that. It's like you taking all of your assets and the assets of the planet Earth and placing them on "red 22." Odds are, after the wheel is spun, you've bankrupted the planet.

So Bernanke took many of these "bad assets" off of the balance sheet of the banks and used them to back the US dollar. Note that the bad assets didn't go away, but they were instead shifted to the Federal Reserve's balance sheet.

Sounds good, huh? Of course, all this has done is move the insolvency problem from the banks to the United States. Not so good if you think about it that way.

But, for the time being, it has prevented the global markets from crashing to zero. Bernanke has created some confidence in markets, and without him you can just about guarantee a crash. Confidence is not, however a permanent fix. It is only the appearance of a fix. The game is to manage your perception by making you believe that things will get better.

Of course, this little "solution" now also requires that an infinite amount of money be created to cover the losses of these contracts. That's probably not good for the currency. Perhaps most importantly, if there's ever a lull in the monetary stimulus of any consequence, the whole house of cards will start to fall apart. Let's not forget that new derivatives are being created even as we speak...

You see, there is no real economic recovery. There is only money printing (ie, devaluing the currency) and management of your perception. There is another round of mortgage resets beginning this month which will get larger next year. There is no consumer spending because inflation has destroyed the money over time and consumers have no assets to borrow against.

You can create money, but it will only drive up the cost of living as it devalues the debt. If that is carried too far, a currency collapse may result.

You cannot print money and believe it will create prosperity. There is no free lunch, even though it may appear right now that the bill will not come due.

No, dear reader, this is only eye of the hurricane and we see the gray clouds approaching on the horizon. The next leg down of this event will make the prior one look meek.

Stay alert. Don't buy the hype. Work with the market and let it tell you when the next crash period is about to begin because it is coming at some point.

Read more...

August 24 Market Update - Natural Gas

By request, we're going to look specifically at the natural gas market.

We are not natural gas experts, though we do closely follow the energy complex as a whole. The issue at the core of the natural gas market is the production of shale gas, notably the Barnett Shale, which has been the fundamental game changer in terms of natural gas production.

At present, there is a massive oversupply which has been driving the price down. At the same time, the characteristics of shale well are such that they deplete very quickly. This forces them to be tapped and run hard, which floods the market with supply in the short term. The low price then forces companies to stop developing new wells, which over time, creates supply shortages. New rigs are then deployed to tap for more gas, which drives the supply up again.

Rinse and repeat. The problem that the industry as a whole will have to adapt to is inventory control of natural gas developed from shale wells. Until the industry resolves a way to adapt to this type of "yo-yo" production, natural gas prices will likely remain volatile.

With that said, here's a technical view of the problem.

First, the typical rules apply. Price is going to be heavily dependent on both the supply and demand of natural gas as well as the supply and demand of the currency it is measure in (dollars). So if the dollar rises, then natural gas prices will weaken, though probably not as much as crude oil prices because of the regional nature of natural gas. Fundamentally, natural gas needs a weak dollar, a cold winter, and some increased LNG demand to resume a bull market.

The intermediate term daily chart of the last 18 months tells the story:


Natural gas began it's crash period in conjunction with crude oil and the rest of the commodity complex in July of 2008 (July 13--the date referred to as the "Midnight Massacre" by those that listen to analyst Don Coxe).

Beginning in March, when the stock market bottomed, the rate of decline of natural gas began to slow until it entered its "basing" phase in May. A basing phase is when a security starts to build a base from which it is likely to rise again. In the chart above, this is denoted by the blue rectangle.

The RSI has turned bearish but downward momentum has slowed considerably. The direction of a confirmed "break out" from the blue rectangle is what we're looking for. If it "breaks down," the implication is that the bear market will resume and prices will be under more pressure. If it "breaks up," the implication is that we *may* return to a bull market.

The problem is, it looks as if natural gas may have broken down through the bottom of that box. It will take a few trading sessions to determine if this will happen or not (there is such a thing as a "false break down.") Let's zoom in a bit.


You can see the support and resistance lines in red on this chart more clearly. There was a break down and a subsequent rise. Natural gas really needs to hod that $3.22 line. The slow stochastic is oversold, which implies that there will be some buying. It will not be in a bull market unless it breaks $4.57 on the upside. That will indicate longer term rising prices.

Short term, natural gas looks like a buy for the next couple of weeks (the short term is the most unpredictable). Mid term, it is likely to stay within its basing range until it breaks up or down with confidence.

Let's look at the long term picture.

Long term, the chart is negative, but may be forming a descending triangle, which will force a move in prices higher or lower. We would suspect that natural gas will decide on a longer term direction within the next 6-8 weeks.

Again, if we look at the fundamentals, we see that the rig counts have dropped massively since the "Midnight Massacre" but are starting to turn the other direction. Speculation is that there is an "economic recovery" around the corner. While we're not so sure about that (again, we may have 6 more months or so of positive signs before a turn over, if we're lucky), we do believe that we're in for a colder than normal winter. While it's not a topic we have addressed here (it would be something for a newsletter versus this blog), we track and record sunspot activity as a predictor for weather patterns, which in turn help with crop forecasts and thus grain commodity prices. With a really good chance of a colder than normal winter throughout most of the Northeast and Central United States and Canada, we will likely see the price of natural gas spike and rise this winter. As the inventories rise going into the spring, we may see a repeat of a crash in prices, barring new innovations in storage management.

Being a trader's market, we're long natural gas short term. Mid term, we need to see a price break out before buying in. Long term, we're bullish, though cautious. This market is not as simple as the crude oil market, so caution is warranted as the industry makes structural adjustments.

Read more...

Dredd Approach to Technical Analysis

In accordance with a few changes that we've stated we're making around better organization of the blog (we actually should consider a complete website, but that's for another time) and redefining our approach to the content, this article will focus on the purpose and usage of technical analysis.

As we described in the article Dredd Market Analysis: Our View of the World, we use a combination of several different concepts, including economic theory, fundamental analysis, historical precedent, cyclical analysis, and technical analysis to determine what's going to happen in the market and when it is likely to occur.

Economic theory and fundamental analysis tell us what is going to happen, or perhaps more precisely, what is likely to happen. Economic theory teaches us how the "machine" that is the economy functions and how policy makers are likely to react to certain events. Fundamental analysis tells us of things like supply and demand that exist that will drive the markets in one direction or the other.

Historical precedent, cyclical analysis, and technical analysis tell us when it is likely to happen. Historical precedent and cyclical analysis specifically give us a broad sense of what to expect at some point in the future based on how a similar series of events unfolded in the past. Essentially, they point create "windows of opportunity" for when things are likely to happen. For example, every time the stock market "crashes" in history, it falls for a given number of months, rebounds, crashes again, rebounds, then crashes to its final low point. If the crash is caused by a debt collapse, the pattern has a specific look to it that is consistent across all cultures and all periods in history for which we have data. Similarly, there are cyclical patterns, like seasonal cycles in the retail markets driven by the Christmas holiday season, which have a very strong influence.

Again, though, these two concepts only create "windows of opportunity" where specific events are likely to occur. A relevant example is our current situation where we are near the end of the summer trading season and about to enter the September/October months. Historically, these months are brutal on the stock markets. In times of stress (like last year), these months tend to start new cycles of crashes. Since we still have a considerable amount of risk in the credit markets due to over-the-counter derivatives and a very bad economy, there is a "window of opportunity" for the stock market to crash. But then again, it may not. So how do we know if the "window of opportunity" for an event becomes an actual event before it wipes out our investments? This is where technical analysis becomes important.

Most of the charts we show on a daily basis are for technical analysis. Every day we must look at the whole of the economy, the policies in place, the movements of the markets, and geopolitical events to best determine if we need to sell things we own and/or buy new things (like stocks, commodities, cash, etc). The nightly charts we look at give us some expectation of things that are likely to come.]

Here's a loose definition of technical analysis that we can use:

Technical Analysis - A collection of various methods of analyzing securities (like stocks, bonds, commodity prices, and currencies) based on factors such price and volume movements in those securities and mass market psychology to determine future price movements in those securities.

There are a wide variety of technical analysis techniques including, but certainly not limited to, classical analysis, Japanese candlesticks, Elliott Wave, and Dow Theory.

The premise of all technical analysis systems is the same: all available information about a given security is contained within its chart, which is a reflection of of supply, demand, and investor psychology. Think about it. "The market" is just a vast collection of people. They are individual investors, pension funds, companies, foreign governments, and all sorts of other people buying and selling things and trying to profit from it. Many of these investors are experts in their industry. So the fundamental theory of technical analysis is that the price of a security (be it a stock, a bond, or corn futures) represents the consensus view of all that is known about that security. So if you watch where the prices and volumes of buying and selling, you can predict where investor sentiment is going and make your decisions accordingly.

Does it work? It's certainly not a crystal ball. In our opinion, it improves the odds and helps with timing, particularly over the next few weeks to several months. It also requires constant observation to try and determine what the market prices are saying. Without the greater context of economic theory, fundamental analysis, and the rest, technical analysis has limited meaning.

It is outside of our scope to try and teach technical analysis in this blog, and there are already many web sites and books on the topic. But we will provide our interpretation of events as they unfold.

With all of this said, beginning with tonight's Market Update, we will try to summarize our position in the market more clearly in addition to the typical analysis and provide a section whereby the casual reader can better understand how we are interpreting the market action for that day as well as its short, mid, and long term implications.

Read more...