Comparing the 2008-09 Stock Market With the Great Depression's 1st Leg Down

This epic stock market rally has done exactly what it was supposed to do - it's retraced about half of the losses from the previous crash. It's got folks feeling comfortable again - while maybe not outright enthusiastic about things, they now believe the carpet is not going to be pulled out from under them.

That's exactly what buying stocks now is a more dangerous proposition than it has been anytime this year thus far.

So can big rallies, following big crashes, be sustained?

I did a little bit of digging through historical data, to see if there was a case where a severe crash was isolated - that is, it retraced back up, and there was nothing more to it. Typically, crashes occur in three legs down (five "waves" in total, counting two countertrend bounces) - at least this was my belief, which I wanted to double check.

I'm going to compare this market crash/rally with the crash/rally from 1929/1930, and only that, because I was not able to find another market crash, and subsequent rally, as severe as what we've experience over the past year or two (severe being 50%). I wish we had another example to look at, but I wasn't able to find one since 1900 in the US that met this criteria!

The Great Depression's first leg down, and the 2008-09 markets, are in rarified air that meets these stomach churning guidelines:

1. A ~50% stock market drop
2. Followed by a ~50% stock market rally

Astute traders and investors, no doubt of which our readers here are, know full well that 50% down, followed by 50% up, does not get you back to break even!

First, let's take a look at the first leg down of the Great Depression, using the Dow Jones Industrial Average (DJIA) as our measuring stick.

Source: StockCharts.com

Date DJIA % Change # Days

09/03/1929 381.17

11/13/1929 198.69 -48% 71

04/17/1930 294.07 +48% 155

You have to love the symmetry of the 1930 rally! 48% down, then 48% up...before turning back down. Eventually the DJIA bottomed in 1932 at 41 - shedding an awesome 80% from the Dow's 1929 high.

Now, let's check out the newly minted Crash of 2008:

Source: StockCharts.com

Date DJIA % Change # Days

10/09/2007 14164

03/10/2009 6547 -54% 518

10/19/2009 10092 +54% 223

Oh the symmetry is fantastic! This time we retraced 54%, after giving up 54% initially - again roughly 50%.

Now, the million dollar question is: "Where to next?"

It's hard to make an argument for stocks continuing their rally from here. They are expensive by all traditional valuation measures, the economic recovery is not robust (maybe even non-existent), and until proven otherwise, this rally has been nothing more than a standard retracement.

The stock market doesn't just drop 50% for no good reason. Something more is usually amiss. Judging from the only recent historical analogy we have to use, caution is still the order of the day!

Positions Update - Even Shorter the S&P

A disappointing week for us dollar bulls/S&P bears. But, after 5 consecutive up days for stocks, we are not yet at new highs - nor are we at new lows for the dollar.

So, until further notice, I am classifying last week as a countertrend bounce, which could reverse as soon as tomorrow.

I did short another S&P contract on this rally - currently underwater on that position - so we shall see if that was a wise move in the weeks to come.

The dollar continues to muddle along - with strong support at 75.

(Source: Barchart.com)

Was last week a countertrend bounce for the S&P, or the start of a rally to new highs?

(Source: Barchart.com)

Open positions:

Thanks for reading!

Current Account Value: $22,947.03

Cashed out: $20,000.00
Total value: $42,947.03
Weekly return: -11.6%
2009 YTD return: -54.8%

Prior yearly returns:
2008: -8%
2007: 175%
2006: 60%
2005: 805%

Initial trading stake: $2,000.00

A Look Into Record High Trading Volume...And What It Says About Investor Confidence

The following article was adapted from the November 2009 Elliott Wave Financial Forecast and reprinted with permission here.

Steve Hochberg and Pete Kendall produce stellar analysis for Elliott Wave International - two of my favorite guys in the biz - here, they take a look at trading volume, and what it says about investor confidence. Read on, and enjoy!

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Finance's Euphoria: The Epilogue -- What Record High Dollar Volume of Trading Says About Confidence

November 6, 2009

Until Nov. 11, you can read the rest of this brand-new report for free, during Elliott Wave International's FreeWeek of U.S. forecasts. Learn more about FreeWeek, and download the rest of this report and others for free here.

By Steve Hochberg and Pete Kendall

When Wall Street’s total value of assets rose to a “mind-boggling 36.6 percent of GDP” in late 2006, The Elliott Wave Financial Forecast published a chart of U.S. financial assets literally rising off the page.

The Financial Forecast observed that financial engineers had “found a new object of investor affections—themselves” and asserted that “the financial industry’s position so close to the center of the mania can mean only one thing; it is only a matter of time” before a massive reversal grabbed hold. Financial indexes hit their all-time peak within a matter of weeks, in February. The major stock indexes joined the topping process in October 2007 and in December 2007 the economy followed. Subscribers will recall that one of the most important clues to the unfolding disaster was the level of financial exuberance relative to the fundamental economic performance.

This chart of the value of U.S. trading volume (courtesy of Alan Newman at www.cross-currents.net) reveals that the imbalance is far from corrected.

Incredibly, total dollar trading volume is even higher now than it was in 2007 when the economy was humming along. In June 2008, dollar trading volume also defied an initial thrust lower in stocks and the economy, eliciting this comment from the Financial Forecast:

The chart of dollar trading relative to GDP shows how much more willing investors are to trade shares in companies that operate in an economic environment that is anemic compared to that of the mid-1960s. A basic implication of the Wave Principle is that the public will always show up at the end of a rally, just in time to get clobbered. This chart shows that it is happening in a big, big way now because the market is at the precipice of the biggest decline in a long, long time.

Total dollar volume continues to rise despite further fundamental financial deterioration. Yes, GDP experienced a one-quarter, clunker-aided uptick of 3.5 percent in the third quarter. But the economy is in far worse shape than it was when we made the above statement. In fact, its recent performance on top of the decades-long economic underperformance (which is discussed extensively in Chapter 1 and Appendix E of the new edition of Robert Prechter's Conquer the Crash) means that industrial production just experienced its worst decade since 1930-1939. Total manufacturing employment slipped to 11.7 million people, its lowest level since May 1941 when it was 33 percent of all jobs. According to Bianco Research, manufacturing now accounts for only about 9 percent of the workforce. Finance anchors the economy now, which makes it far more susceptible to non-rational dynamics.

As Prechter and Parker explain in “The Financial/Economic Dichotomy” (May 2007, Journal of Behavioral Finance), a financial system is not bound by the laws of supply and demand in the same way that an industrial economy is. In finance, confidence and fear rule decisions. “In the financial context,” say Prechter and Parker, “knowing what you think is not enough; you have to try to guess what everyone else will think.”

We do know one thing: When everyone is thinking the same, the opposite will happen.

Right now, record high dollar volume of trading shows that confidence, at least on this basis, has reached a new historic extreme.

***

Read the rest of the 10-page November 2009 Elliott Wave Financial Forecast now, when you signup for Elliott Wave International's FreeWeek of U.S. forecasts. FreeWeek ends Nov. 11, so please act now to get an enormous wealth of current market analysis and forecasts -- for free. Learn more about FreeWeek, and download the rest of this report and others for free here.

Steve Hochberg and Pete Kendall are co-editors of the Elliott Wave Financial Forecast.

Why Nouriel Roubini Thinks Commodities Will Correct, and Dollar Will Rally...Eventually

Nouriel Roubini thinks that commodities and equities have gotten ahead of their fundamentals - now pricing in a "V-shaped" recovery, which Roubini thinks is unlikely (I agree).

Here's an interview with Roubini conducted by our friend Lara Crigger at Hard Assets Investor.

Well, in my view, commodity prices have increased since the beginning of the year too much, too fast, when compared to the improvement in economic fundamentals. Some of that increase is justified. But if the global economy were to have a more anemic, subpar recovery—if instead of a V-shaped recovery, there's going to be a U-shaped recovery—then I actually think demand for commodities would be weak compared to supply, and there could be a correction in commodity prices in 2010.

Take oil prices: They have gone up from $30/barrel to over $80, at a time when demand is back to 2005 levels, and oil inventory is at all-time highs. Part of the increase is justified by fundamentals. But part of it is essentially this wall of liquidity chasing assets, and the effect of carry trade on the U.S. dollar, driving further higher these commodity prices.

So these nonfundamental factors can push oil and commodity prices higher, especially if there's going to be an increase in expected inflation. But the fundamentals of supply and demand actually suggest that, from now on, oil and other commodity prices should be lower, rather than higher.

Also Roubini was also on CNBC, where he described the reversal of the dollar carry trade that he is anticipating at some point in the future. The results are similar to the "All the same markets" theory that Robert Prechter coined, in which the dollar will rally and all other asset markets will tank.

Here's the CNBC interview, which runs about 8 minutes:

Inflaton Isn't Here Yet - Here's When You Can Expect It

A couple of Sundays ago, I spent the morning reviewing the best inflation and deflation arguments and articles that I'd read since the financial world began falling apart. The inflation perspective that I enjoyed the most was that of Terry Coxon, editor of The Casey Report.

Below is one of Terry's recent pieces, which takes a look at the timing of a potential wave of inflation. I was fortunate that the Casey folks granted me permission to reprint the piece below.

Enjoy Terry's guest piece, as he explores what we can expect from inflation over the next few months and years.

***

When Will Inflation Really Hit Us?

By Terry Coxon, Editor, The Casey Report

Most of us are gathered at the station, watching for the Inflation Express to come rumbling in. But we've been waiting for a while now. Just when should we expect the big locomotive to arrive and start pushing the prices of most things uphill?

We’d all like to know the exact date, of course, but no one can know for sure. Not even a careful reading of the Mayan calendar will help. What we can do is estimate a time range for price inflation to show up, and that alone should have some important implications for investment decisions.

Why It’s Expected

The reason for expecting price inflation is the recent, rapid growth in the money supply and the deficit-driven likelihood that more such growth is coming.

As of July, the M1 money supply (currency held by the public plus checking deposits) had grown 17.5% in a year's time. That's not just unusually rapid, it's extraordinarily rapid. Since 1959, M1 has grown more rapidly in only one other 12-month period – and that was the one ending last June, when the M1 money supply jumped 18.4%. Even in the inflation-plagued 1970s, growth in M1 never exceeded 10% in any 12 months.

Dropping large chunks of newly created money into the economy leads to price inflation, because the recipients are likely to find themselves overprovisioned with cash. As they try to unload the excess, they bid up the prices of the things they buy, whether it be stocks, shoes, gasoline, silver coins, or granola. The sellers of those things then find themselves cash rich and start doing some buying of their own, and so the wave of excess money and the bidding it inspires propagate through the economy.

The process isn't instantaneous. It takes time. Just as each player in the economy has a sense of how much of his wealth he wants to hold in the form of money, everyone will move at his own speed to make adjustments when his actual cash holdings seem to be off target.

And the process can seem to stall, especially when fear is growing. When people are worried or otherwise feel a heightened sense of uncertainty, they will gladly hold on to abnormally large amounts of cash – for a while. But when fear abates, as it will when the economy begins to recover from the recession, that temporary demand for extra cash will also fade, and the hot-potato process of trying to pare down cash balances will emerge to do its inflationary work.

But when?

The speed at which the public tries to unload excess cash and the timing of the effects have actually been measured, in the work of the late Milton Friedman and his monetarist colleagues.

The method was indirect and roundabout, and so the results, unsurprisingly, were nothing as precise as nailing down the value of a physical constant.

What the monetarists (or the first of them to be equipped with computers) found was that when the growth rate of the money supply rises:

• The initial effect is on the prices of bonds and stocks, an effect that comes within a few months.

• The peak effect on the growth rate of economic activity comes about 18 to 30 months after the pick-up in the growth rate of the money supply.

• The peak effect on the rate of consumer price inflation comes about 12 to 18 months after that, which is to say it comes 30 to 48 months after the peak growth rate in the money supply.

As Friedman famously put it, the lags in the effects of changes in monetary policy are "long and variable." He might have said, "It's a big, wide blur, but we're sure we've seen it."

And even that picture exaggerates the precision that's available to us. The emergence of money substitutes, such as NOW accounts and money market funds, has added its own muddiness to the picture of how growth in the money supply translates into growth in the level of consumer prices. It is only because the recent episode of monetary expansion has been so extreme that we can look to the results just listed for an indication of what's to come.

If you apply the findings of the monetarists to the present situation, here's what you get. The peak growth rate in the money supply occurred last December, so based on the general monetarist schedule:

• Some of the effect on stocks and bonds should already have been felt.

• The peak effect on economic activity should come between the middle of 2010 and the middle of 2011.

• The peak effect on consumer price inflation should come between the middle of 2011 and the end of 2012.

A More Particular Schedule

This time around, should we expect things to move more rapidly or more slowly than average? My bet is on slow, which would push the peak inflation rate out toward the end of 2012. One reason for slow is that the government's rescue packages are delaying the process. Rescuing banks that are choking on bad loans postpones the day of reckoning for both the banks and the loan customers. It retards the pace of foreclosure sales (whether of real estate or other collateral) and puts the deleveraging that has been going on since last fall into slow motion. A wilting of the recent stock market rally would confirm this.

Investment Implications

The big plus about the Mayan calendar is that, right or wrong, it is very definite about things. Human civilization will come to an end, I'm told, on Dec. 21, 2012 – not on the 20th and not on the 22nd. There was no room for monetarists in those step-sided pyramids, but there still are few what-to-do implications from the monetarist findings.

1. When you hear would-be opinion leaders cite the current absence of rising prices at the supermarket as proof that all the new money isn't a source of inflation, don't believe them. It is much too early for the inflation bomb to be going off, even though the powder has been packed and the fuse has been lit.


2. If the large and growing federal deficits and the Federal Reserve's unprecedentedly easy policies tempt you to leverage up on inflation-sensitive assets, such as gold, give the idea a second thought. It likely will be a year or more until price inflation becomes obvious and undeniable (which is what it would take to bring the general public into the gold market). In the meantime, your inflation-sensitive assets could get paddled rudely as the deleveraging that began last year continues.

For at least the next year, the simple, fire-and-forget strategy is 50-50 gold and cash – gold for what looks to be inevitable but on its own schedule, cash to be ready for the bargains that may show up while we're waiting for the inevitable to arrive.

The editors of The Casey Report keep their ears to the ground, listening for the first rumblings of the inflation stampede coming in. But you can bet on rising inflation – and interest rates – right now and be way ahead of the investing herd. To learn more about investing in this all but inevitable trend, click here.

Does News Drive the Markets? A Closer Look at This Old Wive's Tale

With the markets at a potential inflection point (an inflection point down, in my humble opinion), I thought it'd be fun and instructive to revisit a topic we've noodled on a bit lately.

Does News Actually Drive the Financial Markets?

It's common knowledge that increasing earnings drive stock prices - with the only caveat being that there's no evidence of this being true. A couple of weeks ago, we posted a short guest article that challenged this assumption, making the case that stock prices actually drive earnings, not the other way around.

Since I'm becoming more and more sympathetic to this outlook of the markets driving the news, I thought it'd be a fun exercise to take a closer look at this hypothesis.

To be as objective as possible, I conducted a few searches using the Google News search function, so that we could count up the number of stories that contained my search phrase. First up...

Bear Market Rally

Stories about the bear market rally have tapered off - it's a new bull market!

(Source: Google News)

How ironic that the number of news stories about a "Bear Market Rally" peaked in March...the month the rally was just beginning! Being a somewhat disparaging term, I find it fitting that the use of this phrase in news headlines has dissipated as the markets have rallied.

I'd imagine the reason is this rally no longer viewed as a mere bear market rally, but a new bull market! Probably just in time for the markets to turn down once again.

The grand prize goes to the Financial Post, for their March 5th article Talk of a 'bear market rally' may be premature. It sure was - by about 24 hours!

Bond Vigilantes

Why do interest rates rise and fall? It's a complex question - one that appears to be too complex for the news headlines to adequately explain!

In June, the return of the "bond vigilantes" was a popular reason for soaring yields on long dated US government bonds. The bond markets were pissed, and ready to raise hell about soaring government deficits.

The only problem about investing based on the "news" that the bond vigilantes had returned, ready to drive up yields further, is that your timing would have been exactly wrong.

Yields topped along with this news, and both have quietly rode off into the sunset since.

2009 news about the "Bond Vigilantes" peaked in June.

(Source: Google News)

Right along with yields

(Source: Yahoo Finance)

Dollar Reserve Currency

Here's one near and dear to my heart - the overblown reporting of the dollar's reserve currency status being in imminent danger. You'll notice there was a low, steady hum of stories - up until March of this year, when the dollar topped out (for the time being).

News of the dollar's demise really picked up AFTER it started to decline.

Source: Google News

Since then, the dollar has been declining, and stories of the dollar being replaced as the world's reserve currency have been all over the financial media. My favorite was a recent story in London's Independent entitled The Demise of the Dollar, which may have coincided with a significant bottom in the dollar index, which has rallied steadily since!

Bottom line: Using the news to trade is a losing proposition...you'd be much better off using the charts to predict the news. The financial news media is a fantastic example of groupthink at it's best, or worst, depending on your perspective.

You can always count on financial news stories to break after the market has already tipped it's hand!

The Start of a Larger Decline?

Many of the technical indicators I follow appear to be signaling a shift is taking place in the markets, in which the dollar will once again reign supreme, and everything else should roll over. In other words, an instant replay of the last bit of deleveraging, though probably worse.

To get the "average investor" sentiment after Friday's big decline, I pulled up one of our favorite contrarian indicators, the Wall Street Journal, to see what they were recommending. It's said that bull markets often climb a "wall of worry", so my thinking was that if they displayed a "run for the hills" sentiment, that may indicate that this is just a correction on the way up.

Much to my delight (because I'm short the markets, as you see below), the article I pulled up from the front page expressed optimism that this pullback represents a nice buying opportunity.

Even some of the optimists think it would make sense for stocks to fall as much as 10% before they resume their gains.

The bullish tone and level of confidence being exhibited by investors is truly awe inspiring, given that most investors lost 40% of their porfolios in the previous crash. That says to me that this bear market rally has completed it's mission, and we should prepare for the next leg down.

Positions Update - Long the Buck, and Now Short the S&P

At last - a positive week for the dollar! And no coincidence that, meanwhile, stocks got slaughtered. A sign of things to come? I think so!

On Thursday, I shorted the S&P, thus far successfully. I think over the coming months, you may be able to short just about anything and do pretty well. Long the dollar, short everything else - that's my recommendation until further notice.

The dollar - gearing up for another megarally?

(Source: Barchart.com)

Open positions:

Thanks for reading!

Current Account Value: $25,969.68

Cashed out: $20,000.00
Total value: $45,969.68
Weekly return: 8.8%
2009 YTD return: -48.9%

Prior yearly returns:
2008: -8%
2007: 175%
2006: 60%
2005: 805%

Initial trading stake: $2,000.00