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Special Report: The QE Top

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JEFF COOPER'S MARKET ANALYSIS
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Editor's Note: The following is a free edition of Jeff Cooper's Daily Market Report. For a two-week FREE trial of his daily commentary and nightly day and swing trading picks, click here.

At the end of August 2000, I offered that the market (especially the most speculative segment of the market at that time, the NASDAQ (INDEXNASDAQ:.IXIC)) looked like it was in the most dangerous position since late August 1929.

The Dow Jones Industrial Average (INDEXDJX:.DJI), which captured the heart and soul of speculation in the Roaring 20s, topped on September 3, 1929, followed by a crash.
 
The market could be in a similar position again going into the anniversaries of the 1929 top, the August 2000 test failure of that year's March high, and the late August top in 1987.
 
All were followed by crashes. That of course doesn’t mean that this August will mark a historic top followed by a waterfall in stocks, but for some time, we have been zeroing in on the first week of August as a major turning point.

The current heart and soul of speculative sentiment, the Russell 2000 (INDEXRUSSELL:RUT), carved out a little Head & Shoulders top pattern from late July through mid-August (with a record high registered on August 5) followed by a large breakaway gap to the downside on August 15.
 

 
The break off the highs turned the important 3-Day Chart down, which defined a low coinciding with a test of the 50 DMA on August 19.
 
Subsequently, the 3-Day Chart turned back up on Thursday and is backtesting its overhead 20-day moving average as well as the August 19 gap and the Neckline of the Head & Shoulders top.
 
So, there is well-defined resistance right around these levels going into this important anniversary. The Russell has held up better than the S&P 500 (INDEXSP:.INX) and the Dow Jones, which drove below their respective May highs. Both indices knifed below their 50 DMAs while the Russell basically held its 50 and never violated its May high.
 
Daily SPX Chart from April with 50 DMA:



Daily DJIA Chart from April with 50 DMA:


 
The weeklies are pointing down on the Russell, which closed on the high of the week on Friday, August 23, so any follow-through on Monday will turn the Weekly Swing Chart back up.
 
If our early-August turning point was significant, the turn back up in the 3-Day Chart as well as the presumed turn back up on the Weekly Swing Chart should define a high soon in terms of time and price.
 
Interestingly, last week's 4-day rally seems to mirror the 4-day rally into June 18 prior to going off the cliff. Interestingly, on June 18, the market looked like it was in a strong position. The Russell actually closed at a new, all-time high on June 18.

So while the market may scored another reaction low early last week on the way to yet higher prices, if the indices can eclipse the current cluster of resistance just overhead, a failure here could indicate substantially lower prices and a possible waterfall event as a new battle over a government shut-down looms. The government fiscal battle threatens to drain already-fragile confidence out of equities concurrent with a spike in 10-year yields.
 
It is important to note that spikes in yields have occurred as a backdrop prior to cascades in equities. Such was the case in 1987, for example.
 
In addition, the market often faces tough patches in the second half following first-half stampedes when there may be a rush for the exits to preserve profits when it appears the wheels may be coming off. To be sure, the first half carved out a record stampede in which the Dow Jones failed to generate 3 consecutive lower daily lows, which has not occurred in a century.
 
A daily Dow Jones chart shows its relative weakness compared to the Russell. The Dow Jones currently shows only one higher daily high from last week's low. The S&P 500 is in a position to turn up its 3-Day Chart on a higher high on Monday.
 
Daily DJIA from June 24 with 50 DMA:



Daily SPX from June 24 with 50 DMA:


 
So, the next 1 to 5 days look crucial. If the big picture cycles here are as bearish as my work indicates is possible, this week looks the most pivotal. This week may potentially be the most dangerous in at least 4 years and may possibly be the most important since the summer of 2007 and the summer of 2000 -- not to mention the summer of 1987.
 
If the S&P 500 can recapture the 1666 square-out, which forecast the May high, and follows through above its 20-day moving average and offsets the gap from August 15, then the indication is for higher prices. The presumption would then be that the S&P 500 agenda is to satisfy a full rev of 360 degrees in price above the 2007 high of 1576. This equates to 1739.
 
Let’s take a look at the Dow Jones in 1929.
 

Click to enlarge 

Note there was a little, innocent-looking Head & Shoulders pattern that defined the high followed by a one-month shakeout into early October. Importantly, that early September to early October decline stabbed below prior swing highs of one step back but did not violate the major highs from the first half of 1929.
 
The October 4 low in ’29 was followed by a SIX-day rally with a fateful turndown on the seventh day.
 
Notably, the 6-day rally carved out a secondary and larger Head & Shoulders top.
 
The ’29 crash played out when the prior swing low on October 4, 1929 snapped in conjunction with triple tops from the first half, triggering a Rule-of-4 sell signal for the books.
 
I can’t help but wonder if a decline on the leading Russell below triple tops from May through June will not prove to be analogous in spirit, if not in amplitude, to the break by the leading Dow Jones below triple tops in the fall of 1929.
 
It is also interesting that the October 4, 1929 pivot low ties to the October 4 pre-crash pivot high in 1987. That high marked a tremendous rally in the Dow Jones, which convinced the vast majority of players at the time that another pullback low had been confirmed.
 
Long-time readers will note that the crash phase in ’29 occurred in the so-called Gann Panic Zone, 49-55 days from the September 3 peak. Ditto 1987.
 
Because of several cycles/square-outs at this year’s May 22 reversal, we were on alert for a similar pattern repeating, indicating the possibility of panicky selling into mid-July, vibrating off the mid-July primary high from July, 2007.
 
Instead, the S&P 500 stopped short shy of the 55-day Gann cycle, breaking out above a series of lower lows on July 5, followed by a run to a nominal new high on July 18 around the anniversary of the major mid-July ’07 pivot. There was scant momentum from July 18, 2013 to the August 2 high at 1709-to-1710 S&P.
 
We’ve flagged many historic cycles clustering with 1929, 1987, 2000 and 2007. There have been several intermittent tops on the advance up from the March ’09 low. The bull’s obituary has been prematurely conjectured since the 2009. Most recently, I was fortunate enough to have accurately identified the late May top. The next time frame for a top or test was due the first week of August.
 
The early August top may have just been ‘A’ top, like the May top and others throughout the advance from the ’09 low; however, it is worth considering W.D. Gann’s thinking that advances play out in 3-to-4 sections. We are in the third or fourth section up since March ’09 (depending on whether you are looking at the weeklies or monthlies), and this last section since November 2012 has gone asymptotic on the monthly chart.
 
Moreover, the S&P 500 is potentially in a third section up on a much bigger picture with the first section ending in 2000 and the second section ending in 2007. Since the first section was around 5 years long between 1995 and 2000 and the second section was around 5 years long between 2002 and 2007, with the market up 4.5 to 5 years (depending upon whether you count from the November ’08 primary/crash low or the March ’09 undercut low), risk is currently high.
 
Succinctly, the S&P 500 may be carving out a 13-year Megaphone or Broadening Top.
 
At this stage of the game, if I am correct about risk running high, the idea is not necessarily to identify the exact timing of the top, to find the next hot stock, to find the next hot money manager, or to squeeze the next 5% or even 10% out of the market (if it’s out there). The idea is to sidestep the risk.
 
In other words, we may be in the vicinity of THE top, not A top.
 
1987, 2000, 2007 were tops. They were not THE top. Of course, no one knew that at the time. They sure felt like THE top. And, many thought they were THE tops. 1929 was THE top, and the last time before that was the 1968 ‘mid-point’ top (1966 to 1973).
The interesting thing is that few market participants thought those tops were THE tops. 1929 was THE top because the recovery was so long. It took 25 years to make a new high. Investors today have become used to the idea of quick recoveries. So has the Fed, which obliges or which feels obliged to supply the ‘medicine’ to treat the symptoms (as opposed to the cause) on behalf of their constituencies -- the banks or investors.
 
It’s much more costly for players to not detect a pattern.
 
The bear doesn’t announce himself. He comes like a thief in the night.
 
“It’s much costlier for us -- as a race, to make the mistake of not seeing a leopard than having the illusion of pattern and imagining a leopard where there is none. And that error, in other words, mistaking the non-random for the random, which is what I call the ‘one-way bias.’ Now that bias works extremely well, because what’s the big deal of getting out of trouble? It’s not costing you anything. But in the modern world, it is not quite harmless. Illusions of certainty makes you think that things that haven’t exhibited risk, for example the stock market, are riskless. We have the turkey problem -- the butcher feeds the turkey for a certain number of days, and then the turkey imagines this is permanent.”
-Nassim Taleb
 
I think the risk is that the Fed has been playing butcher and that markets have become fat and happy, first at the trough of Greenspan Put and then with the Bernanke Put.
 
There have been two great crashes in one decade in the new millennium. The prevailing mentality is that the worst must be over, that things are getting better, albeit slowly. Few believed that lightning can strike twice, but it did. The Street is convinced that lightning will not strike a third time within 13 years. This is a dangerous psychological setup that has propagated performance-chasing. However, a look at history shows that markets often play out in threes.
 
Moreover, let’s take a look at this Fibonacci 13-year cycle. Going back 13 years gives the 2000 top. 13 years prior was the 1987 crash. 13 years before that was the plunge into the December ’74 bear market low. Another 13 years back ties to the 1962 panic and then 1949, the liftoff for a new secular bull market and the top in 1937.
 
13 is the seventh number in the Fibonacci series with seven often times being the number of panic and reversal.
 
Conclusion: We are in the ninth squared or eighty-first year from the 1932 low. The tumultuous, explosive 80-year cycle is due to exert its influence. The banks are as big as ever since the 2008 crisis. Ditto derivatives. How much has really changed? Has there ever been a great momentum market that has not ended badly? The blow-off into the 1929 top was around 90 degrees/days. The blow-off into the 1987 top was around 90 degrees/days. The blow-off into May was larger, being around 180 degrees/days from the November 2012 low.
This is potentially a big top that has taken time to occur. We are 90 degrees square the May top. 30 days from the May top was a low. Another 30 days was a minor pivot high, and we are in the third cycle of 30 days from the May 22 peak. It will be interesting to see if this marks an important pivot.
 
That said an authoritative decline occurred from our first week of the August turning point, and this first rebound attempt must be carefully observed because of the cycles at play:

1) The 1709-1710 high vibrates off September 3, the high in 1929.
 
2) The 381 closing Dow Jones high in 1929 vibrates off August 8, our idealized turning point day.
 
The stock market is always in the process of going from one extreme to the other over long periods. In order for that to happen, investor psychology must underpin and drive the market in an extreme for some time. Consequently, at an extreme high, complacency is thick friends with risk. Crashes are not derived from too much bullishness but from too much complacency. The most serious bear markets enter like a thief in the night at times of euphoria, when it appears that nothing can go wrong and things couldn’t look better or when it appears that things are getting better. 2000 was the euphoria top. 2007 was things are getting better top. Is this the QE Top?
 
Last week, I received the following from friend Kristian Kerr of DailyFX:
 
The Minsky Moment
 
We wrote this piece to show that market instruments and movements are not isolated. Global central bank policies are distorting the natural order of the markets, and in their quest to stave off the pain of the last crisis, they have planted the seeds for the next one. Should investors begin to worry about credit, the stage will be set for a traditional “balance of repayments” crisis in the emerging markets as capital flees, which will in turn lead to a crisis in confidence in the developed world. Of course, with equity markets near all-time highs, volatility at multi-year lows, and central banks seemingly in total control, it is difficult to envision such a scenario. However, we remind readers of the great twentieth century economist Hyman Minsky who perhaps said it best, ‘stability begets instability’. With central bank policies seemingly beginning to gain traction, focus in naturally shifting to determining when policy will recert to normal and rates will begin to rise. Throughout economic history, this has been a common trigger for debt crisis as the rise in rates, whether real or perceived, leads to a slump in asset prices which triggers solvency fears in the financial sector which in turn creates a lack of confidence in industry and other parts of the broader economy. In other words, it forces us to look behind the curtain, and when we do, most times we don’t like what we find which prompts a forced liquidation of assets.
 
Putting It All Together: The Currency Lynchpin
 
A forced liquidation of assets in the wake of a confidence crisis would obviously have dramatic impact on all the markets we have mentioned in addition to a multitude of others. We have shown that capital concentrations tend to build slowly but unwind swiftly. As such, it is not beyond the realm of possibility that all gains seen over the past 4 years in the bond and stock markets could be unwound in a very short period of time. Going back to the idea of the web of capital, the lynchpin looks to be the currency markets and specifically the US Dollar. With the Federal Reserve immersed in agressive balance sheet expansion through the use of quantitative easing, the greenback has become a form of funding especially within the emerging markets through various official and unofficial pegs. At the behest of the Fed through its forward guidance, investors have borrowed these cheap dollar assets to invest in higher yielding non-dollar ones. Looking at the difference between the growth in FX reserves and cumulative current account surpluses we can estimate the rough size of the short USD carry trade. According to the most recent data it is at least around $2 trillion based on this metric! The whole trade, however, is built on the notion that the Fed and other central banks will continue with this policy into perpetuity. For this reason, even the slightest realistic hint that the Federal Reserve is set to move away from ZIRP has the potential to unravel the whole thing. All those who have borrowed dollar assets will be forced to buy back their dollars forcing the currency higher -- some 2 trillion USD worth! This de facto policy tightening would have grave and dramatic knock on effects for emerging and developed markets alike. Pay close attention to the dollar. Prolonged strength in the currency could be the unexpected tail that prompts the beginning of the end in the latest central bank induced asset bubble.

 
Strategy: Remember that the Gann panic Zone presumes a pattern of lower highs if it is going to play out into the 55-to-56-day climax.
 
If the first week of August turning point marked a high prior to panicky selling and the second Gann panic mouse is setting up so to speak, then that points to the period from September 11 to 25 as being vulnerable, assuming lower highs play out during the time frame between here and there.

Editor's Note: This is a free edition of Jeff Cooper's Daily Market Report. For a two-week FREE trial of his daily commentary and nightly day and swing trading picks, click here.

POSITION:  No positions in stocks mentioned.

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