History Repeats: 1929 Versus 1999 - Part 3

Broad market at crossroads; do or die for Internets

The broad U.S. stock market, after experiencing a four-day corrective phase, had bounced higher as of this writing on May 26 leaving many analysts feeling assured that equities will resume their impressive upward trend. The Internet sector, meanwhile, showed signs of life as well, with some of the leading issues gaining as much as 14% in a single trading session on high volume. But it may still be too early to tell if this is a turnaround. Most of our indicators are still technically bearish and we will need to see more action before determining whether a continuation of the bullish trend is currently underway. The next couple of days will tell us much.

By all appearances—excluding today's impressive recovery—it would appear that a large-scale distribution campaign is underway throughout the broad market. Looking at the charts for the Dow Jones Industrials and the NASDAQ Composite shows what appears to be a complex "head and shoulders" pattern developing in both of them—a bearish topping formation. While it is still too early to tell, the chart and accompanying volume characteristics of each index are so far conforming to the pattern. If a turnaround has truly taken place, we will need to see a continuation of the upward trend immediately accompanied by high volume. Today was a good start. At best, it did not conform to the typical bear market rally, in which initial reactions occur on low volume. Indeed, trading volume for most participating stocks—including the Internets—was extremely high, which is a bullish sign. Still, the next two or three days will tell us all we need to know.

One technical tool that has a high rate of reliability at market turning points is the Elliott Wave Theory. When the indexes—particularly the Dow—drop sharply at a "pivot point" after experiencing a long upward movement, that is the time to begin watching carefully the charts to see if the pattern conforms to the beginnings of a bearish trend or merely a bull market correction. Under the guidelines of the Elliott Wave Theory we would expect to see this latest corrective move to unfold in three "waves," if it is nothing more than a temporary setback. However, if this is the beginning of a larger downtrend we expect to see it unfold in five waves down. Thus far, three clearly-defined waves have unfolded. We will have to await further movement before determining which of these two categories the correction falls under.

If today's rally was nothing more than a fake-out reaction then we can expect to see further declines in the days ahead punctuated by abrupt pullbacks. If prices keep moving higher toward the previous all-time high levels than our head and shoulders scenario will have been nullified.

Our leading technical indicators are in an immediate-term bearish mode. NYSE Advancing/Declining Volume indicators have begun new bearish trends recently, as have the Cumulative Volume Index (CVI) and 10-Day Momentum indicator. Breadth readings are also bearish. However, we will need to see a continuation and intensification of these trends before they cause us to become full-scale bearish.

Other technical indicators confirm the bearish trend and give some reason for concern. The OEX Put/Call Five-Day Ratio is approaching a bearish level and presently indicates investor complacency. The AAII Sentiment Ratio—a measure of market sentiment among investment advisors—is in an extremely bearish position. Mutual fund cash levels are at their lowest point of this decade—a very bearish indicator. Levels of short interest on both the NYSE and NASDAQ are at dangerously low levels. A low level of short interest means that a market decline may easily develop into panic proportions because there are few short orders supporting the market on the way down. And specialist and member short positions are currently at levels that typically precede bear markets.

One explanation that has been offered over and over for the recent bout of bearishness in the Internet sector and throughout the stock market is that investors fear the return of inflation and a possible interest rate increase. While we rarely discuss fundamentals in our market commentary, we feel a word or two about these concerns is appropriate. Inflation has become a very subjective measure over the past few years. After all, how does one really measure it with any degree of accuracy? In its strictest sense, inflation is an increase in the money supply, and we have indeed seen increases in the broad based M3 money supply in recent years. However, much if not most of this increase has been funneled into financial markets rather than consumer goods, thus offsetting the typical price increases consumers normally see in times of inflation. While M3 has been increasing, the ratio of change in the M3 money supply has been decreasing. So again, do we have inflation or don't we? Another factor to consider is that any inflationary pressure has been offset by increases in productivity as well as the abundance of cheap consumer goods imported from nations presently under economic distress. This also has the effect of offsetting inflationary pressures.

Perhaps the most persuasive argument in favor of rising inflationary pressure has been the rising trend in the crude oil market of late. Crude oil has experienced an impressive recovery in recent weeks and, while the market is correcting recent gains, it is still in the midst of a technical uptrend. As we have emphasized recently this is a commodity that must be watched very closely in the days and weeks ahead because of its sensitivity to inflationary pressures as well as escalations in military hot spots, particularly in the Middle East. Oil should also provide a good barometer for the coming Y2K problem and its risings or fallings in the months ahead will serve as a leading indicator to investor sentiment and expectations.

With regard to interest rates, we would not be at all surprised to see the Fed increase rates somewhat in their next meeting. The Fed can do nothing but follow the standard set by the 30-Year Treasury Bond, and T-bond yields are currently in an uptrend, which means interest rates most assuredly will increase. Besides, our bank sources tell us the Fed has already given them advanced notice of their plans to increase rate (the Fed must notify member banks several weeks in advance before raising or lower rates in order to provide preparation time for members to adjust their own rates accordingly). How all of this will "affect" the stock market is irrelevant. As any market technician knows, the market will factor into prices any such changes in the interest rate and inflation outlook months in advance of the actual change. Hence, we needn't worry what the Fed plans to do. The market itself will tell us in advance what the business outlook will be like for the remainder of the year. It is up to us to heed its call.