A Summer "Crash" Scenario

Despite the recent weakness, the broad market has displayed a fair amount of resilience in the face of rising interest rates and falling commodity prices.  The charts even leave us with some hope that there will be one more rally to new highs in the coming weeks.  But a growing list of problems also suggests the market could be setting up for a repeat of the 1998 mini-crash later this summer.

There are several parallels between now and the spring and summer of 1998 which led to the July-October decline.  The year 1998 was an exceptionally strong one for U.S. equities for the first half of the year; that year also witnessed a strengthening domestic economy.  Like this year, however, 1998 saw trouble begin overseas with global weakness reflected by falling commodity prices. 

Another point of concern for the market this summer is the global financial sector.  While U.S. banks are doing well due to improving balance sheets, foreign banks are lagging.  The comparison between the SPDR International Financial Sector ETF (IPF, black line) and the Philly Bank Index (BKX, yellow line) illustrates this point.  

As go the banks, so goes the broad market is the old saying.  This applies to foreign banks as well, for as we’ve experienced many times in the past, weakness in foreign markets sooner or later always spills over into U.S. equities, a’ la 1998.

The U.S. stock market sell-off of ’98 was also preceded by late spring weakness in the Chinese stock market.  In June the Shanghai Composite Index topped out several weeks ahead of the Dow Jones Industrial Average and began a decline which continued until August.  China’s stock market bottomed several weeks before the U.S. indices, once again affirming the leading indicator relationship that has typically existed between U.S. and Chinese equities. 

This time around the China ETF (FXI) is showing exceptional weakness versus the Dow and S&P 500 indices.  FXI has established a series of lower highs against the higher highs in the Dow and S&P.  This could be warning of another coming period of weakness ahead later this summer.

Commodity price weakness was another thing that led to the late summer sell-off in 1998.  Several major commodities, including oil and gold, were in declining heading into the summer of ’98 and the decline in commodities can’t be overestimated.  Falling commodities prices are a sign of deflationary pressures, which in this case are being brought on by the 120-year cycle being in its final descending stage into 2014. 

Low gold prices in particular are a sign that the market doesn’t have any inflation expectations for the economy in the foreseeable future.  Moreover, with a highly touted housing market recovery underway it’s unusual to see lumber prices showing this much weakness (see chart below).

 
Copper prices are another important barometer of global economic health and right now copper is hovering near a two-year low.
 

In the 2013 forecast edition of the report published in early January we examined the Kress cycle “echoes” for this year.  We specifically looked at the 6-year, 10-year, 30-year and 60-year patterns for stock prices for clues as to what the coming year might unfold.  In each of the aforementioned “echo” years – 2007, 2003, 1983 and 1953 – stocks experienced a rocky period in the June-August period, with July and August being especially rough.  This suggests that the coming July-August period could also be a rough one.

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Clif Droke is the editor of Gold & Silver Stock Report, published each Tuesday and Thursday.  He is also the author of numerous books, including most recently, “2014: America’s Date With Destiny.” For more information visit www.clifdroke.com