How Close is an Equity Market Crash?

A fatal flaw in "specialist education" is that it provides one with canned answers in search of recognisable questions. Economists thus tend to think in economic terms, Accountants in accounting terms, and so on. To solve problems of great magnitude, it is necessary to think "holistically". As an example, it is an exceptionally difficult concept for an Economist to grasp that the Kondrat'eff wave - which purports to measure economic activity - is much more meaningful when thought of in terms of measuring the bio-rhythm of Society as a whole.

"Society", in turn, can be thought of as a single macro-organism. This statement can be more clearly understood if one pictures a shoal of fish swimming in one direction, and then suddenly, instantaneously - as if a single organism - it changes direction. How could the individual fish at the back of the shoal possibly know when to turn if it did not form part of a greater whole? Clearly, the whole is something other than merely the sum of its individual parts. It has a discrete identity.

I have learned over a career of 35 years that "outside the box" ideas are typically ignored when there is stability in the environment. Most people comfortably accept the status quo on the rationale that "if it ain't broke, don't fix it"

Not to beat around the bush (no pun intended), IT SEEMS TO ME THAT THE US EQUITY MARKETS MAY BE CLOSE TO BREAKING DOWN, THAT THE US PRESIDENT APPEARS HELL-BENT ON TAKING THE WORLD INTO A WAR, AND THAT THESE TWO PHENOMENA ARE PROBABLY RELATED.

It is therefore appropriate to begin thinking "outside the box" about how to fix the economy, so as to minimise the equity market crash and avoid a war which has the potential to escalate into a world-wide conflict between Islam and Judeo/Christians.

Just how close are we to an equity market crash?

The two weekly charts below (reproduced from StockCharts.com) seem to be telling us that a rally might be possible in the near term.

It is clear from these charts that the S&P500 has been weaker than the Dow Jones Industrial Average, and that following September 11th, Institutional Investors exited the broader market in favour of the Blue Chips. Note how the On Balance Volume Chart of the DJIA rose to a new high even as the OBV chart for the S&P continued in its bear trend.

Notwithstanding this, whilst the recent July lows in price took both OBV charts to new lows, the OBV charts are currently showing strength relative to the price charts in both instances and, in both instances, the MACD's seem to be oversold.

These two observations lead me to conclude that we "might" experience a rally of some limited scope.

But there are two technical issues which need some further comment:

• On a Point and Figure chart count, a target of around 7000 on the DJIA is anticipated. This, in turn, implies that the recent July lows (and the September 11th 2001 lows) will likely be taken out. In turn, this will have serious implications!
• The OBV of the DJIA shows a broadening formation - which is sign of a market that has lost its underlying rationality.

In a market that is acting irrationally, a time is very likely to arrive when emotion takes over - ie, a "panic" is quite possible; bordering on probable if circumstances warrant.

What could those circumstances be? From where I sit, a break below the September 11th (and recent) lows of the DJIA will act like a "brick in the face" to wavering investors who will come to understand that the talking heads and unscrupulous brokers have been talking to their books. A break below these levels (which were previously justified as having been artificially generated by the attack on the Twin Towers) will cause investors to focus on the fact that the Twin Towers attack was merely a red herring (in market terms) and that we had actually entered a Primary Bear Market long before that event occurred. At the point in time when that understanding dawns, volume selling will kick in, and a strong crack will likely manifest.

How far down will the market fall?

Using simplistic technical methods - by reference to the monthly chart of the S&P 500 - the "minimum" move of the S&P500 will take it to around the 500 mark (or around 40% below the current level). However, from a fundamental perspective, such a move will only take the P/E ratios down to around 20X (based on information published on decisionpoint.com) . What seems more probable is that (provided earnings remain intact) P/E ratios will overshoot the norm and land up at around 10X - which implies a destination on the S&P 500 chart - of around 250. (70% below current levels, BUT ASSUMING NO CHANGE IN UNDERLYING EARNINGS)

Ultimately, the reason we may be heading for a "panic" style crash is that the destination of 250 (although not rational) will start to look possible from the perspective of an investor who now understands that we are indeed (and have been for some time) in a Primary Bear Market; and he will want to sell out "ASAP".

So the $64,000 question is: If the market looks like it "may" rally from here, when could the breakdown occur?

There was some very interesting work done by Martin A. Armstrong and published under the banner of the Princeton Institute on September 26th 1999. Using cyclical analysis which he discovered was "driven" by a ratio of Pi (22/7) Armstrong forecast a market "bottom" to manifest on November 8th 2002, and that the ultimate bear market "bottom" would finally manifest on June 18th 2011.

At this point, many eyes will have started to glaze. "The guy's a fruitcake. He is attempting to pinpoint stock market crashes to the day, 9 years in advance. It's ridiculous". To these people I reply: "Relax. Have some patience. I am demarcating the boundaries of a conceptual scenario".

First, let us go back to the "target" of 250 on the S&P, and we can quickly dismiss that. Earnings will not remain constant or even shrink over the long term. They will grow. The only question is: "By how much?"

If we proceed from the base assumption that earnings continue to compound at around 12% p.a. from current levels for the next 10 years, and we also assume that during that time Price/Earnings ratios slowly deflate from their current level of 32.3X to a more reasonable level of 10X, this is what could to happen to the S&P500 (column 5):

Now let's do the same exercise but assume compound e.p.s. growth of only 5% p.a.

From Table 1 above it is clear that if earnings could grow at 12% p.a., the equity markets would experience only one sharp correction; and then share prices would start to rise from that point even as P/E ratios continued to shrink. i.e. Armstrong would be wrong.

On the other hand, for Armstrong to be right, then an implication (as can be seen from Table 2 above) is that underlying earnings will grow at less than 6% p.a. before equity prices finally bottom out in 2011 and then start to rise again.

BUT IN EITHER CASE, WE CAN EXPECT A FALL OF AROUND 35% IN THE S&P IF P/E RATIOS WERE TO ADJUST DOWNWARDS TO 20X AT ANY TIME WITHIN THE NEXT YEAR. i.e. The fundamentals corroborate what the simplistic technicals are telling us - even assuming future earnings growth at 12% p.a., compound.

I have chosen this line of reasoning to demonstrate that the "real" underlying issue -implicit from Armstrong's work - is there is a risk that earnings growth rate for the foreseeable future is likely to be closer to 5% p.a. compound than 12% p.a. compound.

This conclusion is further corroborated by the Kondrat'eff related issue that - in the absence of a ratification by the USA Government of the Kyoto protocols - there is unlikely in the foreseeable future to be a market related "engine" sufficiently powerful to drive the world economy.

It follows that - in the absence of a ratification by the USA Government of the Kyoto protocols - there is almost certainly going to emerge a War of global proportions as the world's economies start to implode from the weight of the debt levels that are going to give rise to deflationary forces.

BUT THERE IS STILL HOPE - FLOWING FROM THE FACT THAT THE CHARTS ABOVE SHOW THE POSSIBILITY OF A RALLY OVER THE NEXT COUPLE OF WEEKS.

If, in the next couple of weeks, George W Bush moves to ratify the Kyoto protocols instead of declaring war on Iraq, then the probability of a stock market crash would be reduced (an optimist would argue that a crash could even be avoided, but it draws a long bow to argue in this way)

Why? Because a ratification of the protocols would "force" the industrial markets to change direction, away from Internal Combustion Engines towards Fuel Cell powered vehicles and all that this implies. Because it would "force" the industrial markets to move to replace copper electric cables with High Temperature Superconductor cables and all that this would imply. These two technologies hold the potential, by themselves, to drive the next up-leg of the Kondrat'eff wave (and incidentally reduce the CO2 emissions - over time - by as much as 50% - 60%).

So George W. Bush is faced with a choice:

• Declare war on Iraq - which will probably cause the Gold Price to break through the $335 barrier and scream upwards which, in turn will likely be accompanied by a stock market crash, and an escalation of conflict on a global scale.
• Ratify the Kyoto Protocols - which would likely lead the markets to the recognition that the nature of "The Game" has changed, and that there may be a chance of stronger economic growth than now seems likely.

In either case, we can probably anticipate a fall in the US equity markets - before the end of 2002 - of at least 40%. But under scenario 1 above the fall might even be greater than 40% unless the US Government moved to "suspend" stock market trading - a truly frightening prospect.

The fact is that our elected leaders have been behaving in a reprehensible manner for generations, and the chickens seem likely to come home to roost unless George W Bush starts to behave with a bit less indignation.

The time has come when politicians (both Republican and Democrat) must finally wake up and recognise that the needs of the community as a whole outweigh the vested interests of the Elite, which is merely a subset of the whole macro organism.

George, you can go down in history as a hero or a villain. Choose wisely!!