Dr Doom on stock markets, the Hindenburg Omen and what next

Marc Faber, aka Dr Doom, notes that Michael Kahn, who writes technical comments for Barron’s, recently highlighted the fact that according to the Hindenburg Omen [see explanation below], the US stock market had given several strong sell signals in July.

“Normally a single signal is not of great significance, but when several signals occur within a short period of time, the odds for a stock market crash increase”, says Faber.

As of Tuesday, July 23, the Hindenburg signal had fired at least eight times over the previous six weeks. The Hindenburg Omen is the alignment of several technical factors that measure the underlying condition of the stock market and warns of either impending market crashes or severe declines.

According to Wikipedia:

the rationale behind the indicator is that, under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows — but not both. Large new highs and large new lows simultaneously indicate a period of extreme divergence in the stock market. Such divergence is not usually conducive to future rising prices. A healthy market requires some degree of internal uniformity, whether the direction of that uniformity is up or down.

Faber stresses that “the Hindenburg Omen does not always work, but there are other factors to consider, which would argue for more market weakness ahead”.

First, it is remarkable that so close to a market high the number of 52-weeks new lows has expanded so dramatically (new lows: July 25: 412, July 26: 732, July 27: 400). Not surprisingly the percentage of shares above their 200-day moving average has dropped to below 50 per cent.

The internal conditions of the US stockmarket began to deteriorate after the February stock market high with fewer and fewer stocks trading above their 200-day moving average. Simply put, says Faber, the US stock market continued to rise into the July peak, but fewer and fewer shares were driving the advance.

Specifically, the advance after the late February/early March sell-off was driven by energy and oil servicing stocks, and companies with large overseas earnings or by companies that were taken over in financial history’s largest LBO boom.

For Faber’s taste the US stock market’s advance “was particularly suspect because of the failure of brokerage stocks to better their February highs and because of the collapse of sub-prime lenders”. Moreover, says Faber, the continuous underperformance of financial stocks was a very negative indicator, since financial stocks had led the advance which began in October 2002.

This was “a particularly negative omen for a credit-addicted economy, such as the US has become, and for the credit driven global asset bubble”, he says.

Most market observers will argue there is nothing to worry about and that we are in the midst of a sharp correction, such as we experienced in May/June 2006 or between February 22 and March 14 of this year. Since these corrections led to over-sold technical readings and were followed by higher prices, the view is, therefore, that stocks will shortly recover and make new highs.

However, that is far from certain for a variety of reasons, argues Faber. Remember, he says, how, following a period of poor performance, in 1981/82 the US stock market “took off like a rocket” in August 1982. Suddenly, the number of stocks hitting 12-month highs exploded and the market became very quickly over-bought.

So, the same way the stock market remained over-bought for a very long time in 1982/83, it could remain over-sold for a long time in 2007. But the crux of the matter is that, for stocks hitting 12-month new highs to explode on the upside in 1982, they had to have been basing for a long time while the indices were still declining, notes Faber.

But now we have the same situation in reverse.
Take as an example JPMorgan Chase (JPM). The stock formed a top between February and July 2007 and suddenly broke down over the last ten trading days. The problem, now, is that the top between February and July will act as a barrier of resistance which makes it difficult to achieve a new all-time high in the future.

A technical analyst, Peter Mauthe, recently commented that “a real correction is clearly under way. This correction should set up a great buying opportunity. Start building your buy list because the rally that erupts from the low of the next several weeks should be a very profitable one.”

Faber predicts an imminent short, sharp rebound to work off the current over-sold condition, but new highs are not very likely (certainly not in euro terms), he says.

“Moreover, what is interesting about the current sell-off is that it was not accompanied by very negative sentiment,” he says, quoting a trader on the ETF trading desk of a top tier bank saying unlike previous occasions, there is “much greater concern playing a squeeze than avoiding a train wreck”.

“Why is this going on?” asks the trader. “My hunch is that most folks are having a good year and they are playing with house money. Why not leverage up and play for a recovery, like what has always happened since 2003?”

“Seven years in the markets and three years in ETFs may not seem like a lot of experience, but it is enough to know what unalloyed speculation looks like, the trader says, warning that “we are nowhere near the end”. “This is not even the first inning, or even the national anthem. We’re across the street at Stan’s and (!) carry unwind is just beginning.”

Faber agrees with the trader. And even after a near 100-point drop in the S&P 500, he notes, “investors seem more concerned about missing the next rally than avoiding, as the trader remarked above, the train wreck.”

Another point: If one looks at the recent market action we see a sharp recovery following the March 2007 lows until the end of May. Then we have a trading range and a break out on the upside in mid-July. But it was a “false break-out move”, notes Faber, as it quickly reversed, and when this occurs “the counter-move is usually very powerful”.

False breakout moves frequently occur near market lows and market peaks, says Faber. Near market lows, the selling pressure becomes exhausted and new lows are followed by a quick reversal to the upside.

There is no doubt that from time to time stock markets will rebound sharply, he says. However, given the high probability of the US economy moving shortly into recession (if inflation was properly measured the economy would already be in stagflation) and with an increasing number of companies reporting disappointing earnings (cost pressure leading to a margin squeeze) Faber “would be inclined to reduce positions on rebounds”.

This time, he warns, the decline could be far more severe than what we saw in the second half of 2005, in May/June 2006, and in February/March of this year. Moreover, as explained above, new stock market highs are unlikely for the rest of the year. He is, however, doubtful that the “supercycle” will turn down to rock bottom. “On any further severe market weakness the Fed and the Treasury will come up with some hyper-inflating tricks.”

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