Monthly Market Analytics & Technical Analysis

October 2011 Edition - Euro Experiment: The Results Are In.

Gordon T Long 10/5/2011

1 October 2011 Edition
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Monthly Market Analytics & Technical Analysis
OCTOBER 2011 EDITION
MONTHLY MARKET UPDATE: PLAN IV

MARKET ANALYTICS .................................................................................... 4
HIGHLIGHTS - WHAT YOU NEED TO KNOW ........................................................................................................................................... 5 CURRENT MACRO EXPECTATIONS ................................................................................................................................................. 6 Long Term Linear Regressions and Boundary Conditions ................................................................................. 7 Head & Shoulders ............................................................................................................................... 10 Yen Carry Trade Unwind ....................................................................................................................... 12 Rolling and Cascading Global Markets ...................................................................................................... 13 Confirmed Death Crosses (Reference) ...................................................................................................... 21 OUR APPROACH ................................................................................................................................................................................26 Identification of Major Pivots .................................................................................................................. 26 Global Macro Driver - Our Proprietary Techno-Fundamental Bridge ................................................................... 27 SHORT TERM – TECHNICAL ANALYSIS ................................................................................................................................................30 Gann Analysis ................................................................................................................................... 30 Elliott Wave....................................................................................................................................... 31 Channels ......................................................................................................................................... 32 Sentiment - Consumer, Investor & Trader .................................................................................................. 33 CONSUMERS Consumer Confidence - Conference Board ........................................................................................... 33 Consumer Sentiment - Michigan ........................................................................................................ 36 INVESTORS Investors Intelligence ..................................................................................................................... 37 American Association of Independent Investors ..................................................................................... 38 National Association of Active Investment Managers (NAAIM) .................................................................... 39 Small Business Optimism ................................................................................................................ 40 TRADERS Smart Money / Dumb Money Confidence ............................................................................................. 41 Percentage Stocks Above 50 & 200 DMA ............................................................................................. 42 Margin Levels .............................................................................................................................. 43 Mutual Fund Cash Levels v S&P 500 .................................................................................................. 46 Oscillators & Breadth Indicators of Importance............................................................................................. 47 NYSE Overbought / Oversold ............................................................................................................. 47 OEX Open Interest (Puts/Calls) .......................................................................................................... 48 TRIN........................................................................................................................................... 49 McClellan Oscillator ........................................................................................................................ 50 INTERMEDIATE TERM – RISK ANALYSIS............................................................................................................................................51 RISK SUMMARY- Aggregated Average..................................................................................................... 51 Global Macro Risk - Risk Items ............................................................................................................... 52 Banking Risk - Libor-OIS Spread (Updated) ............................................................................................ 52 Credit Risk - Global Credit Default Spreads (Updated) .............................................................................. 52 Credit Risk - EU Credit Default Swaps (Updated) .................................................................................... 53 Consumer Risk - Housing - Rate of Change (Reference) ............................................................................ 54 Economic Risk - ECRI Leading Index (Updated) ...................................................................................... 56 Economic Risk - US Economic Surprise Index (Updated)............................................................................ 57 Inflation Risk - Money Supply Growth - M3 (Updated) ................................................................................ 58 Inflation Risk - Money Velocity (Updated) ............................................................................................... 58 Monetary Risk - Bank Liabilities (Updated) ............................................................................................. 59 Cost of Money Risk - Interest Rates (Updated)....................................................................................... 60

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Volatility Risk: VIX / VXO Warnings (New) .............................................................................................. 61 The Longer this Goes - the Greater the Risk - the Poorer the Risk:Reward .......................................................... 65 Consecutive Days Without a Bollinger Cross........................................................................................... 65 50 DMA Boundary Condition Near Failure .............................................................................................. 67 Market Warning Telltales - 'Canaries in the Coal Mine' ................................................................................... 69 The Market Breaks Its Neck ............................................................................................................... 69 Five Months Down For Stocks: Time For A Bounce? ................................................................................. 71 Mutual Fund Outflows Surge As NYSE Short Interest Back To March 2009 Levels ............................................. 73 World Markets Review: The End Of A Bad 3rd Quarter .............................................................................. 75 Tired of Ups and Downs, Investors Say, 'Let Me Out!' ................................................................................ 77 Comparing The 2007 Topping Pattern To Now (Reference) ......................................................................... 79 New Stock Bear? (Reference) ............................................................................................................ 81 LONGER TERM - FUNDAMENTAL ANALYSIS.........................................................................................................................................82 Highlights ......................................................................................................................................... 82 Shifting Secular Sands - Emerging Impediments to Global Earnings Growth Rates ................................................. 85 Cost Push now Creating Margin Compression! ............................................................................................ 87 Margin Compression versus PE Compression ......................................................................................... 88 S&P 500 PE Ratios ......................................................................................................................... 89 Big companies' P-E's shrivel to single digits ............................................................................................ 90 Reduced Earnings Growth Rates - Need to be Watched Carefully .................................................................... 91 The Charts Wall Street Doesn't Want You To See On Annual Returns ............................................................ 91 Some Sobering Japanese Comparison Charts from Michael Darda at MKM Partners .......................................... 96 Are Corporate Profit Margins About To Grind Lower For Another 10 Years? (Reference) ..................................... 99 Corporations Have Captured 88% Of All Post-Recession Income Growth (Reference)........................................100 Think Stocks Are Cheap? Here's 7 Reasons Why That's A Myth (Reference) ..................................................101 Valuation Methodologies ......................................................................................................................102 Four Set Consolidated Market Valuation Indicators Continue to Signal Caution ................................................102 Crestmont from the Arithmetic ...........................................................................................................104 Cyclical PE 10 Ratio .......................................................................................................................106 Q Ratio.......................................................................................................................................110 S&P Composite Regression-to-the-Trend .............................................................................................114 Rule of 20 (Reference) ....................................................................................................................115 Cyclically Adjusted PE's (CAPE) are Richly Valued (Reference) ..................................................................116 Value Line Arithmetic (Reference) ......................................................................................................117 Shiller PE Ratio(Reference) ..............................................................................................................117 Comments on Estimated Forward Operating Earnings (Reference) ..............................................................118 S&P Earnings Yield versus Bond Yields ...................................................................................................119

S&P 500 TARGETS ..................................................................................... 120
Time Frame .....................................................................................................................................120

NOMINAL V REAL MARKETS ................................................................... 123
REAL MARKETS ............................................................................................................................................................................... 123 COMMODITY CORNER ..................................................................................................................................................................... 125 GOLD ............................................................................................................................................125 SILVER ..........................................................................................................................................126 CURRENCY CORNER ....................................................................................................................................................................... 127 US DOLLAR INDEX ...........................................................................................................................127 US TREASURY MARKET ....................................................................................................................128

CONCLUSION .............................................................................................. 130
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MONTHLY PROCESS OF ABSTRACTION
The Monthly Market Analytics & Technical Analysis Report is an integral part of our monthly Process of Abstraction research methodology. The process starts monthly from the Tipping Points and completes with a final Synthesis. The sequence is optimized to align with the established Macro Economic Data releases.

Plan
III.

Release Date
3rd Saturday of the Month

Service
Global Macro Tipping Points (GMTP)

Focus

Coverage

Tipping Points Abstraction Abstraction IV. 1st Day of the Month Market Analytics & Technical Analysis (MTA) Technical Analysis Market Analytics Market Analytics II. Day Following Monthly Labor Report (~ 1st Saturday) Monthly Market Commentary (MMC) Synthesis Thesis

Tipping Points Global Macro US Economy

Technical Analysis Fundamental Analysis Risk Analysis

Commentary Conclusions

4 October 2011 Edition
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MARKET ANALYTICS HIGHLIGHTS - What You Need to Know

The market action since March 2009 is a bear market counter rally that has completed the classic ending 5 Wave 3-3-3-3-3 diagonal pattern we have been predicting since March 2009. The Bear Market, which started in 2000, will resume in full force once a broad 'rounded top' formation is completed with cascading weakness across multiple markets presently being clearly evident. The rounded top formation is not yet completed. We are now in the midst of a Global 'rolling top'. We are seeing broad based weakening analytics and cascading warning signals. This behavior is typically seen near major reversals. It is all part of a final topping formation and a long term right shoulder technical construction pattern. I expect the rounded top to be shown to have been centered on the markets June 17th Quadruple Witch. It will take a further 1-2 months to complete. Rounded Top patterns are extremely difficult to trade as trading reversals are significant and frequent with high volatility. This adds to the confusion about market direction. The market behavior should be viewed as the market forces being in the process of systemically changing balance. It is very typical of major reversals. They are protracted affairs. Highlighted examples of continuing weakening analytics and warning signals are as follows: CONSUMERS -Consumer and small business sentiment remains at levels associated with other recent recessions. The trend in sentiment since the Financial Crisis lows has been one of slow improvement. The recent final numbers from the Michigan survey are consistent with deep recessions. - The University of Michigan Consumer Sentiment Index has plunged from 77.5 in February to 59.4 in September. There was a similar large drop in August 1990, another in September 2001, and a third one in October 2008. All three were associated with recessions and turned out to be big sell signals for the stock market.

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- The Consumer Confidence numbers after totally collapsing in August and falling to 44.5, were basically flat in September at 45.4. The Present Situation however fell to 32.5 from 34.3. Twice as many respondents thought that business conditions would worsen as improve. - What continues to stand out to me is that against comparable prints taken at financial crises and tragedies of the past, such as the October 1987 market crash, Desert Storm, LTCM, the dot com collapse, September 11, Katrina, and Lehman, they are substantially WORSE and getting worse fast! INVESTORS - The NFIB Small Business Optimism Index stands at 88.1, well below 100 and continues to deteriorate. - The National Association of Active Investment Managers (NAAIM) shows that on average they are extremely bearish at 22.19%, having plummeted from last quarter's average of 66.99%. - The American Association of Independent Investors shows that we now have more Bears than Bulls. This is what we would expect as the Secular Market resumes. However we are reaching levels which often initiate counter rallies. - The National Association of Active Investment Managers (NAAIM) shows that on average they are extremely bearish at 4.18%, having plummeted from last quarter's average of 66.99%. - The Smart Money is now beginning to buy while the Emotional money is now selling. Significantly, for the first time since the fall of 2009 the Smart Money Index broke above its 200 DMA. -With approximately 10% of the S&P 500 above their 200 DMA we have an over-sold market. With only 10% of the S&P 500 above their 50 DMA we have a moderately over-sold market which is nearing support levels. The market is now looking for a support base to launch a short term relief rally. -Markets can and often fall the greatest during periods considered as being oversold. The sell-off from overbought levels was not unexpected. A bounce from the current oversold levels, likewise should not be unexpected. Look for divergence to occur between falling prices and a higher oversold low. This should indicate a short to intermediate, tradable low is in. -The McClellan Oscillator has dropped significantly and is now looking for support. Markets can fall further looking for support, however the 21 Day suggests it is near at hand since it seldom reaches this low a level. - The Surprise Index measures the divergence between actual data and economists' forecasts, and is therefore another form of sentiment or expectations index. Economists are at a near record divergence against the reality of the data, and net bullish market sentiment is also at a near record divergence to how the data is coming out versus expectations. This is highly unusual and should be considered a market warning. CURRENT MACRO EXPECTATIONS

OUR CURRENT MACRO EXPECTATIONS FOR FINANCIAL EQUITY MARKETS The following schematic best represents the US S&P 500 Stock Index

We still consider ourselves to be WITHIN the Rounded "M" Top. We will need to put in the right side 'external strength' of the "M" pattern later this fall. HOWEVER, the bottom of the "V" is not yet in - Early fall will be scary!

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Long Term Linear Regressions and Boundary Conditions
Long time observers of the markets know that markets tend to always migrate to the mean. The question is therefore what mean are we talking about? The following chart examines the key regressions presently in place at higher "degrees". It is important to examine these regressions because many algorithm driven trading systems have some element of this statistical analytic within their constructs. 'En Mass' they therefore act a mysterious magnets within the financial markets. KEY REGRESSIONS 1. 2. 3. Regression starting since the era of 'irrational exuberance' began in 1995, Regression starting since the dot.com bubble high correction in 2000, Regression starting since the pre-financial crisis high in 2007

The three regressions show a convergence at the present time. LONG TERM OSCILLATOR We have overlaid a 160 Weekly Moving Average on the three regressions. Most algorithm driven analysis uses 20, 40 and 80 WMA for shorter to intermediate views of the market. We have circled the intersection of the above with a red circle and the current trading price for the S&P 500.

7 October 2011 Edition
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CONTROLLING BANDS We have next placed Bomar Bands which were fitted using an 80 WMA and 2 Standard Deviations. We can see that they have a strong control over the present extremes of the market. Bollinger Bands have proven that there is a high probability that once the 80 WMA is broached that the markets will weaken or strengthen until the other band is reached and a 'cross over' is achieved. We appear to be presently engaged in such a market movement and can expect the market to want to minimally 'touch' the lower band presently at 1025 on the S&P 500 and rising.

Gann construction lines have been placed on the chart (red ellipse) suggesting a tentative Elliott wave count into 2012 and 2013. Indications are strong that 2012 and 2013 will be poor years for the US equity markets.

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BOUNDARY CONDITIONS The following chart drills down to reflect the market pattern in the S&P 500 since the pre-financial crisis high in 2007. We have used a 400 Day Moving Average with 2, 3 and 4 standard deviations drawn in. The analysis indicates that 4 standard deviations has acted as a boundary condition throughout the turmoil since 2007.

The market is presently attempting to find intermediate support at the 3 standard deviation boundary condition. We have drawn in a regression channel since the March 2009 market low which is also acting as support. One final move lower in the market in October 2011 is a strong possibility before we see an Intermediate Low. The 4 Standard Deviation Boundary Condition currently reflects 1025 on the S&P 500.

9 October 2011 Edition
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Head & Shoulders
We have a very strong indication that we have a classic "Head and Shoulders" pattern in the US equity market when viewed over the last 15 years. The S&P 500 pattern is very suggestive that we have a major long term high in the equity markets.

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If we examine the right shoulder of the above pattern we see 'fractals' of this pattern with smaller degree "Head and Shoulders" present.

If these pattern are valid any Intermediate rally will be short lived and 2012 and 2013 will be a continuation of the secular bear market which we believe we have been in experiencing since December 1999 when measured in 'real' terms versus nominal terms. Though the Head and Shoulders pattern gives very reliable target projections (measured from the head to the neckline) it is too early to reliably use them. We look for a confirmation of the validity of the pattern. This will come with the size and speed of the coming 'counter rally' which will be part of what we outline in this document as a 'rounded top'.

11 October 2011 Edition
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Yen Carry Trade Unwind
For over 20 years the YEN Carry Trade has fueled Global Credit Market expansion. This Carry Trade is now being forced to unwind which is draining the world of this 'liquidity' stimulus.

• •

The strengthening of the YEN (weakening US Dollar) has been a surprisingly orderly affair as the chart above shows What we are seeing is the value of YEN assets held as US Treasuries slowly being translated from value in US Dollar assets to a higher YEN value. The result is weakened returns on the Yen Carry Trade which forces the unwinding of positions. This effectively is working as a liquidity drain on Global Markets. The unwind of the Carry is being accelerated by the pressures on the YEN:EURO cross. Further weakening in the Euro versus the YEN will force further unwinding and the associated global squeeze in liquidity. Watch the YEN:EURO cross closely.

12 October 2011 Edition
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Rolling and Cascading Global Markets
A PERSPECTIVE ON A ROLLING OR CASCADING TOP

What we are watching for:

We are looking for Death Crosses of the 50 DMA crossing the 200 DMA

Summary To-Date: November - Starts in Asia January – Top in ‗City‘s‘ FTSE February – US 10 Year Treasuries Weaken February – Banking Stocks Start Falling Late February – Technology Begins Weakening Early March – Japan‘s Natural Disaster Early April – Commodities Countries Weaken – Canada, Brazil Early May – Commodities Top Early May – US Markets Show First Signs of Weakness Mid May – Weakening Agricultural Stocks Early July - Transport begin to Plummet Early July - Retailers Plummet Late July - Nasdaq Plummets Late July - S&P 500 Large Caps Plummet

Early Sept - Gold puts in a top - - NO DEATH CROSS but a flattening 50 DMA

SEE FOLLOWING CHARTS:

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IT STARTED IN ASIA - November 2010

TOP IN LONDON'S FTSE - Early January 2011

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US TREASURIES START FALLING - February 2011

Note the 50 DMA cross of the 200 DMA - Further Treasury Weakness Ahead with Rising Yield BANKING STOCKS BEGAN THEIR DROP WITH WEAKENING us TREASURIES

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TECHNOLOGY STOCKS BEGIN WEAKENING

JAPAN'S NATURAL DISASTER HITS - Early March

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MAJOR COMMODITY COUNTRIES STARTEN TO WEAKEN - Canada & Brazil

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COMMODITIES TOP - Early May

US MARKETS SHOW FIRST SIGN OF WEAKNESS - Early May

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TRANSPORTS BEGIN TO WEAKEN - Early July

RETAILERS PLUMMET - Early July

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NASDAQ PLUMMETS - Late July

S&P 500 LARGE CAPS PLUMMET - Late July

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Confirmed Death Crosses (Reference)

A BRIEF EXAMINATION OF CONFIRMED DEATH CROSSES When 50 DMA CROSSES 200DDMA it is a Confirmation of a Trend Reversal
It is one thing for the markets to start to exhibiting an initial new pattern of lower lows and lower highs which usually suggests a downward trend channel. It is another for the 50 Day Moving Average to cross through and below the 200 Day Moving Average. When this occurs it is referred to as a "DEATH CROSS'. It is a fairly reliable confirmation that an intermediate term downward trend has been established and is in place. Markets and Traders react badly to such a Technical signal. Let's examine the markets to see what we find.

We will start with Japan and the Earthquake, Tsunami and Nuclear Disaster that occurred. It is evident from the above chart when this event occurred and the initial impact it had on Japanese stocks. Though the Japanese market has bounced from its initial lows it established a DEATH CROSS.

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Coincident with this event we see above that US Treasuries reacted and started a downward trend.

Bank stocks began seriously eroding in value.

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Financials overall began eroding as did the funding situation in Europe. Is there a Yen Carry Trade problem at work here? Commodities were impacted as we see here with cooper - a strong indicator of industrial activity.

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Commodity countries began feeling the pain. Semiconductor stocks soon began feeling the pain.

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China began feeling the pain.

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OUR APPROACH We take a completely different approach to Techno-Fundamental Analysis. It is best summarized as follows: TIME FRAME Short Term DURATION Less than 90 Days APPROACH Technical Analysis KEY TOOLS Elliott Wave Principle, WD Gann, JD Hurst, Bradley Model, Proprietary Mandelbrot Fractal Generator Global Macro Analysis Tipping Points - Pivots Financial Metrics

Intermediate Longer Term

12 Months 18 Months +

Risk Analysis Fundamental Analysis

The Global Macro Analysis, which is so prevalent in our articles and on our Tipping Points site, plays the critical role of bridging our highly analytic Technical Analysis with our detailed Fundamental Analysis. We have found that in the short term the markets are driven by emotion and sentiment. In the longer term, they are driven by financial fundamentals. As Warren Buffett is often quoted as saying: ―In the short term the market is a slot machine but in the long term it is a weighing machine.‖ We have found that the transition shows a lagging correlation between changes in the Global Macro, followed by Corporate Earnings, then followed by the sell side analyst community estimates. Our focus within the Global Macro is: i) Quantification of Risk

ii) Establishment of pivots through the mapping of Tipping Points iii) Identification of ever shifting competitive financial drivers to corporate profitability

Identification of Major Pivots
As we show above it is our RISK Analysis that connects the transition from TECHNICAL ANALYSIS to FUNDAMENTAL ANALYSIS. Usually this occurs over a protracted period of time with a Regression-to-the-Mean occurring within a 12 month window. At major reversal points this transition is often seen to be shorter abrupt and comes as a surprise. Normally ongoing bad news becomes so accepted, as though it doesn't really matter, then suddenly it does. Similar to living in a high crime rate neighborhood where there is a 90% chance of being 'mugged' if you go for a walk. If you go out night after night for a walk and nothing occurs, you logically start to feel safe. The fact is however that you are actually statistically becoming less safe. Our experiences are misaligned with the probabilities of the natural outcome. In the financial markets when over extended period occurs, it is normally the larger Debt and Currency markets that trigger the adjustment in the Equity markets. Because these two markets are so much larger than the equity markets, and the equity markets are often over extended, the adjustments can be violent. Life time memories of their adjustment havoc are the outcome.

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Global Macro Driver - Our Proprietary Techno-Fundamental Bridge
Our Global Macro Analysis becomes critical in identifying and preparing for major market pivots. Our Global Macro Economic Analysis is indicating the following outlook:  The recent events in Europe has precipitated a temporary flight to quality. The US Dollar and US Treasuries have been the recipients of this flight to safety as the US financial markets are seen to be a safe haven relative to other options. These Global Macro developments have temporarily halted the previously weakening US dollar. Any PERCEIVED SOULTIONS to the European Sovereign Debt Crisis, even if they are 'kick the can down the road' policies, will result in the US dollar rapidly weakening.

 

When the reality of the European "Printing Efforts" finally set in, the Euro will weaken and the US Dollar will resume its advance.

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The Euro has confirmed this with its recent technical "Death Cross" with the 50 DMA moving through the 200 DMA. The 100 DMA is well advanced in following the 50 DMA

US Treasury prices will fall towards the lower descending channel as interest rates move higher (see below).

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Eventually the problems in Europe will no longer act as a 'flight to safety trade' for the US Dollar. The US dollar will weaken against hard currencies and more potentially stable economies and alternative investments.  As the US dollar weakens it will give a boost to the US Equity markets fundamentally because stocks are priced in 'smaller' American dollars. Additionally, Global Corporations listed on US exchanges receive more than 50% of their revenues outside of the US which will help with US earnings reporting. With out-of-control US deficit spending pushing up US Treasury Supply, and QE II stopping and thereby reducing US Treasury Demand (in addition to a flight to quality reversal), we can eventually (after the flight to safety recedes) expect bond prices to fall and interest rates to climb. Eventually increasing cost push will drive inflation in basic needs such as food, energy and consumables. However, as disposable income continues to fall the US Economy will begin an acceleration into a severe Bear Market and economic slowdown. The Bear Market which began in December 1999 will resume with full force.

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SHORT TERM – Technical Analysis

Gann Analysis

THE FINAL 'V' OF THIS TOPPING "M" PATTERN IS STILL TO BE PUT IN.
 
Our proprietary Bomar Band shown in red above will rise quickly and determine support for the current market weakness. We expect further weakness near term until a last 'kick at the can' coordinated European solution is announced which will triggered a strong yearend rally driven by global central bank actions. The Secular Bear Market has resumed so you can expect rising upward counter rallies to force short covering and therefore to be VIOLENT.

30 October 2011 Edition
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Elliott Wave
There are a number of wave counts for the current market weakness. All count as incomplete five waves or impulsive structures. The impulsive structures are suggestive that the Secular Bear Market has resumed.

The detailed tradable Elliott Wave count which specifically aligns with the Gann Analysis above is not available within this service.

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Channels
The market is presently trading between various longer term regression channels as shown below. Boundary conditions associated with 3 and 4 standard deviation Bollinger Bands are also playing into the mix (not shown on the chart below), as well as the 160 WMA (shown below)

Expect a violent move up once final support is found. The RSI on a long term basis is becoming highly stretched.

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Sentiment - Consumer, Investor & Trader

Consumer Confidence - Conference Board
The Consumer Confidence numbers after totally collapsed in August falling to 44.5 were basically flat in September at 45.4. Present situation however fell to 32.5 from 34.3.

What additionally stands out to me is that against comparable prints taken at financial crises and tragedies of the past such as the October 1987 markets crash, Desert Storm, LTCM, the dot com collapse, September 11, Katrina, and Lehman they are WORSE and getting WORSE!

Conference Board (SA, 1985=100) Consumer Confidence Index Present Situation Expectations

Sep 45.4 32.5 54.0

Aug Jul 45.2 59.2 34.3 35.7 52.4 74.9

Y/Y % -6.6 39.5 -17.6

2010 2009 2008 54.5 45.2 57.9 25.7 24.0 69.9 73.7 59.3 50.0

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The Conference Board's September Index of Consumer Confidence showed stability following the harrowing August decline. The index actually ticked up slightly m/m to 45.4 following the nearly one-quarter August downdraft, which was lessened slightly. The latest figure remained near the lowest since April, 2009 and it was just short of Consensus expectations for a reading of 46.0. This month, it was consumer's reading of the present economic situation that showed a m/m decline. The index's drop to 32.5 was to its lowest since January. The reading worsened as just 11.7% saw economic conditions as good but 40.4% felt they were bad. Jobs were seen as hard to get by an increased 50.0% of respondents, the highest since May, 1983. The expectations component of confidence edged up m/m after the 30.0% August decline. The index level was off 44.6% versus its February peak. Twice as many respondents thought that business conditions would worsen as improve. There was an even greater disparity between those who thought employment would worsen and those who saw improvement. Only 13.3% felt their income would rise, the least since October. Expectations for inflation in twelve months fell again m/m to 5.7% versus the peak of 6.7% three months ago. A much fewer 46.4% thought interest rates would rise, the least since November and slightly more respondents foresaw higher stock prices, but 48.3% expected a decline.

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Consumer Sentiment - Michigan
The University of Michigan Consumer Sentiment Index plunged from 77.5 in February to 67.5 in March. Drops of this magnitude are rare. But when they happen, they send the message: Look out below! Since then the index has continued TO TREND LOWER with a possible low having been achieved in August.         February March April May June July August September 77.5 67.5 69.8 74.3 71.5 63.8 55.7 59.4

As you can see from the chart below, this indicator‘s history is impressive …

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Investors Intelligence
Bullish Percentage as of 02/24: 03/24: 04/28: 05/19: 06/23: 07/21: 08/25: 09/29:

52.2 50.6 54.2 45.6 37.6 46.2 44.0 37.0

We have now dramatically broke through 50 shown to the right

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American Association of Independent Investors

Note the rising channel of the Bear/Bull ratio based on a 3 week moving average.
Difference as of 02/24 is 52.2 - 19.6 = 32.6 Difference as of 03/24 is 50.6 - 22.4 = 28.2 Difference as of 04/28 is 54.2 - 19.2 = 35.0 Difference as of 05/19 is 45.6 - 19.2 = 26.4 Difference as of 06/23 is 37.6 - 28.0 = 9.6 Difference as of 07/21 is 46.2 - 21.5 = 24.7 Difference as of 09/01 is 38.6 - 32.3 = 4.3 Difference as of 09/29 is 29.45 - 45.38 = -15.93

LONGER TERM - The bias should be towards Sentiment Increasingly Bearish - Decreasingly Bullish. The data above reflects this as we resume the Secular Bear Market.

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National Association of Active Investment Managers (NAAIM)
The National Association of Active Investment Managers (NAAIM) shows that on average they are extremely bearish at 4.18%, having plummeted from last quarter's average of 66.99%. The NAAIM Survey of Manager Sentiment

The red line shows the close of the S&P 500 Total Return Index on the survey date. The bars depict a two-week moving average of the NAAIM managers' responses.

The NAAIM Number 4.18 Last Quarter Average 66.99%

Date 9/28/2011 9/21/2011 9/14/2011 9/7/2011 8/31/2011 8/24/2011 8/17/2011 8/10/2011

NAAIM Number Mean/Average 4.18 27.90 26.78 25.31 22.19 20.17 28.78 21.40

Bearish -125 -125 -125 -125 -140 -125 -125 -125

Quart 1 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Quart 2 0.00 11.00 10.00 15.00 15.00 15.00 20.00 14.50

Quart 3 26.25 50.00 50.00 50.00 50.00 45.00 50.00 50.00

Bullish 90 190 200 120 100 100 200 100

Deviation 46.65 64.46 57.01 66.24 33.00 63.27 62.33 54.80

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Small Business Optimism
Consumer and small business sentiment at 88.1 remains at levels associated with other recent recessions. The trend in sentiment since the Financial Crisis lows has been one of slow improvement. The September preliminary number from the Michigan survey is consistent with deep recessions.

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Smart Money / Dumb Money Confidence

We have had a protracted period of Divergence with the Smart Money Index. This suggested the Smart Money did not believe this rally is real. They had insufficient confidence in its underpinnings to put capital at risk. The best assessment was that the market is being driven by Federal Reserve buying, Momentum Traders and Trading Programs. This is a chart of an unhealthy and artificial market. HOWEVER, the Smart Money is now beginning to buy while the Emotional money is now selling. Significantly, for the first time since the fall of 2009 the Smart Money Index broke above its 200 DMA.

  

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Percentage Stocks Above 50 & 200 DMA

  

With approximately 10% of the S&P 500 above their 200 DMA we have an over-sold market. With only 10% of the S&P 500 above their 50 DMA we have a moderately over-sold market which is nearing support levels. The market is looking for a support base to launch a short term relief rally.

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Margin Levels

  

Margin Debt fell off early 2000 which was a precursor to a major market retrenchment into the fall of 2001. Margin Debt fell off in early fall 2007 which was a precursor to a major market retrenchment into March 2009. We are presently experiencing Margin Debt falling off significantly. This is highly unusual and a strong precursor of "risk off' beginning to creep into the market.

BACKGROUNDER: Pragmatic Capitalist In times of uncertainty, when many fear the sky is falling and that there is no hope for recovery, a prudent investor will begin to look for opportunities. The problem is getting the timing of those opportunities right. Lately, there have been a raft of analysts and pundits promoting that the market is cheap and now is the time to be getting in. But is it? Put simply the market is not cheap enough yet. Warren Buffet once said “Be fearful when others are greedy; greedy when others are fearful.” While I don‘t agree with Buffet‘s political viewpoints – his sage investment advice is priceless. This bit of advice goes to the very core of the mistakes that investors repeatedly make.

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The emotions of ―greed‖ and ―fear‖ have robbed more investors of their wealth than what has been lost at the point of a gun. Investors, by and large, react emotionally to investing. The average investor has the best of intentions of investing for the “long term” yet wind up doing the exact opposite of Buffet‘s advice – they buy high and sell low. This can be no more clearly shown than by the chart of margin debt and net credit balances. During the 80′s investors used a modest amount of margin debt (borrowed money) to leverage their investments in the market. As the internet boom launched online trading and turned the stock market into a giant casino margin debt exploded. The speculative greed driving stocks higher was boosted by the addition of margin debt to unsustainable levels until the market peaked in 2000.

As the market subsequently declined those same investors that were heavily indebted to broker-dealers for their margin lines were forced to liquidate. As the markets declined forcing margin calls the additional liquidations drove the markets lower in turn forcing more margin calls and liquidations to occur. This process continued even though each and every bounce on the way down led analysts and pundits to call a market bottom. Late in 2002 and early in 2003, as many an investor had been wiped out and given up on the markets altogether, the markets finally bottomed. By this point investors had gotten themselves back into a positive net credit balance in their margin accounts just in time for the Alan Greenspan to launch the next big bubble – real estate. As credit flooded the system due to lax restrictions and regulations the markets began to recover and move higher. Investors, quickly remembered the boom years of the late 90′s and after having been decimated early in the decade were salivating at an opportunity to recover. They quickly returned to the casino table to lever up their balance sheet drawing down on margin lines again all the while believing that this time they would know when to ―sell‖. Margin debt obtained an all new peak heading into 2008 rising to more than $380 Billion. Investors didn‘t figure out when to ―sell‖ this time around and the unwinding of that much debt spelled disaster for the financial system. By the time the bottom of the decline was reached in March of 2009 positive net credit balances had ballooned to almost $200 Billion. Surprisingly, after investors had been wiped out twice in a single decade they came storming back to the casino flush with cash as the Fed, due to the introduction of Quantitative Easing, removed investment risk, from the markets. Investors scrambled to lever up their portfolios for a third time. This time margin debt

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didn‘t quite achieve its previous peak but quickly surged to $330 Billion. We are now witnessing the third unwinding of leverage and the destruction of investor portfolios as a variety of risks run rampant through the markets. However, can this unwinding of margin debt tell us anything about the market and where the next bottom, and buying opportunity, might be? If we overlay the S&P 500 against the Margin Account Net Credit Balance (Free Cash and Credit Balances minus Margin Balance Outstanding) you can see that bottoms in the market occur when there are positive net credit balances. Furthermore, bottoms in the market generally occur AFTER the peak occurs in the reduction of margin balances. Currently, the recent decline has reduced the outstanding net credit margin balances to just a little over $4 Billion as of the end of August, however, we are still on the negative side. Therefore, markets likely have further to go on the downside which will induce more unwinding of margin balances. The next bottom, if history serves as a guide, will not be until the reduction in margin debt peaks and begins to reverse. At that point we can begin to more safely deploy capital as 1) 2) The markets should be extremely oversold as liquidations have peaked; and There will excess buying power due to lower margin debt and positive net credit balances.

While this is not a great ―market timing‖ indicator, just like valuation levels, for investors; it is a good warning sign that we most likely have not reached the ―fear‖ level necessary to denote a good buying opportunity. Being patient and unemotional about investments are the two hardest things for an individual to do. This is why there are so few successful investors in the world today that have survived the ―long term‖ investing game. Risk is a function of how much investors lose when they are wrong which brings us back to Warren Buffet and his two rules of investing: 1) Never lose money and; 2) Always refer to rule #1.

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Mutual Fund Cash Levels v S&P 500
Mutual funds are levered to record levels. As the redemption requests start piling in, they will be forced to proceed with a rapid liquidation of winning holdings.

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Oscillators & Breadth Indicators of Importance

NYSE Overbought / Oversold

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Markets can and often fall the greatest during periods considered as being oversold. The sell-off from overbought levels was not unexpected. A bounce from the current oversold levels, likewise should not be unexpected. Look for divergence to occur between falling prices and a higher oversold low. This should indicate a short to intermediate, tradable low is in.

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OEX Open Interest (Puts/Calls)

• •

The topping pattern similarities to 2007 was a good warning signal to the recent price decline. There is likely more downside to the pattern, however it will likely find support at the bottom of the rising lower trend channel line (shown above).

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TRIN

 

The chart for the NYSE shows we are near a short to intermediate bottom. A bottom pattern with retest will need to be put in.

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McClellan Oscillator

 

The McClellan Oscillator has dropped significantly and is now looking for support. Markets can fall further looking for support, however the 21 Day suggests it is near at hand since it seldom reaches this low a level.

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INTERMEDIATE TERM – Risk Analysis

RISK SUMMARYAggregated Average

ANYTHING OVER 5 SHOULD BE CONSIDERED SERIOUSLY ELEVATED
PREVIOUS BANKING RISK - LIBOR-OIS SPREAD CREDIT RISK - GLOBAL CREDIT DEFAULT SWAPS CREDIT RISK - EU CREDIT DEFAULT SWAPS CONSUMER RISK - HOUSING - RATE OF CHANGE ECONOMIC RISK - ECRI LEADING INDEX ECONOMIC RISK - US ECONOMIC SURPRISE INDEX INFLATION RISK - MONEY SUPPLY GROWTH - M3 INFLATION RISK - MONEY VELOCITY MONETARY RISK - BANK LIABILITIES COST OF MONEY RISK - INTEREST RATES VOLATILITY RISK: VIX / VXO Warnings (New) Average (1 = Low Risk, 10 = High Risk) 7 6 8 7 6 4 4 4 7 5 5 5.73 CURRENT 8 7 9 8 8 5 5 4 8 1 9 6.55

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Global Macro Risk - Risk Items

Banking Risk - Libor-OIS Spread (Updated)
When the LIBOR-OIS Spread is increasing, it tells us that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they are charging a higher interest rate to offset this risk. It also tells us that the credit markets are not functioning as smoothly as they could be—which is sign of potential economic contraction. NOTE: The Banks are presently under investigation for manipulating the LIBOR rate during the financial crisis. For a Current Update: Bloomberg

Credit Risk - Global Credit Default Spreads (Updated)
Anything over 300 is a concern.

VENEZUELA at 1131 and rising may be a blow to Latin America MIDDLE EAST & NORTH AFRICA Dubai (500) and Egypt (472). ASIA China at 174 has been steadily rising. USA For the first time the US has appeared on the this list since losing its AAA rating.

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Credit Risk - EU Credit Default Swaps (Updated)
Anything over 300 is a concern. GIIPS GREECE: At 1700, Greece is completely locked out of the funding markets and must have EU/ECB/IMF assistance for rollover and budget funding.

IRELAND: At 699 the problems are still festering. ITALY: At 475, Italy now has a serious funding problem. PORTUGAL: At 1116 and though recently having accepted an EU/IMF bailout, Portugal is still showing that the problem has not been solved. SPAIN: At 383 Spain would appear to be in the best shape of the GIIPS. However, the Spanish banks have the highest PIIGS exposure as a percentage of their domestic banks' Tier I Core Capital requirements. EU CORE GERMANY: At 112, German CDS' have been steadily rising and the recent approval of €211B towards the EFSF places Germany's AAA rating in jeopardy if this amount is increased further. FRANCE: At 187 French CDS' have been steadily rising along with Germany. The major banks of France border on insolvency. AUSTRIA: At 170 becoming a concern. BELGIUM: At 260 and problems at Drexia, Belgium has become a concern.

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Consumer Risk - Housing Rate of Change (Reference)
Prof. Robert Shiller (one of the creators of the CS Index) pointed out that when 6 out of 20 US cities in the index have hit new lows (even lower than in early 2009) that the economy would face “serious worries” if house prices kept falling this fast Why did he say ―this fast‖? To understand, you have to look at the annualized rate of change of the last 3 month. And it is not a pretty picture. While the 10-city index dropped an annualized 8.8% in the three-month period from July to October 2010, the 20-city index fell at a rate of 10.4%. The annualized three-month rate of change gave an early warning sign when it went into negative territory in June 2006, while both the 10-city and 20-city only showed declining house prices in January of 2007.

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The chart on the left displays net changes in household holdings of credit market instruments (debt) and liquid assets as ratios to total consumption expenditure. Until the early 1980s, households were lowering their debt and accumulating liquid assets at a rate equivalent to 3 percent and 6 percent of aggregate consumption, respectively, on a yearly basis. Around 1986, households started accumulating debt and eroding their liquid asset holdings. By 2007, households were increasing debt at a rate equivalent to 6 percent of aggregate consumption every year. Accumulation of liquid asset holdings restarted around the mid-1990s. The financial crisis of 2008 resulted in the largest deleveraging observed in the sample period. Debt accumulation plummeted from 6 percent to –4 percent of aggregate consumption. Liquid asset holdings declined by almost a factor of two as well. Furthermore, as shown in the chart on the right, the financial crisis coincided with the largest simultaneous declines in the value of housing and equities in the sample period, substantially eroding households’ wealth and financial positions. Durable consumption (not shown) was also substantially affected: By the first quarter of 2011, it stood 25 percent below the trend implied by 1990-2006 data. Households are the sector that the financial accelerator appears to have hit hardest, according to the data. The business sector was apparently no different than in previous recessions, which suggests that either the negative accelerator effects are not as important for businesses or they were counteracted by existing policies. One way the financial accelerator can affect individual households is as follows: Lenders’ monitoring costs must be passed on to borrowers and result in a premium on borrowing rates. The size of the premium varies negatively with the net worth and overall financial position of the borrower. Hence, any shock that affects a household’s financial position also affects its borrowing capacity. In turn, lower borrowing capacity may depress household spending, economic activity, and, ultimately, asset values. The resulting vicious cycle accelerates the impact of negative economic shocks.

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Economic Risk - ECRI Leading Index (Updated)
When the ECRI indicates the patterns to the right, then the following sequence happens: 1. 2. 3. 4. PE Ratios Compress GDP Reductions in Outlook Earnings Estimates are reduced Markets Regress-to-theMean.

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Economic Risk - US Economic Surprise Index (Updated)
The Citi US Economic Surprise Index demonstrates the magnitude of the drop historically. The Index tracks cumulative degrees of upward and downward surprises in US economic releases weighted both to relative significance and timeliness. The peak to trough drop was on par with that of the 2008 crisis itself. Ultimately, economic data disappointed like clockwork relative to economists‘ expectations. Some of this can be attributed to supply chain disruptions as a result of the Japanese earthquake and effects of higher energy prices with unrest in the Middle East and North Africa, but the point is clear – it was an ugly second quarter, at least compared to what many expected. Short Term

Long Term

Annaly Capital Management

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Inflation Risk - Money Supply Growth - M3 (Updated)
Though the government no longer releases the M3 money supply statistics, they are put together by such organizations as ShadowStats.com. The massive efforts by the US Federal Reserve the overall money supply as represented by this broadest measure of US money and credit appears to have finally begun to work and has recently risen above the zero line. However, it has quickly flattened. What is worrying is that the rise was based on programs such as QEII which have now ended! What will stop it from rolling over as we are seeing in Housing and the Economy overall? Source: ShadowStats

Inflation Risk - Money Velocity (Updated)
The US Federal Reserve is unable to get any 'traction' with Money Velocity despite increasing M3 Money Supply. This is primarily because Nominal GDP Growth is insufficient. The Federal Reserve needs to get Nominal GDP growth above 4%.

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Monetary Risk - Bank Liabilities (Updated)
The Shadow Banking System as the prime pusher of toxic debt instruments collapsed in the 2008 financial crisis and so far it simply has not re-emerged in some sort of hybrid fashion. The Federal Reserve desperately needs this to happen and this has been another reason for the Fed's "Extend & Pretend" policy. To the right is the latest figures from the Federal Reserve's Flow of Funds report for Q4 2010. The report was startling since Q3 2010 was even worse than thought after final adjustments were made. We had aQ4 2010 decline of $206.4 Billion in Shadow Banking liabilities with $440 Billion in combined Shadow and Conventional Banking System Liabilities. This almost guarantees that the Federal Reserve must continue QEX.

MONEY MARKET FUNDS Remember, banks borrow short and lend long. Money Market Funds are a prime source of cheap borrowing.

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Cost of Money Risk - Interest Rates (Updated)
2 months ago we wrote: "The dramatic rise in the 10 Year US Treasury following the November 3rd FOMC Q2 press release is nothing short of dramatic. However, it has recently begun to stall. "The rally will not continue if rates are allowed to rise!" You can be assured the US Federal Reserve has more 'bullets' ready to hold yields down! Note what has dramatically happened since we wrote this. Yields are at historic lows and the Federal Reserve will now roll US Debt to longer maturities almost free of cost.

It is interesting that the Fed's "Operation Twist" precisely targets that range of the yield curve that is now negative in real terms. With any further increases in the US inflation rate, the Federal Reserve is being "paid" to buy mid-maturity treasuries.

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Volatility Risk: VIX / VXO Warnings (New)

The set up on the VIX is now looking increasingly like a double bottom within a triangle. This often results in an explosive breakout. This is extremely negative for the markets. First Chart: Long Term Second Chart: Shorter Term Detail

What we said would happen:

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What happened:

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REFERENCE: Adam Hamilton at Zeal does a very nice job of linking the VIX to the Bullish Percentage Indicator to the Put Call Ratio (PCR) 21 DMA in his analysis SPX Correction Looms (updated)

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The bottom line is the unsustainable sentiment imbalances that existed before the March pullback still persist. That selloff was so minor and short-lived that the extreme greed and complacency generated by a massive and uninterrupted stock-market upleg were barely dented. Until this greed is bled away, and the quickest and surest way is through enough selling to finally generate fear, the risk of an imminent stock-market correction remains high.

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The Longer this Goes - the Greater the Risk - the Poorer the Risk:Reward

Consecutive Days Without a Bollinger Cross
What we warned of in earlier reports:

The trigger will be the cross of the 50 DMA and the 100 DMA. Watch this cross closely. Below is what has occurred so far:

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• •

The previous lows should now act as SUPPORT to complete this sell-off A Year-End Rally towards the arrow on the above chart can be expected.

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50 DMA Boundary Condition Near Failure
What we warned of last month:

  

The 100 DMA normally resides within the 50 DMA two standard deviation band. When the 100 DMA moves outside this band the 50 DMA will close on the 100 DMA to reestablish this Boundary Control. A "Bear Market" counter rally has stopped the 50 DMA from CROSSING the 100 DMA and giving us a frim downside signal.

Below is what has occurred so far:

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Market Warning Telltales - 'Canaries in the Coal Mine'

The Market Breaks Its Neck
Editor's Note: I am skeptical of the second, lower level head and shoulders but it does surprisingly come close to our lower level S&P 500 support call. See Targets.

BACKGROUNDER: The Market Breaks Its Neck Lance Roberts, Street Talk Live

For the second time this year the market has broken the neckline of a classical "head and shoulders" pattern. For you non-technical investors this is simply a pattern of price movement that has been indicative of market topping patterns in the past. In fact, outside of the two times this year, the last time we witnessed a clearly defined "head and shoulders" pattern was at the peak of the market in 2008 just before the major crisis hit. Back in April we first began to recommend overweighting cash and fixed income relative to equities due to the fact that the Quantitative Easing program by the Fed was coming to an end and the lack of stimulus was going to act like a vacuum on the markets. This was a highly unpopular position at the time, especially with the media, but has saved us lots of grief over the summer.

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After the initial break of the "neckline" in early August during the midst of the "debt ceiling debacle" the market plunged to 1120 on the S&P 500 index. The market then remained range bound between the lows of 1120 and highs 1220-1230. After the initial plunge we began to repeatedly make calls in our weekly newsletter to sell into rallies due to the overriding weakness in the domestic and international economies. Furthermore, when trends are negative in the market the primary trading rule becomes "selling rallies" rather than "buying dips". Each attempt at a rally in the markets failed at critical levels of resistance but repeatedly found support at 1120...until today. The break of the "neckline" today leaves the market in a very tenuous position flirting with the August intraday lows of 1103 on the index. In our opinion this level most likely will not hold and we could well see the markets decline to the next major psychological level of 1000 on the index. This will be consistent with both the retracement of the initial selloff and the break of "neckline" support which should lead to a decline of the same proportion as the original decline. This will also be consistent with traditional bear market declines of 30% from peak to trough. With the markets now negative for 5 months in a row a sharp decline to flush out investors could well set a short term bottom in the market. However, as we showed in our post on Friday, after 5 or 6 months (depending on how October ends) the markets have always rallied for 3 to 6 months before declining to new lows before finding THE longer term investment opportunity. The point here is that many investors are now trapped in the market and are hoping for a rally so they can get out. This is why the next rally that we likely see will be into the the end of the year. This will most likely be a "suckers rally" as it will suck investors in as the media bleets about the end of the bear market. Unfortunately, that will be the set up for the decline to the longer lasting bottom. This was very much the same pattern that we saw play out at the end of 2008 as the rally abruptly ended and the markets declined 22% from January to the final low on March 9th. Caution is highly advised. Having a hefty hoard of cash will provide the ability to take advantage of the next buying opportunity whether it comes sometime this month or next year. There are many threads of this finely woven economic fabric that are now unraveling. As such it will pay not only to be patient but "fashionably late" to the next buying opportunity to make sure it isn't a "suckers rally".

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Five Months Down For Stocks: Time For A Bounce?
Editor's Note: Fits well with our expected rally as part of our year-end rounded top completion.

BACKGROUNDER:

Five Months Down For Stocks: Time For A Bounce? Lance Roberts, Street Talk Live

Goodbye September! The S&P 500 is sporting a healthy 10% decline for the year and nearly an 18% drop from the peak. The recommendation to move primarily to cash and fixed income back in April has served us well. So, what about October? October has been the month that has seen the end of bear markets more often than not. Unfortunately those bear market endings generally consisted of very large declines. The month of October this year is, unfortunately, laden with risks. The government is still engaged in trench warfare which means little assistance from the Whitehouse. The Fed has effectively thrown the towel in at this point with "Operation Twist" which will do little to bolster the economy or the financial markets. The Greece/Europe standoff is quickly coming to a head and Greece will most likely have to default which will put tremendous pressure on the European economy. Europe and China are slowing rapidly and it is a race to see whether it will be the US that drags the world in to a recession or vice versa. As you can see there is more than enough systemic risk to disrupt the markets. Unfortunately, we are going to plaster those systemic risks with a good solid coat of financial risks as the 3rd quarter earnings season kicks off. Analysts estimates remain very high and earnings season could prove to be a disappointment with the slowing of corporate profits combined with a weakening of incomes and a despondent consumer. Now for the stats. September was the 5th negative month of returns in a row which has only happened 5 times previously. The reason I point this out is twofold.

First, there have been numerous analysts pointing this fact out lately touting that this is the time to get back into stocks because of the rarity of 5 month negative return periods. However, a look at the data tells us a potentially different story. If we average each of the 12 months following 5 months of negative declines and look at average monthly returns we find that the better buying opportunity generally comes after a reflex bounce.

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This is assuming that September was the bottom. Which brings me to my second point. What if September wasn't the bottom?

What these analysts don't tell you is what happens if October turns out to be a negative month as well? There have been four 6 month periods of negative returns the markets since 1930. After each 6 month period the market did indeed bounce. Unfortunately, 3 out of 4 times those bounces let to brutal market declines with one of those 6 month periods bouncing before starting a slide into the 9 month long crash of 1974 which still holds the record. Also, what is interesting is that after 6 months of negative returns a 3 month bounce occurred 3 out of 4 times which turned out to be a suckers rally. The subsequent six months led to negative return and that second bottom, with the exception of 1974, was the better buying opportunity. With the both a high level of financial and systemic risks in the market today combined with a lack of support from the Federal Reserve, the odds of a strong rebound from these levels looks questionable. If September turns out to be the bottom of the market then our technical indicators will signal to us a better time to wade cautiously back in to the risk pool. However, if October turns out to be negative then most likely we have much more work to do before a better buying opportunity presents itself.

Finally, if our economic models are correct and we are on the verge of a second recession then stocks do have further downside risk. A reflexive rally is certainly possible BUT should be sold into. This is the first rule of trading during negative market trends as we currently witness today. During an average recessionary bear market stocks decline by 33% on average. As stated previously, with the markets currently down around 18% from the peaks this year, this leaves roughly another painful 20% to go. Of course, I did say "average" recession. In the current economic environment my concern is that the next recession will be anything but "average".

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Mutual Fund Outflows Surge As NYSE Short Interest Back To March 2009 Levels
Editor's Note: We have a presentation up on LONGWave that expands on this further.

BACKGROUNDER

Mutual Fund Outflows Surge As NYSE Short Interest Back To March 2009 Levels Zero Hedge

ICI has reported the latest weekly mutual fund flow data and it is not pretty: the outflow from domestic equity mutual funds of $5.7 billion for the week ended September 30 is the largest since August 10, and is the 6th consecutive week of redemptions from mutual funds, bringing the total outflow YTD to $89 billion, following $98 billion in 2010. This is almost $200 billion in nearly consecutive weekly outflows from equity funds in the past two years, the bulk of which has gone into bond funds. Is there anyone who still thinks that retail has any interest in investing in stocks? But wait, there's more. According to the NYSE, short interest at the exchange soared to a whopping 15.7 billion shares as of September 15, an 828 million increase in one fortnight, and the biggest since the March 2009 lows. There is one difference: back then the S&P was 40% lower. Which means that the bear cavalry is positioned and waiting for a massive market flush... which keeps on not materializing. Why? Because these same mutual funds, despite having record low cash holdings, continue to refuse to sell their stock holdings and replenish cash. The only reason we can attribute to this is that slow money managers keep hoping Bernanke will pull something out of his sleeve and create another Hail Mary market rush into year end, saving quite a few P&Ls, not to mention careers. Alas, with stocks where they are it is increasingly looking like Operation Twist may be the only thing they will get for 2011 - Bernanke needs the S&P in triple digits to have a strong case for a $1-2 trillion LSAP. As such funds find themselves in no man's land, where they will be redeemed at the end of the year unless stocks soar for whatever reason, but will refuse to sell before they absolutely have to, which will be end of December, or whenever the Nash equilibrium fails. So with less than three months left, every single day that does not result in a massive market move, brings stock ever closer to that proverbial flush which the noted shorts are so stubbornly waiting for. And with every passing day this equilibrium becomes more and more tenuous until one day the selling has to commence. Is it any wonder that hedge funds are now overwhelmingly bearish and also waiting alongside the bear cavalry to scoop up the firesale which should begin if Bernanke does nothing but sits on his gluteus maximus? NYSE short interest:

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Domestic Equity Mutual Fund flows:

Mutual Fund cash balance:

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World Markets Review: The End Of A Bad 3rd Quarter
Editor's Note: Note particularly: 1- The magnitude of volatility in the Global Markets, 2- The fact that Global Markets have given up much of their gains since the market bottom associated with the 2008 Financial Crisis. 3- Except for India and China markets in Nominal terms are below their 2000 Market Highs. Returns have been negative. BACKGROUNDER: World Markets Review: The End Of A Bad 3rd Quarter Doug Short, dshort.com The 3rd quarter saw wretched performances in all of the world markets in this series. The best quarterly performer, the Nikkei 225, lost 10.3% of its value, followed by the SENSEX, which was down 11%. At the other extreme the DAX, CAC 40 and Hang Seng all lost about 25% of their value. The middle ground was occupied by the Shanghai, FTSE and S&P 500, which lost 14%, 14.4% and 15.9% respectively. Let's hope next month sees some improvement. Certainly a bounce is due. But the ongoing stresses in Euro land, the nasty bear market in China, and ECRI recession call in the U.S. suggest a cautious outlook. The tables below provide a concise overview of performance comparisons over the past four weeks for these seven major indexes. I've also included the average for each week so that we can evaluate the performance of a specific index relative to the overall mean and better understand weekly volatility. The colors for each index name help us visualize the comparative performance over time.

The chart below illustrates the comparative performance of World Markets since March 9, 2009. The start date is arbitrary: The S&P 500, CAC 40 and BSE SENSEX hit their lows on March 9th, the Nikkei 225 on March 10th, the DAX on March 6th, the FTSE on March 3rd, the Shanghai Composite on November 4, 2008, and the Hang Seng even earlier on October 27, 2008. However, by aligning on the same day and measuring the percent change, we get a better sense of the relative performance than if we align the lows.

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A Longer Look Back Here is the same chart starting from the turn of 21st century. The relative over-performance of the emerging markets (Shanghai, Mumbai, Hang Seng) is readily apparent.

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Tired of Ups and Downs, Investors Say, 'Let Me Out!'
Editor's Note: When people start saying the following it means that the capital markets have disconnected from their central artery - the small private investor who is an investor who wants to build savings versus a stock speculator: "I felt the people buying were people inside the market. They weren't the investors of the past who wanted to protect what they had or see it grow a little bit". "Nothing out there looks like a winner," says Ms. Fletcher, who has $70,000 in investments. "Normally, I would just add the money to my portfolio, but I am too freaked out to do that right now." Even some young investors are nervous. Dan Manges, a 26-year-old software developer in Chicago, is so worried about extreme stock-market movements and sluggish job growth that he has shifted 70% of his $100,000 investment portfolio into bond funds. "I am basically investing like a retiree with very few risky choices," he says.

BACKGROUNDER: Tired of Ups and Downs, Investors Say, 'Let Me Out!'

Wall Street Journal - 10-07-11

Leonard Gerber, a 65-year-old financial planner, has seen plenty of volatile markets during his career. But this one feels different. Last month, the Syracuse, N.Y., resident cashed in his stock funds—and he has no intention of diving back in anytime soon. "I feel like a deer in headlights," he says. Across the country, investors are fleeing the stock market for the safety of cash. On Tuesday the Standard & Poor's 500-stock index lost as much as 2.2% before a late-day rally sent the index up 2.3% for the session. In the 46 trading days since the beginning of August, the S&P 500 has seen 29 swings of 1% or more. Tuesday is a "perfect example" of why Mr. Gerber has bailed out. "The market is manic," he says. "There's no consistency ... and there's a worrisome amount of volatility." The wild action is keeping brokerage firms busy. At Scottrade Inc., trading volume increased 36% on Tuesday afternoon from the day before, which was 30% higher than last week's average. Principal Financial Group saw callcenter volume from investors in work-based retirement plans climb 27% between Friday and Monday. Volatility is usually associated with market losses, and the current period is no exception. Since April 29 the Standard & Poor's 500-stock index has fallen by 17.6%—not far from the 20% drop that defines a bear market. Investors nearing retirement age are among the most skittish. About 20 such clients have called Bob Morrison, principal of Downing Street Wealth Management LLC in Littleton, Colo., in the past two weeks. "People are worried," he says. "They want to move out" of the market. He says he is trying to talk them out of making rash moves. But, "ultimately, it's their money," he says. Nancy Stein, an 80-year-old retired real-estate agent in Northbrook, Ill., has sold off almost all her stock positions in recent months—some of which she held for nearly three decades—because she can't stomach the ups and downs. "I felt the people buying were people inside the market. They weren't the investors of the past who wanted to protect what they had or see it grow a little bit," she says. Some professional money managers are pulling their clients out, too. Joe Wirbick, an investment adviser in Lancaster, Pa., moved $17 million in his clients' portfolios into cash this past week. "Just because it came back at the end of the day [on Tuesday] doesn't mean it can't fall tomorrow," he says. "It's just too crazy right now." Lew Altfest, chief investment officer of Altfest Personal Wealth Management Corp. in New York, says many clients have pared back their stock allocations to 50% or less from 65%. "If people feel that stocks are on their way to a revisit of the '08 difficulties, then they're just going to get out. We don't have that yet, but they're still very afraid," he says. If the Dow Jones Industrial Average, currently at about 10809, dips below 10000, he says, more clients will likely pile out of stocks. The problem, of course, is that investors who sell now could be left stranded on the sidelines when the market begins to rise. Bull markets are often sparked by a single rally so powerful and so fast that individual investors fail

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to react in time. This happened for many of them when the market rebounded in 2009 after plummeting the year before. But it is difficult for some investors right now to think positively about the long term. Tammy Fletcher, a 48-year-old insurance-claims adjuster in Winston-Salem, N.C., opted to put the $15,000 she inherited last month into a savings account rather than the stock market. "Nothing out there looks like a winner," says Ms. Fletcher, who has $70,000 in investments. "Normally, I would just add the money to my portfolio, but I am too freaked out to do that right now." Even some young investors are nervous. Dan Manges, a 26-year-old software developer in Chicago, is so worried about extreme stock-market movements and sluggish job growth that he has shifted 70% of his $100,000 investment portfolio into bond funds. "I am basically investing like a retiree with very few risky choices," he says. The wild swing on Tuesday, he says, "just underscores my general reluctance to make any risky bets." Keith Luke, 45, an economic-development executive in Westbrook, Maine, says his 66-year-old mother two weekends ago advised him and his brother that investing in a 401(k) is "like pouring money into a sewer," he says. "You'd expect your parents to tell you to be socking away as much money as you can to save for retirement and to be like your dad and I. To me, it was a stunning statement from their generation," he says. The advice seems to have sunk in: Mr. Luke says that, given the choice between investing $2,500 and spending it on a trip, "I'd rather take a vacation than watch the same money evaporate from my 401(k)." Some investors are too paralyzed to do anything at all. When Dave Fazio, 41, a tax practitioner in West Bridgewater, Mass., checked the balance of his roughly $400,000 portfolio Tuesday morning, it had dropped about $20,000 from the last time he checked. But so far, he's left his and his wife's allocation at about 85% in stocks. "I'm numb at this point," he says. "I'll be down $20,000 one day, up $10,000 another. It's almost like a fact of life."

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Comparing The 2007 Topping Pattern To Now (Reference)
Editor's Note: This article points out the importance of our proprietary approach of integrating Macro Economics into TechnoFundamental Analysis. Few if any attempt such analysis, and only a select few have developed and proven methodology that have been back tested. As the article correctly concludes, there is nothing positive about the Debt Ceiling Deal.

BACKGROUNDER: Comparing The 2007 Topping Pattern To Now

Tony Pallotta of MacroStory

Remember one simple truth, 91.8% of ES Futures daily volume is attributed to day traders and computer algorithms. And since not one single person within that group uses macro data for their intraday trades then it is safe to say the market in the short term has little to do with pricing in macro economic data. Remember how the SPX peaked two months before the great recession actually began. That is not forward looking. Market participants are already analyzing today's afternoon rally as a sign that this market is resilient, that the economy is still headed for a soft patch and that the bull is alive and well. I beg to differ but instead would rather highlight two important aspects of this market I suspect is dictating price. Shorts are scared and longs are delusional. Bernanke not only taught investors to buy every single dip he even has them convinced the removal of the Bernanke put (i.e. QE) has no downside risk to the market. The move the past two weeks was foreseen by no one and hurt a lot of shorts while making longs feel smart yet again. Even a lot of macro bears were capitulating on the economic data the past two weeks. That is until today. The next and probably most important aspect of this market I suspect is psychology.  It's not technicals even in the face of some bearish patterns created today like island reversals.  Nor is it macro data although the transitory weakness argument just got a whole lot more difficult to defend. A number of times I have compared the current topping pattern to that of the 2007 pattern. The reason I suspect they are similar is for psychology during such times does not change. Longs don't want to surrender their money making machines. Shorts are eager to price in economic weakness and the argument about soft landing or recession grow louder. The magical Point E may now be in for the current market. The similarities are striking of the move to point E in both 07 and 11. A similar move also occurred in the treasury market as highlighted here. That wild move higher shakes a lot of shorts out of their position, pulls in the last remaining dollars from the longs before finally ripping lower leaving few on the train. During these Point E's the macro data is confusing as well. For example the NFP reports (and ADP) right before the great recession showed a positive reversal in job growth. I am sure the debate of soft patch or recession were just as loud then as now.

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So if in fact Point E is in (the current chart is not updated with today's price but trust me it was lower) expect a pullback, one last sucking sound of doubt move higher and then hell breaking loose. Which by the way would be a lovely set up for the Bernanke Put round 3. Lastly I suspect one additional thing keeping a bid in the market is the hope of a debt ceiling deal possibly as early as this coming weekend. How that is bullish is beyond me for it will result in the government agreeing to reduce up to $4 trillion in fiscal stimulus from the economy and easily could put the US back into recession. Other than a bounce and removal of doubt as if there should be any on this matter there is nothing positive about a debt ceiling deal.

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New Stock Bear? (Reference)
Editor's Note: This article is a good recap of secular Bear Markets which we have long advocated we have been in since December 1999 in real terms. A secular bear is a long consolidation, often a demoralizing sideways grind. We are presently in the early duration of even a normal Secular Bear Market BACKGROUNDER: New Stock Bear? Adam Hamilton

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LONGER TERM - Fundamental Analysis

Highlights
RULE PROFITS must rise faster than REVENUES for PE's to Expand Conversely, when PROFITS rise slower than REVENUES then PE's Contract. PROFITS AND REVENUES can both be growing but it the RELATIVE RATE OF ADVANCE PROFITS AND REVENUES can both be falling but it the RELATIVE RATE OF DECLINE

The Secular BEAR Market since 2000 has been marked by Profits rising slower than Revenue The Cyclical BULL Market since 2009 has been marked by Profits rising faster than Revenue

This is in the process of reversing. The market will top when the RATE of Profit and Revenue Equal.

John Hussman warns in: Warning - An Updated Who's Who of Awful Times to Invest
The following set of conditions is one way to capture the basic "overvalued, overbought, over-bullish, rising-yields" syndrome: 1) S&P 500 more than 8% above its 52 week (exponential) average 2) S&P 500 more than 50% above its 4-year low 3) Shiller P/E greater than 18 4) 10-year Treasury yield higher than 6 months earlier 5) Advisory bullishness > 47%, with bearishness < 27% (Investor's Intelligence) [These are observationally equivalent to criteria I noted in the July 16, 2007 comment, A Who's Who of Awful Times to Invest. The Shiller P/E is used in place of the price/peak earnings ratio (as the latter can be corrupted when prior peak earnings reflect unusually elevated profit margins). Also, it's sufficient for the market to have advanced substantially from its 4-year low, regardless of whether that advance represents a 4-year high. I've added elevated bullish sentiment with a 20 point spread to capture the "over-bullish" part of the syndrome, which doesn't change the set of warnings, but narrows the number of weeks at each peak to the most extreme observations]. The historical instances corresponding to these conditions are as follows: December 1972 - January 1973 (followed by a 48% collapse over the next 21 months) August - September 1987 (followed by a 34% plunge over the following 3 months) July 1998 (followed abruptly by an 18% loss over the following 3 months) July 1999 (followed by a 12% market loss over the next 3 months)

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January 2000 (followed by a spike 10% loss over the next 6 weeks) March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002) July 2007 (followed by a 57% market plunge over the following 21 months) January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks) April 2010 (followed by a 17% market loss over the following 3 months) December 2010

Earnings GROWTH is likely not to maintain the RATE of increase we have been experiencing.

FactSet Research Systems in July is reporting a significant flattening in profit margin growth based on Q2 earnings and the guidance from Q2 earnings conference calls. Their results are reflected in the chart to the right.

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Source: Business Abroad Drives U.S. Profits

WSJ

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Shifting Secular Sands - Emerging Impediments to Global Earnings Growth Rates
Editor's Note: The report summarized below ,by Wilfred J. Hahn of Hahn Investment Stewards, is worth a careful study. Too often we are so absorbed by short term immediate concerns that we fail to realize the larger, quietly shifting paradyn that underlie the shifting secular sands.

BACKGROUNDER: Profit Surge Dirge - Unexpurgated

Hahn Investment Stewards

SECULAR SHIFTS: 1. 2. 3. 4. 5. 6. Unprecedented High Government Deficits Secular Era of Declining Interest Rates Payout Levitation Modern Day Profit Alchemy Off-Shoring Profit Drilling Techniques Foreign Outsourcing

POTENTIAL PROFIT PRESSURES:  Collapsing Offshore Margins due to:  Rising Labor Costs  Higher Input Costs  Supply Chain Currency Movements China & Asia Wide Manufacturing Slowdown Government Austerity Programs due to Sovereign Debt Constraints Interest Rate Bottoming & Credit Financing Pressures Politically Coordinated Offshore Tax Loop Hole Pressures Higher Corporate Income Tax Rates Pro-Employment Government Policies  Pressures on Employers for burdening Benefits & Social safety Net Costs Declining Global Demand Growth Rate (law of larger numbers)

     

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Cost Push now Creating Margin Compression!
The following analysis is from dshort.com. A Look At The Margin Squeeze And Inflation Risk That's Threatening The Economy as published March 24th, 2011 on Business Insider The two charts below offer a way to evaluate the risk of profit margin squeeze in the current economy. One is the ratio of crude to finished goods in the Producer Price Index (data through February). The other is an indicator constructed from two data series in the Philadelphia Fed's Business Outlook Survey. It is the spread between the Philly Fed's prices paid (input costs) and received (prices charged) data. A major risk factor for margin squeeze is the increase in commodity prices over the past several months. The latest turmoil in the North Africa and the Middle East has now putt oil prices in the spotlight. So let's take a broader view of these two indicators by viewing them within the context of inflation as measured by the Consumer Price Index. As the first chart clearly shows, the all-time high in the PPI crude:finished-goods ratio was in July 2008, the same month that crude oil and gasoline prices in the US hit their all-time highs. The previous ratio high was in the summer of 1973, a few months before the outbreak of the October Arab-Israeli War and the Oil Embargo. Inflation had already been rising in a series of waves since the mid-1960s. But Middle-East events of 1973 were the primary trigger for the nearly ten years of stagflation that followed.

The Philly Fed Prices Paid Minus Prices Received Index is an extremely volatile series, which I've emphasized by using dots for the monthly data points. To highlight the underlying pattern, I've included a 12-month moving average (MA). The two date callouts, one for the February monthly data point and the other for the 12-month MA, show that the comparable levels in the past were associated with inflationary peaks. The March ratio is down from last month but still extremely high: It is at the 98th percentile of the 515 monthly data points in this series. The 12-month MA for the ratio is at an all-time high.

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By official government metrics, the CPI and PCE, inflation is not a near-term threat. In fact, the Federal Reserve has been working hard to raise the level of core inflation. Of course, there are many differences between the inflationary decade of the 1970s and the present, not least of which is the rate of unemployment. In August 1973 (first chart above), unemployment was at 4.8%. The latest Gallup Poll unemployment survey puts the mid-March rate at 10.2%, over a percentage point higher than the 8.9% February number from the Bureau of Labor Statistics. Also, US demographics are quite different. The oldest Boomers were turning 27 in 1973. They were at the beginning of their careers with decades of wage increases in their expectations. This year they are turning 65, and many are already on Social Security as their main source of income. At present, in light of the unemployment rate and the ongoing demographic shift, the rise in commodity prices probably poses more risk of margin squeeze than run-away inflation. Some degree of cost-push inflation may be a near-term risk, but the demand-pull inflation we saw in the 1970s is difficult to evision in the US economy of this decade.

Margin Compression versus PE Compression
Margin compression is going to make it very hard to maintain profit growth. It will be HIGHLY UNLIKELY that the rate of profit growth will be able to be sustained at a rate faster than revenue with cost price push. Additionally we see the following as reported by Business Insider on April 1st, 2011. ISM Diffusion Signal

It might be time for investors to temper their expectations for future equity returns.

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That‘s what the ISM Manufacturing data could be forecasting given its recent correlation with the S&P 500. According to Jeffrey Kleintop of LPL (via Bloomberg) the pace of change in the ISM‘s diffusion index has a very close correlation with the year over year change in the S&P. I went into the Fed database to run the numbers and the correlation is indeed tight:

This doesn‘t spell impending doom, but it does mean the red hot returns of the last few years are likely set to slow. With the diffusion index at its 20 year highs there is a very small chance that we don‘t begin to see mean reversion in the coming quarters. Of course, this doesn‘t mean we won‘t continue to see year over year gains and economic expansion, but it does mean the pace of gains in the S&P will become more muted as expectations of robust economic growth decline.

Editor's Note: The following two articles reflect that trading PE's are adjusting to an expected PE compression as earnings grow at a slower rate than revenues. This does not however mean prices are cheap!

S&P 500 PE Ratios
BACKGROUNDER: S&P 500 PE Ratios Chart of the Day July 15th, 2011

Today's chart illustrates how the recent rise in earnings has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1900 into the mid-1990s, the PE ratio tended to peak in the low to mid-20s (red line) and trough somewhere around seven (green line). Notice how investors were willing to pay much more for one dollar of earnings during the dot-com boom, the dot-com bust and financial crisis. Currently, the PE ratio stands at 16.1 – a level not seen (except very briefly in August 2010) in over two decades.

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Big companies' P-E's shrivel to single digits
BACKGROUNDER: Big companies' P-Es shrivel to single digits USA Today The stock market is trading for a price-to-earnings ratio, or P-E, of 15, meaning investors are willing to pay $15 for every $1 that the average big U.S. company earns. But some major household-name U.S. companies are selling at bargain-basement prices, with P-Es in the single digits. In the benchmark Standard & Poor's 500 index, 47 stocks trade for less than 10 times their earnings the past 12 months, a USA TODAY analysis of data from S&P's Capital IQ found. A single-digit P-E is either a sign investors have low expectations or simply a recognition that the company is growing very slowly. Some examples of stocks with single-digit P-Es include giants Microsoft (MSFT), Chevron (CVX) and AT&T (T), with P-Es of 9.5, 9.7 and 9.0, respectively. "It's remarkable how many bargains there are in the market today" even as the market at large is "reasonably priced," says Jack Ablin of Harris Private Bank. Investors are punishing stocks that fit several criteria, including those of companies that have: •Questionable growth prospects. With a desktop computer on every desk already, some investors wonder where the companies involved in PCs will find growth. That's why Microsoft, Hewlett-Packard and Dell are among the largest companies with single-digit P-Es. •Older and lagging business units. AT&T is at the cutting edge of technology, namely wireless communications, but investors are fixated on the part of the business locked up in the declining wired phone business, says Pacific Crest's Steve Clement. Meanwhile, rival Verizon has a 28 P-E, as it has sold more of its wired business to invest more heavily in wireless. •Exposure to downside of the economy. Energy firms, commodity firms such as FreeportMcMoRan Copper, plus carmaker Ford are seeing their P-Es languish on the concern their earnings could fall if the economy sputters, says Robert Maltbie of Singular Research. Yet the knockdown of stalwart companies shows how many investors have become cavalier, and scoff at solid companies as being too conservative, on faith the Federal Reserve will keep spurring the economy, says Michael Farr of Farr Miller and Washington. If the Fed stops stimulating the economy, "expect to see a rotation back into some of these stocks," he says.

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Reduced Earnings Growth Rates - Need to be Watched Carefully

The Charts Wall Street Doesn't Want You To See On Annual Returns
Editor's Note: Since the truth is the average annual rate of return for the S&P 500 since 1871 has been about 5.63% to 5.85% annually, it begs the question how Underfunded Public and Private Pension plans can assume 8.5% returns with total bond yields even lower than equities. The market must eventually come to this realization. BACKGROUNDER: The Charts Wall Street Doesn't Want You To See On Annual Returns John Riley, Cornerstone Investment Services There are several common myths about stock market returns. Some believe an investor can expect an annual rate of return of 10%. Some say it is 12% and others are as high as 15%. Unfortunately for many investors, they have banked on these myths, investing for their retirements based on getting returns of 10% to 15% annually. If an advisor were to tell an investor that those expectations might be unrealistic, the investor would go to a different advisor that will tell him what he wants to hear. At Cornerstone we do not shy away from reality. The facts are that the average annual rate of return for the S&P 500 since 1871 has been about 5.63% to 5.85% annually. This is a far cry from the 10% to 15% many investors are expecting. The table below shows the annualized return numbers from a 1 year, 10 year and 20 year perspective. It also shows the Median Annual return, which for the 10 and 20 year time frames is significantly lower than the average annual rate of return.

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The problem with these types of numbers is that they don‘t tell the whole story. Averages don‘t tell you what the range of returns and frequency of those return have been. So we did that analysis as well. We asked, ―how often did a certain rate of return occur?‖ The answers are in the charts on the next page. You will see that the odds of hitting a rate of return like 15% or even 10% per year is much harder than you think. What is more interesting is that while the market has had rates of return of 15% or more, over 30% of the time on an annual 1 year basis, it hasn‘t been able to string them together.

When looking at the 10 year chart, you will see that the market achieved an annual return of over 14% only about 3% of the time.

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This is well below 30% of the time the market returned over 15% on an annual basis when measuring 1 year at a time. Over 10 years, the market achieved a return of 10% or better return 20% of the time. Investors that were hoping for returns of 15% or more over the long run may be sorely disappointed.

Since most investors identify themselves as long term investors, they should pay more attention to the long term charts and not the 1 year charts. And the 20 year chart is even more revealing.

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What the 10 year and 20 year frequency charts show is that while certain rates of return can happen in any given year, the market has not been able to string those winning years together over the long run. But this research still lacks something. What is missing is putting these rates of return into further context. We plotted the returns out as they happened and the chart reveals a clear cyclical pattern. The chart below shows the pattern of annual 1 year returns and the average annual returns of 10 year periods. While the 1 year annual return line (blue line) is very random, the 10 year average annual return shows a distinct cycle.

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It was clear that the market was peaking in 2000. What is also clear is that the average annual returns of a rolling 10 year period has hit what appears to be a bottom. But, the normal duration of the cycle‘s bottoming action is 10 to 20 years. So far, the market has been forming a bottom for only about 4 years. It could be 6 to 16 years before the market‘s 10 year average annual return starts to head up again. The smart investor does not ignore the reality of the current markets cycle and blindly chase promises of better returns. Instead, after looking over the hard data, he will lower his expectations to be aligned with what he knows the current environment can deliver. He then implements a strategy (or finds an Advisor with a strategy), based in reality, that will get him through the current cycle and prepare him to reach his long term goals.

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Some Sobering Japanese Comparison Charts from Michael Darda at MKM Partners
Editor's Note: As Zero Hedge points out, even a traditionally optimistic Michael Darda, of MKM Partners, is having trouble discovering the silver lining among the flotsam and jetsam that is the global macro-economic ocean currently. The Japanification theme continues with five charts offering too-correlated-to-be-ignored perspectives on equities, money supply/velocity, valuations/multiples, and demographics.

BACKGROUNDER: Some Sobering Japanese Comparison Charts from Michael Darda at MKM Partners Hedge

Zero

An updated chart of Japan versus U.S. equities is breathtakingly grim. This chart originally ran as a Bloomberg ―Chart of the Day‖ back in August. The chart may tell us what is in store if euro zone policymakers fail to forestall a collapse of Italy/Spain. The ECB's reluctance to even take back the errant rate hikes imposed earlier this year—the least it could do, in our view—is not encouraging in this regard.

A high ratio of liquidity doesn’t guarantee a rise in risk assets or nominal income, as Japan has found out over the last two decades. Tightening credit markets are an ongoing threat to the velocity of money.

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Low long rates have not led to higher P/E ratios in Japan. Moreover, long rates tend to move with expected nominal growth prospects, which is why they have been closely correlated to movements in equity prices over the last several years.

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Like Japan, the U.S. is facing demographic challenges, albeit not to the same degree (i.e., we are not headed for negative population growth). However, the Federal Reserve Bank of San Francisco has done work on equity multiples and societal age distribution (middle-aged cohort versus the old-age cohort) and has found a stunningly close relationship that does not bode well for a rise in earnings multiples from here. Indeed, the researchers note that, ―the actual P/E ratio should decline…to 8.3x in 2025 before recovering to about 9x in 2030.‖

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Are Corporate Profit Margins About To Grind Lower For Another 10 Years? (Reference)
Editor's Note: Cyclical Adjusted PE's suggest that minimally in the short term earnings grow rates must slow. It is difficult to not see taxes increasing significantly on corporations to help address global sovereign debt issues. Even if taxes increases were held back, then fiscal austerity programs, reduced disposable incomes, unemployment levels, labor unrest and stringent regulatory actions will do the rest. BACKGROUNDER: Are Corporate Profit Margins About To Grind Lower For Another 10 Years Or More? Business Insider The corporate margin question usually is framed in the short term. Investors wonder whether margins for the cycle have peaked, thus posing a threat to earnings and the stock market. In a new note, Morgan Stanley euro equity strategist Graham Secker takes a much broader look at the question, while musing that margins could actually head lower for a decade or longer. First, he observes that for 40-years the general direction of margins was down, before bottoming in the early 80s.

He identifies 5 reasons for the 30-year uptrend in margins.  An incredible period for technological advance.  Steadily lower interest rates.  Steadily lower corporate tax rates.  The rise of outsourcing (which is really lowered CAPEX relative to sales).  Lower real commodity prices (a trend that was in place for the first 20 of the last 30 years). Secker offers up all kinds of charts to support each one of those, though they're all fairly intuitive, and it's not too hard to make an argument that there's not much more that can be mined from each one. More outsourcing? Seems doubtful. Nobody thinks interest rates can head much lower. And certainly nobody expects another technological revolution like we saw with computers and the internet since the early 80s.

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Granted, you probably could have made this same argument a few years ago, but the bottom line is that long-term trends to change, and after 30-years of gains, it's probably best to consider the prospect of big structural changes to corporate earnings.

Corporations Have Captured 88% Of All Post-Recession Income Growth (Reference)
Editor's Note: This sort of corporate grab cannot be sustained without major labor unrest. Personal disposable incomes are being steadily reduced. Eventually, corporate margins will be impacted with slowing growth rates. BACKGROUNDER: Corporations Have Captured 88% Of All Post-Recession Income Growth Robert Johnson Business Insider

Economists at Northeastern University have found where the money that once went to company employees has gone. A new study released by the school shows that "corporate profits captured 88 percent of the growth in real national income while aggregate wages and salaries accounted for only slightly more than 1 percent" of growth. The New York Times reports: The study said it was ―unprecedented‖ for American workers to receive such a tiny share of national income growth during a recovery ... The share of income growth going to employee compensation was far lower than in the four other economic recoveries that have occurred over the last three decades, the study found. ―The lack of any net job growth in the current recovery combined with stagnant real hourly and weekly wages is responsible for this unique, devastating outcome,‖ wrote the report‘s authors, Andrew Sum, Ishwar Khatiwada, Joseph McLaughlin and Sheila Palma. According to the Bureau of Labor Statistics, average real hourly earnings for all employees actually declined by 1.1 percent from June 2009, when the recovery began, to May 2011, the month for which the most recent earnings numbers are available.

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Think Stocks Are Cheap? Here's 7 Reasons Why That's A Myth (Reference)
Editor's Note: A nice Summary and Perspective. Also, check out the Morgan Stanley link at the bottom. BACKGROUNDER: Think Stocks Are Cheap? Here's 7 Reasons Why That's A Myth Business Insider A fundamental pillar of the bull case in equities is that, well, stocks are just too cheap not to buy right here, with the S&P trades at 12.7x earnings. In a brilliant note out today, Morgan Stanley's Adam S. Parker, Ph.D plays devils advocate, laying out reasons why the market isn't so cheap. We summarize them:  The PE isn't that cheap. The market is actually in the 43rd percentile of cheapest markets -- not ridiculous by any stretch.  Profit margins are high, so on a price-to-sales ratio, the market isn't that cheap.  Dividend yields remain low on a historical basis.  Most of the cheapness is in the mega-caps. Excluding them, the market is right in the middle of hits historical range (see chart below).  While it's true that cash balances are high -- also a part of the bull case -- a lot of that cash is parked overseas where it can't be touched. Also, because of low interest rates, it's not generating much income.  A rebound in inflation, historically, would indicate further multiple compression.  EPS volatility is also historically tied to multiple compression. Here's the chart, mentioned above, on the EPS gap between the biggest mega caps and the rest of the market.

Ultimately, Parker thinks the multiple could go to just 10x. Combine all this with another bit of analysis from Morgan Stanley -- the case for a secular downdraft in corporate margins -- and it's easy to be bearish on stocks right here.

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Valuation Methodologies

Four Set Consolidated Market Valuation Indicators Continue to Signal Caution
SOURCE: Market Valuation Indicators Continue to Signal Caution dshort.com October 4th, 2011 Here is a summary of the four market valuation indicators I regularly follow: ● The Crestmont Research P/E Ratio (more) ● The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more) ● The Q Ratio, which is the total price of the market divided by its replacement cost (more) ● The relationship of the S&P Composite to a regression trendline (more) To facilitate comparisons, I've adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflationadjusted S&P Composite to its exponential regression. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I'm using as a surrogate for fair value. Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 20% to 41%, depending on the indicator. Three of the four indicators (Crestmont P/E, cyclical P/E and regression analysis) are showing a significant improvement (reduced overvaluation) from last month's numbers. The Q Ratio remains elevated near last month's level. However, as I pointed out in my separate Q commentary, the Flow of Funds data on which the Q Ratio based is increasingly stale. The new Flow of Funds report will be released on September 16th, at which time I'll post a Q update. I've plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read. It also reinforces the difference between the line charts — which are simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart.

Click for a larger image

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The chart below differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the "average"). The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers. In my view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but I've included the geometric variant as an interesting alternative view for the two P/Es and Q. In this chart the range of overvaluation would be in the range of 27% to 52%.

As I've frequently pointed out, these indicators aren't useful as short-term signals of market direction. Periods of over- and under-valuation can last for years. But they can play a role in framing longer-term expectations of investment returns. At present they continue to suggest a cautious long-term outlook and guarded expectations. .

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Crestmont from the Arithmetic
SOURCE: Crestmont Market Valuation Update dshort.com October 4th, 2011 The recent article P/E: Future On The Horizon by Advisor Perspectives contributor Ed Easterling provided an overview of Ed's method for determining where the market is headed. His analysis is quite compelling. Accordingly I have added the Crestmont data to my monthly market valuation updates. The first chart is the Crestmont equivalent of the Cyclical P/E10 ratio chart I've been sharing on a monthly basis for the past few years.

The Crestmont P/E of 17.4 is 27% above its average (arithmetic mean) of 13.7. This valuation level is identical what we saw in the latest S&P Composite regression to trend update and somewhat higher than the 20% above mean for the Cyclical P/E10 (more here). The Crestmont P/E of 17.4 puts the current valuation at the 84th percentile of this 140-year series. Because inflation is a key driver for direction of P/E multiples, I occasionally update this chart twice a month if the mid-month release of the Consumer Price Index marks a significant change in the annualized rate of inflation.

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For a better understanding of these charts, please see Ed's two-part commentary here: P/E: So Many Choices, Part I P/E: So Many Choices, Part II And this article explores a key concept for investment expectations and planning. What "Secular Cycle" Means

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Cyclical PE 10 Ratio
Here is a new update of a popular market valuation method using the most recent Standard & Poor's "as reported" earnings and earnings estimates and the index monthly averages of daily closes for September 2011, which is 1173.88. The ratios in parentheses use the monthly close of 1131.42. For the latest earnings, see the table below created from Standard & Poor's latest earnings spreadsheet. ● TTM P/E ratio = 13.3 (12.9) ● P/E10 ratio = 19.7 (19.0)

The Valuation Thesis A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias. TTM P/E Ratio The "price" part of the P/E calculation is available in real time on TV and the Internet. The "earnings" part, however, is more difficult to find. The authoritative source is the Standard & Poor's website, where the latest numbers are posted on the earnings page. (See the footnote below for instructions on accessing the file). The table here shows the TTM earnings based on "as reported" earnings and a combination of "as reported" earnings and Standard & Poor's estimates for "as reported" earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers. The average P/E ratio since the 1870's has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as the 120s — in the Spring of 2009. In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 34. It peaked close to 47 two years after the market topped out. As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. "Why the lag?" you may wonder. "How can the P/E be at a record high after the price has fallen so far?" The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500. Let's look at a chart to illustrate the unsuitability of the TTM P/E as a consistent indicator of market valuation.

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Click for a larger image The P/E10 Ratio Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected the 10-year average of "real" (inflation-adjusted) earnings as the denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.4. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation. The Current P/E10 After dropping to 13.3 in March 2009, the P/E10 rebounded to an interim high of 23.5 in February of this year but has now declined to a level fractionally below 20. The next chart gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren't especially relevant (e.g., the difference between the monthly average and monthly close P/E10).

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Click for a larger image Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits. Where does the current valuation put us? For a more precise view of how today's P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? The Financial Crisis of 2008 triggered an accelerated decline toward value territory, with the ratio dropping to the upper second quintile in March 2009. The price rebound since the 2009 low pushed the ratio back into the top quintile, although it has now dropped slightly below the 20.8 boundary of the top quintile. By this historic measure, the market is expensive, with the ratio approximately 20% above its average (arithmetic mean) of 16.4. We can also use a percentile analysis to put today's market valuation in the historical context. As the chart below illustrates, latest P/E10 ratio is approximately at the 75th percentile.

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A more cautionary observation is that when the P/E10 has fallen from the top to the second quintile, it has eventually declined to the first quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 540. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its eleventh year. Or was March 2009 the beginning of a secular bull market? Perhaps, but the history of market valuations suggests a cautious perspective. Note: Follow these steps to access the Standard & Poor's earnings spreadsheet: 1. 2. 3. Click the S&P 500 link in the second column of the Standard & Poor's home page. Click the plus symbol to the left of the "Download Index Data" title. Click the Index Earnings link to download the Excel file. Once you've downloaded the spreadsheet, see the data in column D.

Note: For readers unfamiliar with the S&P Composite index, see this article for some background information.

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Q Ratio
SOURCE: Market Valuation: The Message from the Q Ratio dshort.com Octber 4th The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It's a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Flow of Funds Accounts of the United States, which is released quarterly. The first chart shows Q Ratio from 1900 to the present. I've calculated the ratio since the latest Fed data (through 2011 Q2) based on a linear extrapolation of the Z.1 data itself.

Click for a larger image Interpreting the Ratio The data since 1945 is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.102., Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically it is the ratio of Line 35 (Market Value) divided by Line 32 (Replacement Cost). It might seem logical that fair value would be a 1:1 ratio. But that has not historically been the case. The explanation, according to Smithers & Co. (more about them later) is that "the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8%, while the long-term real return to investors is around 6.0%. Over the long-term and in equilibrium, the two must be the same." The average (arithmetic mean) Q Ratio is about 0.71. In the chart below I've adjusted the Q Ratio to an arithmetic mean of 1 (i.e., divided the ratio data points by the average). This gives a more intuitive sense to the numbers. For example, the all-time Q Ratio high at the peak of the Tech Bubble was 1.82 — which suggests that the market

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price was 157% above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.30, which is about 57% below replacement cost. That's quite a range.

Click for a larger image Another Means to an End Smithers & Co., an investment firm in London, incorporates the Q Ratio in their analysis. In fact, CEO Andrew Smithers and economist Stephen Wright of the University of London coauthored a book on the Q Ratio, Valuing Wall Street. They prefer the geometric mean for standardizing the ratio, which has the effect of weighting the numbers toward the mean. The chart below is adjusted to the geometric mean, which, based on the same data as the two charts above, is 0.65. This analysis makes the Tech Bubble an even more dramatic outlier at 179% above the (geometric) mean.

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Click for a larger image Extrapolating Q Unfortunately, the Q Ratio isn't a very timely metric. The Flow of Funds data is over two months old when it's released, and three months will pass before the next release. To address this problem, I've been making estimates for the more recent months based on a combination of changes in the VTI (the Vanguard Total Market ETF) price changes and an extrapolation of the Flow of Funds data itself. Bottom Line: The Message of Q The mean-adjusted charts above indicate that the market remains significantly overvalued by historical standards — by about 41% in the arithmetic-adjusted version and 52% in the geometric-adjusted version. Of course periods of over- and under-valuation can last for many years at a time, so the Q Ratio is not a useful indicator for shortterm investment timelines. This metric is more appropriate for formulating expectations for long-term market performance. As we can see in the next chart, the current level of Q has been associated with several market tops in history — the Tech Bubble being the notable exception.

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Please see the companion article Market Valuation Indicators that features overlays of the Q Ratio, the P/E10 and the regression to trend in US Stocks since 1900. There we can see the extent to which these three indicators corroborate one another.

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S&P Composite Regression-to-the-Trend
SOURCE: Regression to Trend: A Perspective on Long-Term Market Performance dshort.com August 1st 2011. About the only certainty in the stock market is that, over the long haul, over performance turns into under performance and vice versa. Is there a pattern to this movement? Let's apply some simple regression analysis (see footnote below) to the question. Below is a chart of the S&P Composite stretching back to 1871 based on the real (inflation-adjusted) monthly average of daily closes. I've using a semi-log scale to equalize vertical distances for the same percentage change regardless of the index price range. The regression trendline drawn through the data clarifies the secular pattern of variance from the trend — those multi-year periods when the market trades above and below trend. That regression slope, incidentally, represents an annualized growth rate of 1.71%.

The peak in 2000 marked an unprecedented 155% overshooting of the trend — nearly double the overshoot in 1929. The index had been above trend for nearly 18 years. It dipped about 9% below trend briefly in March of 2009, but at the beginning of September 2011 it is 27% above trend. In sharp contrast, the major troughs of the past saw declines in excess of 50% below the trend. If the current S&P 500 were sitting squarely on the regression, it would be around the 918 level. If the index should decline over the next few years to a level comparable to previous major bottoms, it would fall to the mid 400s.

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Rule of 20 (Reference)

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Cyclically Adjusted PE's (CAPE) are Richly Valued (Reference)
John Hussman writes Rich Valuations and Poor Market Returns Last week, the S&P 500 Index ascended to a Shiller P/E in excess of 24 (this "cyclically-adjusted P/E" or CAPE represents the ratio of the S&P 500 to 10-year average earnings, adjusted for inflation). Prior to the mid-1990's market bubble, a multiple in excess of 24 for the CAPE was briefly seen only once, between August and early-October 1929. Of course, we observed richer multiples at the heights of the late-1990's bubble, when investors got ahead of themselves in response to the introduction of transformative technologies such as the internet. After a market slide of more than 50%, investors again pushed the Shiller multiple beyond 24 during the housing bubble and cash-out financing free-for-all that ended in the recent mortgage collapse. And here we are again. This is not to say that we can rule out yet higher valuations, but with no transformative technologies driving the economy, little expansion in capital investment, and ongoing retrenchment in consumer balance sheets, I can't help but think that the "virtuous cycle" rhetoric of Ben Bernanke is an awfully thin gruel by comparison. We should not deserve to be called "investors" if we fail to recognize that valuations are richer today than at any point in history, save for the few months before the 1929 crash, and a bubble period that has been rewarded by zero total return for the S&P 500 since 2000. Indeed, the stock market has lagged the return on low-yielding Treasury bills since August 1998. I am not sure that even members of my own profession have learned anything from this.

Based on our standard methodology (elaborated in numerous prior weekly comments), we presently estimate that the S&P 500 is priced to achieve an average total return over the coming decade of just 3.15% annually. Again, we've seen weaker projected returns over the past decade. But then again, the S&P 500 lost about 5% annually in the decade following the 2000 peak, and even including the recent advance, has achieved an annual total return since 2000 of almost exactly zero. So despite periodic speculative runs, rich valuations have an annoying way of ruining the fun. Equally important, even during extended speculative periods as we observed in the late-1990's,

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those advances have tended to suffer deep and abrupt intermediate-term corrections once elevated valuations are joined by overbought conditions, over-bullish sentiment, and rising interest rates, as we observe today. While we can certainly find analysts who believe stocks are cheap, we can easily test the long-term accuracy of their methods (which often amount to nothing more than applying an arbitrary multiple to forward operating earnings, or dividing the forward earnings yield by the 10-year Treasury yield). Frankly, many of those alternative methods stink. Regardless of whether an analyst claims that stocks are cheap or expensive, they should be expected to provide some sort of evidence that their methods have a strong relationship with subsequent market returns.

Value Line Arithmetic (Reference)

Shiller PE Ratio(Reference)

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Comments on Estimated Forward Operating Earnings (Reference)

Comstock Funds

Many investors are confused when they hear the vast majority of portfolio managers and strategists in the media say that the stock market is cheap while the minority bears assert that it is significantly overvalued. After all, aren't the two sides looking at the same facts? Well, yes and no. The bears look at trailing cyclically-smoothed reported (GAAP) earnings for the S&P 500, a number that we calculate at about $68 for the year ended 2010. The bulls, on the other hand use estimated 2011 consensus operating earnings of $95. On today's closing price of the index of 1283, we calculate the P/E ratio on $68 at about 19 times, while the bulls divide 1283 by their 2011 estimate and come up with a P/E ratio of 13.5 times. Since both sides are aware that the long-term average P/E ratio is about 15 we see overvaluation where the bulls see undervaluation. We have three major problems with the way the majority determines the value of the market. First, operating earnings differ significantly from earnings calculated in accordance with "generally accepted accounting principles", commonly referred to as "GAAP" or "reported" earnings. Operating earnings throw back into earnings a number of expenses considered non-recurring such as severance pay, plant closings, inventory write-downs and any number of other expenses that corporations may want to write off. In the past ten or fifteen years companies have gotten a lot more creative about what items they can write off, and now a large number of expenses that used to be considered normal are called unusual even when these write-offs are taken year after year. In other words, in too many cases what is called operating earnings is pure fiction. That is why we prefer to use earnings calculated in accordance with generally accepted accounting principles. Second, the long-term average P/E ratio of 15 is based on trailing reported earnings, not operating earnings. Prior to the last dozen years of sequential bubbles the 71-year average P/E on this basis was 14.5 (rounded to 15). Operating earnings as they are used today did not even exist until the mid-80s when they came into vogue partly as a means of making earnings look better than they would have under the accepted rules. Since operating earnings almost always exceed reported earnings, often by significant amounts, even if we had such results going back further in history, the average P/E on them would be much lower than for reported earnings. For instance in the last 12 years cumulative operating earnings exceeded reported earnings by 23%. This would be enough to reduce a 15 P/E ratio to about 12. In that case the market would be overvalued even on operating earnings. Third, but not least, estimates of operating earnings a year ahead are notoriously unreliable. In the last 12 years such forecasts have missed the target by an average of 23% in either direction, and some of these misses were laughable. At year-end 2007 the consensus estimate of S&P 500 operating earnings for 2008 was $89. At the end of May 2008, five months into the year, the estimate was still at $89 (see Barron's article May 26, 2008 on home page "What is the Real P/E Ratio?"). Even at the end of October, only two months away from year-end the estimate was at $72. The actual number came in at slightly under $50 just a short while later. The estimate of operating earnings for 2009 turned out to be just as ludicrous as for 2008. In May 2008 the consensus estimate for 2009 was as high as $110. At year-end 2008, when the extent of the credit crisis was already known for months, the 2009 estimate had only come down to $99. It ended up far lower at $57. In sum the use of 12-month forward operating earnings to determine the value of the market can be extremely hazardous. In our view the market is selling at about 19 times reported trailing cyclicallysmoothed earnings, about 26% higher than the average historical multiple of 15, let alone the average multiple of 7-to-10 seen at the bottom of past secular bear markets. At present levels the market is already discounting an optimistic outlook and is highly vulnerable to any of the serious global problems that can come to the fore at any time.

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S&P Earnings Yield versus Bond Yields

The gap between the 10 Year Note Yield and the Forward Earnings Yield is excessive by any historical measure. It must and will be closed with: i) A significant rise in bond yields, ii) A drop in stock earnings, iii) An increase in stock prices, iv) A combination of all these.

NOTE: Chart Updated Quarterly: Last 10/05/11

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S&P 500 TARGETS The market action since March 2009 has been a bear market counter rally that completed a classic ending diagonal pattern on May 11th, 2011. The Bear Market which started in 2000 will now resume in full force, after a broad 'rounded top' formation is completed and cascading weakness across multiple markets is clearly evident. Short Term Rounded Top The short term will be marked by sudden and abrupt changes in trend as part of an extended rounded topping pattern. This is not a pattern to trade, but a pattern to prove that the big move is ahead and to prepare accordingly. Intermediate Term Top

Our target for a short term bottom was 1075 on the S&P 500 with the continuing possibility of a short term throw over to 1030. Time Frame
We presently see this Bear Market counter rally which started in March 2009, having ended May 11th. This does not mean that the S&P has necessarily topped but rather the global financial market has. The S&P will follow and will take 2-3 months more before it is clearly evident. What happened and where we presently stand:

Looking for a Short Term counter rally into Year End

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Longer Term Though we can expect a yearend rally, IF a coordinated response to the European Crisis is rolled out, 2012 and 1013 will be difficult years for the global equity markets.

We can expect a retest of the March 2009 lows within 18 months.

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NOMINAL v REAL MARKETS If you haven't already, I recommend you read my article: Debt Saturation & Money Illusion. or listen to the Global Insights Audio recording of August 3rd, 2011 found on the www.gordontlong.com/Global_Insights.htm web page. They are illustrative of the fact that is critical to consider the market denominated in real terms. As such we need to look at the market priced in hard assets. Additionally, we need to consider the direction of the US dollar as well as interest rate differentials which directly affect the movement of the US dollar. REAL MARKETS The S&P 500 when denominated in Gold shows that the market is actually down from its nominal low in October 2008.

Though on a weekly basis the S&P 500: Gold ratio maintains a close correlation with its 40 week moving average we have shown the relationship to Fibonacci above. We are comparing above the 13 to 34 to 89 simple moving average Fibonacci numbers.

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The S&P 500 : Silver ratio demonstrates a much different profile since August 2010 when Chairman Bernanke signaled Quantitative Easing II was in the.

The plunge has been dramatic with a parabolic move upward in Silver. Silver as both a precious metal and industrial product has a much different demand / supply profile than Gold.

The WTIC and the CRB denominated S&P 500 below indicate similar profiles.

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COMMODITY CORNER

GOLD Continuous Contract
The Fibonacci Count and Extension suggests Gold should soon head towards $2,200/Oz.

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SILVER Continuous Contract

We have a classic Elliott Wave pattern in Silver This suggests we are near Wave 4 lows and should soon begin a final wave 5 up towards new highs in Q1 2012.

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CURRENCY CORNER

US DOLLAR INDEX
The US dollar has staged an impressive rally, no doubt the direct result of the 'flight-to safety' trade stemming from the European Sovereign and Banking Crisis. This move is not finished, however it is time for a relief rally as shown by wave #4 below.

The move in the dollar is presently more associated with Euro problems and the slowly unwinding Yen Carry Trade. I would expect to see the Euro substantially weaker into Q1 2012 as the crisis in the EU comes to a head and the 'mindless' programs of 'kick the can down the road" are forced to be addressed.

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US TREASURY MARKET

Exactly how low can US Treasury Yields Go? It would not surprise me now that the 10 Year UST has traded to 1.80 that it eventually finds drops during the Euro Crisis towards 1.00.

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CONCLUSION Bloomberg put out the following chart in August which MKM Partners have recently updated to reflect the US Market decline since early August. The eerie similarity to Japan is now clearly evident.

Global statistics were recently published by the Financial Times in London which shows the global slowdown is now confirmed.

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The US ECRI Leading Index is suggesting the slowdown borders on being more violent and abrupt than anything since the 2008 collapse.

Consumer Credit in the US startled analysts on October 7th with a negative 9.5B decline on expectations of $8B increase. Both Revolving Credit fell -3.4% as did non-revolving credit at a stunning -5.4%.

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The coincident to lagging ratio (shown below) has proved to be an incredible leading indicator. When an expansion is nearing its final stages both sets of indicators will be rising, but the increase for the coincident will be slower than the lagging, hence the ratio will fall. As of 8/31 data, this ratio has now fallen for FIVE months in a row. As the chart shows, a pretty high correlation (~93%) exists between this ratio and stock prices.

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If we then consider the following Earnings Momentum chart, we have yet another indication that we should expect further ongoing weakness in the equity markets.

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Elevated Risk The market action since March 2009 is a bear market counter rally that has completed the classic ending 5 Wave 3-3-3-3-3 diagonal pattern we have been predicting since March 2009. The Bear Market, which started in 2000, will resume in full force once a broad 'rounded top' formation is completed with cascading weakness across multiple markets presently being clearly evident. The rounded top formation is not yet completed. We are now in the midst of a Global 'rolling top'. We are seeing broad based weakening analytics and cascading warning signals. This behavior is typically seen near major reversals. It is all part of a final topping formation and a long term right shoulder technical construction pattern. I expect the rounded top to be shown to have been centered on the markets June 17th Quadruple Witch. It will take a further 1-2 months to complete. Rounded Top patterns are extremely difficult to trade as trading reversals are significant and frequent with high volatility. This adds to the confusion about market direction. The market behavior should be viewed as the market forces being in the process of systemically changing balance. It is very typical of major reversals. They are protracted affairs.

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SHORT TERM We are presently completing Wave four of a five wave set down.

TARGETS We expect the five wave set down to find support around 1075 with the possibility of 1030

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Gordon T Long Publisher & Editor
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Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that you are encouraged to confirm the facts on your own before making important investment commitments. © Copyright 2011 Gordon T Long. The information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities. Please note that Mr. Long may already have invested or may from time to time invest in securities that are recommended or otherwise covered on this website. Mr. Long does not intend to disclose the extent of any current holdings or future transactions with respect to any particular security. You should consider this possibility before investing in any security based upon statements and information contained in any report, post, comment or suggestions you receive from him.

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