Saturday, February 17, 2018

Has the Fed Made a New Bear Market Possible?

Before we discuss the present, we need to lay some groundwork; a look backward to help us look forward.  In 2013, we had a similar -- albeit 180 degrees reversed -- situation, so let's begin there.

On January 14, 2013, I published an article titled A Survival Guide for Bears in a Bulls' WorldI wrote that article because a lot of my readers were bears at heart, but many of the charts I studied pointed the other direction, toward a massive bull market.  The technical charts had set themselves up into what seemed to be a large "bull nest" (a series of first and second waves pointing higher).  Since the third wave is often the longest and strongest, a bull nest is a "launch pad" pattern.  In addition to that, the Fed was beginning to pump unprecedented amounts of liquidity into the market via "QE Infinity" (a term I coined, incidentally, when I was writing for Minyanville -- and which many others have used since).

Over the subsequent weeks of early 2013, I outlined my long-term targets for the S&P 500 (SPX), which pointed to the potential of a strong bull market and substantially higher prices.  And the fundamentals backed up the chart projections. 

Now, when I say "fundamentals," I don't mean irrelevancies such as the actual economy (only professors are naïve enough to believe the stock market is driven by the real economy) -- I mean the only "fundamental" that has actually mattered to the stock market over the past couple decades: 

The Federal Reserve. 

When the Fed (and other Central Banks) are creating unprecedented amounts of money from thin air, as they were doing from 2009 to 2014 (and beyond), then asset prices almost have no choice but to rise.  Asset markets are all driven by the simple laws of supply and demand -- so excess cash (liquidity) equals excess demand.  More demand than supply equals rising asset prices.  When the Fed is printing as much money as they were, then huge pools of cash all end up chasing the same resources -- stocks, bonds, real estate, etc. -- and that drives prices higher, because it must.

Combined with the Elliott Wave patterns, it wasn't hard to see that stocks probably had no choice but to rally in such an environment. 

Thus I tried to warn bears about that pending bull market... but to my surprise, many bears didn't like that.  Many didn't want to hear it at all, in fact -- and the bullish articles I was writing in early 2013 were, at the time, anyway, some of the least popular articles I had ever written (!).  Those articles actually cost me some readers. 

Of course, now everyone looks back and views those bullish predictions in a much different light.  But when I was publishing them in real-time, they were quite unpopular-- to the point that for a while, I had to spend time looking for small turns against my always-bullish big picture outlook, just to give my bearish readers something to do.

I suspect the articles I've been writing more recently will be similarly unpopular with bulls.

Because here's the thing:  Nearly 5 years later, the charts finally began to give signals that the bullish move might be getting close to exhausting itself.  On October 4, 2017, I wrote:

Given the structure of the entire wave, there is a genuine possibility of an extended fifth wave, so bears are going to want to be careful...  We have to be aware of the potential for an extended fifth, which, outside of technical analysis, is also known as a "blow-off top." 

In Elliott Wave, the fifth wave (extended or otherwise) is always the final move before a correction.  As time progressed, while the near-term waves kept pointing us toward higher prices, it became obvious that the extended fifth wave was indeed underway.  On December 18, 2017, I concluded the update with:

A few months ago, I began talking about the possibility of an "extended fifth blow-off top," and it appears that's what we're now unwinding.  These can be very difficult to trade if you're a bear, but they're gobs of fun (for as long as they last, anyway!) if you're a bull.  The thing about extended fifths is that they do tend to retrace rapidly -- so once this ends, it's going to catch a lot of bulls by surprise.  

We continued looking for higher prices virtually every day -- up until January 31, that is. 

The main reason I'm mentioning all this is to provide perspective and lay the groundwork for the remainder of this article, by establishing two points:
  1. The Federal Reserve is a force to be reckoned with, and their actions can help point the way toward the market's future -- as we've seen time and again.
  2. I am not a "perma-bear."  To the contrary, despite the fact that I've always believed the massive money printing from the Fed would all end badly (and despite a few near-term hiccups along the way, where I sometimes thought additional near-term downside was forthcoming when none was), I've remained long-term bullish pretty consistently for the past 5 years.  So if I say "look out below" now, it's not coming from an unbending bearish bias (truth be told, I've grown rather fond of trading this bull market and would prefer a bear market to wait!  But the market doesn't care one iota about what I want.)

Finally, there is one last piece of groundwork that needs to be laid:  On October 30, 2017, I penned an article that I consciously intended as the final chapter of a book that began with January 2013's bullish "Survival Guide for Bears in a Bulls World."  I was aware that I was writing this bearish "reality-check" article a bit prematurely -- but I did so intentionally, because, as I wrote in the article itself:

I have recently become aware that there seems to be an entire generation of new investors who have absolutely no idea what's been going on

They apparently think the 2009-present bull market was driven by... I don't even know what.  Magic fairies or something.

So I don't want everything to come as a complete shock to them when it starts getting real.  The time for education isn't in the midst of a crisis, it's beforehand.  And again, don't get me wrong, I'm not saying that's going to happen tomorrow.  But forewarned is forearmed.

How many of us have read the fresh horror stories of people who were wiped out by the massive recent spike in the VIX (Volatility Index)?  I believe those traders could have lived to fight another day, had they only been forewarned of the danger before things "started getting real."

Anyway, this "bearish bookend" article I'm referencing is titled: The Acrobats:  Why the Central Bank-Driven 'Prosperity' Must Eventually End.  If you're not familiar with it, it discusses the role of Central Bank liquidity in the modern market, why that intervention leads to "unintended consequences" and inevitable problems (including negative impact on businesses) -- and it discusses some of the basic foundations that underpin the rest of this discussion.

Instead of waiting here patiently while everyone runs off and reads it (I'm on a tight schedule!), let me briefly quote one of the key points of understanding from that article:

Bull markets do not come about because of “good economies” (although they can). Ultimately there is only one thing that drives a bull market:


When there is extra cash floating around (liquidity), then some of that cash finds its way into the market. That means more buyers. More buyers than sellers means a rising market. Sometimes extra liquidity is the sign of a healthy economy (which is what has led to the thinking that "good economies create bull markets").  But in today's world, sometimes the extra liquidity has nothing to do with the fundamentals of the economy.

To better understand this concept, Americans might consider looking around and asking themselves: “Is the real economy significantly better than it was in, say, 1997?”

Most who lived through that time would answer “No, it’s not.”

Yet the S&P 500 is currently trading at roughly double the highest price of 1997 even after being adjusted for inflation.

If the above concept is foreign to you, then I suggest reading the entire article when you have time, because the topics it discusses are necessary in order to truly understand what is going on in the world right now, in the present -- and into the future.  And why.

Let's get back to discussing the market for a moment:

While we were on the right side of the trade for the rally, we were also well aware that when it ended, it was at least possible that this would kick off not merely a "correction," but a cyclical bear market, in the form of a high-degree fourth wave. 

However, that cyclical bear would probably still come in the context of a secular bull market, and would likely not be the final end-all to the bull market that began in 1982 -- though it would almost certainly trim current valuations substantially, amounting to collective trillions of dollars of "paper profits" being destroyed in investors' stock portfolios.

This is what the technicals (the charts) were/are telling us. 

But what are the fundamentals saying?

To learn that, we have to look at what the Federal Reserve is doing now.  Because what they're doing now is very different than anything else they've done since 2009.

Back in September, I briefly discussed (in a very tongue-in-cheek manner) when Janet Yellen announced that the Fed would begin to shrink its balance sheet, a process which the Fed calls "normalization." 

If anyone doesn't already know this, at present, the Fed has a monster balance sheet, unprecedented in history.  The chart below is from the Fed's own website.  It doesn't look so bad at first glance, because they put M next to the dollar amounts, leading you to think these are "millions of dollars" -- however, at the bottom they disclose that these millions of dollars are themselves measured in millions of dollars!  So this scale is "millions of millions" (cue Dr. Evil clip). 

Meaning that the Fed's total assets number in the TRILLIONS of dollars (over $4 trillion currently).

You can see that pre-2008, the Fed was carrying less than a trillion dollars on their balance sheet.  But between then and 2015, their balance sheet more than quadrupled.  This is a large part of what bought us that wonderful "can't go wrong" bull market of the past 9 years.

You can also see that their balance sheet has remained largely flat until very recently. 

However, in October, they finally began rolling off $10 billion per month.  The market initially had no trouble absorbing that drain, in light of the bullishness surrounding the Republican tax cut, foreign capital influxes, and ma and pa investor finally "getting back into stocks" (the market recently saw record levels of mutual fund and ETF inflows -- $58 billion from late December to January 19, for example.  This type of thing often happens near market tops.).

In January, the Fed doubled their roll-offs and began draining $20 billion per month from the banking system.  And that gave us a 10% drop in the stock market in less than two weeks.  The fourth fastest 10% drop in the entire history of the stock market, I might add.  The pundits who are treating this as if it's a "normal," healthy run of the mill correction either haven't been paying attention, or don't know their own history.  Or both.

And here's the thing:  The Fed plans on accelerating the amount they're draining from the banking system each and every month from here on out, until the amount of this "reverse cash flow" reaches $50 billion per month in October 2018.  In addition, they seem intent on continuing to raise interest rates.

If a $20 billion drain gives us a 10% "correction," then what will a drain of $50 billion per month give us?  A true crash and/or a bear market? 

Well... quite possibly.

This will, after all, represent the most aggressive Fed tightening program in history.

The problem is, as I've argued for years, we are in uncharted waters.  None of this has ever been attempted before -- so we don't really know how this story ends.  The level of Fed intervention from 2009-2014 was unprecedented; so, of course, the drain the Fed is now attempting is likewise unprecedented.

Before I discuss this further, let's look at a chart, because the fundamentals and the technicals seem to be aligning.  The chart below is the long-term count I've been operating from over for the past several years.  So far, it has played out rather well, having reached (and slightly exceeded) October's target -- which then generated a reversal, exactly as the chart suggested it would.

Here's how the chart looked in October:

And here's how it actually played out (basically perfectly -- so far, anyway):

(Note:  Chart below is from Feb. 11, when I originally intended to publish this; we've since reached the beginning of the blue projection line, where the market presumably heads lower again.)

I'm showing that chart because it's relevant to my thesis on how everything fits together.  Below is a basic outline on my Theory of Everything.  My thesis is basically the market equivalent of Unified Field Theory:
  1. I have long-argued that, from a technical standpoint, we seemed to need a large fourth and fifth wave to fulfil this wave structure.  On the chart above, that fourth wave is represented by Red 4 and 5. 
  2. I have also long-argued that the Central Banks (CB's) would likely cause Red 4 -- probably through some mistake or miscalculation (I actually first developed and presented this theory years ago, while QE was still underway).  We may be witnessing the beginning of Central Bank action directly causing Red 4 now. 
  3. I have likewise argued that the CB's would then also cause the Red 5 recovery rally. Once they realize their mistake, they are likely to overcompensate, and flood the market with liquidity once again.  That's how the Fed seems to work, after all:  They seem to realize everything on a delay, as if nobody there has the faintest clue how all these puzzle pieces fit together.  (They tend to be late in recognizing both recessions and recoveries.)
  4. The same Fed actions that cause the Red 5 rally to new highs (presumably more "easy money" policies) are going to drive us further into the territory of the unprecedented.
  5. Red 5 could even come about via some form of hyperinflation, depending on the Fed's reactions, and the market's reactions to the Fed.
  6. When Red 5 finally ends, we are going to experience a bear market of truly epic proportions, as the massive imbalances created in the system will need to be rectified -- likely destructively.  As Friedrich Hayek said: "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."
Let's examine a few implications of my thesis.  The biggest implication can be boiled down to one simple sentence: 

The Fed is already trapped by the monster they created during 2009-2014. 

They just don't know it yet.

If they unwind the monster, the market will tank.  In fact, several markets will tank -- likely bonds, stocks, and real estate, among others.  If they try to salvage the market, then they will drive us further into "bubble" territory, because the only way to keep a bubble expanding is to add more air.

However, there is one way out of the trap they've laid for themselves... but it's one most of us prefer not to consider:  Rapid inflation.  And/or hyperinflation.  I don't know if they'll choose that route, if the market will choose it for them, or if they will avoid it altogether.  (I hope the latter.)  

But the Federal Reserve and Treasury both love inflation.  In fact, they need inflation.  Because inflation lets you pay back yesterday's debt for much less money, by using today's dollars.  For example, $1 in 1980 currency is equal to about $3 today -- so for every dollar you borrowed then, you'd only need to pay back the equivalent of 33 cents today.  Thus, if the Fed had a $4 trillion balance sheet back in 1980 and had done absolutely nothing since, then that balance sheet would have already shrunk by $2.66 trillion in relative terms.  They would really only need $1.33 trillion-worth of 1980 currency ($4 trillion in today's dollars) to clear it entirely.  ("Only," he says.) 

In other words, they would have basically gained $8 trillion for "free" ($4 trillion spent in 1980 is equal to $12 trillion spent today) -- through The Miracle of Inflation. 

Except it's not free.  It's paid for by the American people.

See, inflation is a silent tax on We, the People.  Each time the Fed prints more money, that money gains its value in part by stealing value from all the other money in circulation.  In other words:  Every time inflation ticks upwards, your liquid net worth ticks downwards. Some of your money was just stolen from you, courtesy of the Federal Reserve's printing press. 

But there's no new Boston Tea Party for this silent "taxation without representation," because most people don't realize what's going on. 

So there's the whammy.  And that might be what brings us Wave 5 -- above average levels of inflation, courtesy of some new "emergency, one-time program" the Federal Reserve will create near the bottom of Wave 4, the way they created Quantitative Easing near the bottom of Wave 1 (the bottom was March 2009 at 666 SPX -- which has always struck me as an oddly-coincidental price point).

A scary thought to consider is that an extended fifth wave (should one materialize) at Primary wave degree (as represented by Red 5 on the chart) would cause the market to nearly triple from current prices.  If that were to happen, then it's hard to imagine that coming without large doses of inflation.  Please don't panic too much yet, though, because I can't predict a fifth wave extension from this far out; I can only make such a prediction sometime after the fifth wave actually begins, which it hasn't done yet.  This is not "officially" part of my long-term thesis; I'm mentioning it simply because it's always valuable to be aware of the possibilities.  

But Wave 5, no matter which route it chooses, will only drive us higher into the already-rarefied air -- which means we'll have that much farther to fall when it finally ends.  And it must eventually end, for reasons I discussed in The Acrobats article.
The amazing thing is:  We may be witnessing my long-time thesis unfold, both technically and fundamentally, starting right here and now.

But this is the trickiest part.  Finding the beginning was easy, because the Fed shouted from the rooftops that it was going to print money for however long it took (hence my term "QE Infinity") to reflate the stock market bubble, and they did exactly that.

Finding the end is a little tougher, because there are factors such as foreign capital influx and so forth that could help markets absorb the current liquidity drain, or at least cushion it.

I suspect my thesis is correct (obviously, or I wouldn't have formed it!), but I'm not 100% certain on the "starting right here and now" part.  Perhaps they can kick the can a bit farther down the road.

Hence, now I'm going to play Devil's Advocate against myself, and rain all over the idea that it's already begun -- because one thing I try to avoid is complacency in my own theories.  I learned long ago that getting tunnel vision as a trader is a sure-fire way to go broke.  Confirmation bias is one of worst potential enemies in market analysis, so we must always strive not to merely "see what we want to see" in all the ways that agree with us, but to instead see what's really there.

The first thing we need to be aware of is that, from a technical standpoint, this drop has done nothing more than back-test the prior breakout.  On the chart above, the upper red trend line represents the long-term bull market that (in the Nasdaq, anyway) began in 2002.

All the decline has done so far is drop back down to test that trend line -- and so far, that test has held.  That's all that's "really there" right now.  And it's not even an unusual thing to see.

So we need to be aware that if that trend line continues to hold, then that would actually be a bullish signal, not a bearish signal.

There are similar breakout patterns on other major indices (the Dow Jones, the S&P), and they've all done essentially the same thing (back-test their breakouts -- but not whipsaw their breakouts... yet, anyway). 

In other words, it's a little premature to know yet if Red 4 has actually begun or not.  There is room in the charts for this to be a lesser degree fourth wave, so perhaps Red 4 gets delayed a while longer.  The market often has a way of pushing things out just a little farther than you sometimes think (although, it's already done that to most people, and maybe that's enough -- we happened to be on top of the last rally and turn, so it didn't run farther than we thought... yet.). 

Anyway, I can't entirely rule out the possibility that this back-test will hold, which could lead to a rally back up to new highs.  All the evidence points to the idea that it won't, but market analysis is never 100% clear-cut.

The best we can do in market analysis is try to parse probabilitiesThere are no guarantees, ever. 

I am inclined to think that the probabilities favor the idea that Red 4 has indeed begun (or is very close to beginning) -- but I can in no way guarantee that yet.  Despite the huge and fast drop we just experienced, from the perspective of the pattern itself, we are (at best) still in the early stages of a turn, and there's just not much to go off of yet.  If we are instead witnessing a fourth wave at a lesser wave degree, then that could represent what Wall Street calls "a correction" as opposed to "a bear market."

Depending on what the market does next, I should be able to assign additional probability to either scenario.

Thus, if you take away nothing else from this, at least take away this much:  I suspect Red 4 has begun, but I can only assign a probability of maybe 55-60% to that at this early stage in the game.  The red trend line on the chart above is important to the bull case.  If the market sustains a breakdown below that trend line, then that will suggest a whipsaw of the breakout.  And whipsaws can be very bearish. 

If it doesn't -- well, we just discussed that.

Thus, a sustained breakdown of the upper red trend line is the first signal we'd like to see, to help confirm the intermediate-term bear case.

In early favor of the bear case is an apparent impulsive decline from the all-time highs.  That impulse suggests the market needs at least one more impulse to new lows, ideally to break the min-crash's low.  Typically that second impulse is at least equal in length to the first impulse, which (if we peak near current levels) would send the SPX down toward 2400.

A standard Fibonacci extension of 1.618 would send it down to the low 2200's -- and all that can still happen within the context of a lesser degree fourth wave (although at that point, Wall Street would call it a "bear market").

A true new bear market by my definition (an intermediate or long-term downtrend) could see the market ultimately trim most (or all) of the gains we've had over the past two years, and possibly more.

So, all that said, we always need to know our exit.  In the event the market sustains a breakout over the all-time highs from here, then we would have to rethink the timing of all of this.  I'm favoring the idea that it won't do that, and, as discussed, believe there will be at least one more "mini-crash" type wave down of at least equal or greater length to the first drop.

Incidentally, I didn't use as much Fed data as I initially thought I would when I began this article -- had I done so, I would have drawn heavily from the work of a friend of mine named Lee Adler.  (Prior to beginning this article, I emailed Lee to ask his permission to reprint some of his data -- which I never did -- but I feel obligated to give him a shout-out anyway!)  If you're looking for detailed data on what the Federal Reserve is doing week in and week out, then no one tracks that better than Lee.  I would recommend checking out his site (The Wall Street Examiner) if you're interested in learning more.

In conclusion, we may be witnessing the early stages of a decent bear move, and the fundamentals support the charts in this regard.  If we're not, then we have a fairly clear line in the sand to watch -- a brief break of the all-time highs would be okay, but a sustained breakout would suggest bears need to move back into "watch and wait" mode.  I am currently favoring the idea that this decline has farther to run -- but I'm far from infallible, and this market has behaved as an oulier both on the way up and on the way down, so there are no easy calls here.  Thus I will continue watching for any signals that could prove my preferred outlook to be wrong.  Trade safe.

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