Clif Droke
June 30, 2008
©2002 - 2008 Publishing Concepts

RBS issues crash warning: should we believe it?

Equities were under more selling pressure this week and by Friday’s close some of the major indices were testing the yearly lows or falling below it. The Dow 30 index closed at a new low for the year on Thursday, June 26, and was on its way to another low on Friday as of this writing. The S&P 500 Index (SPX) was testing its March intraday low on Friday.

On a relative basis, the NASDAQ sector has fared much better than either the Dow 30 or the SPX. The NASDAQ 100 index (NDX) still has a lot of leeway between its current level of 1,836 and its March low of 1,690. However, the NDX violated its 60-day moving average on a closing basis last week, which obviously is a negative sign for the near term outlook.

The S&P 400 Midcap Index (MID) also broke below its 60-day trend lin and was recently quoted at 820. Up until recently it had been a relative outperformer compared to the Dow and the SPX and is still closer to its high for the year than it is its March low (see chart below).

Then there’s the growth stock sector which was showing even more relative strength than most major sectors up until this week. The growth stock ETF (symbol PIV) has just violated its 60-day moving average yet but has still held up better than most broad market indices.

The stock market isn’t the only place showing cross currents. Some areas of the economy are faring much better than others in this year’s slowdown. In his latest Business Outlook column for Businessweek, James C. Cooper observed that in spite of modest payroll declines in 2008 and obvious weakness in the housing and banking sectors, funding for operations and expansion in the non-financial sectors don’t appear to be a problem despite the prevailing credit worries. He also pointed out that April orders for capital equipment other than aircraft rose to a 1 ½-year high and was well above the first-quarter average. He also mentioned that “April outlays for business construction rose strongly for the third month in a row despite concerns about tighter standards on commercial mortgages.”

In a recent CNBC interview, real estate mogul Donald Trump told the interviewer that this was the most complex economy he has ever seen in his long career. It has been characterized by global interdependence, extreme volatility and relative outperformance and underperformance among the major market segments and industry groups. Airlines, automakers, homebuilders and financial institutions have suffered. On the other hand, many non-financial industries and service sectors have performed on par for the year considering the weak economy. As we saw in the opening paragraphs, this mixture of strength and weakness is also quite evident in the equities market.

To what can we attribute these extreme cross currents? It will come as no surprise to most of you that the cycles are the main culprit here. Consider that this year the 6-year cycle is bottoming, the 12-year cycle is peaking, the 10-year cycle is still up while the various interim weekly cycles are also at odds with each other. It’s a veritable zig-zag pattern of cycles going up-down-up that hasn’t been seen in most of our lifetimes.

I asked my friend Samuel “Bud” Kress, the discoverer of the Kress cycle series, when the last time such a cyclical configuration occurred. He informs me it hasn’t been seen since the late 1940s. At that time the U.S. economy was transitioning from a war-time into a peace-time economy. The transitional stage was characterized by a flat stock market as the market and the economy prepared to enter its long-wave boom phase. This time around the transition is also taking a lateral appearance as the economy transitions, longer-term, from a peace-time economy to a (most likely) war-time economy as we enter the next decade. Instead of preparing for a long-wave boom, we’re on the cusp of a long-wave bust once the 10-year cycle peaks in later 2009. Once again we can see the old reliable “Rule of Alternation” coming into play.

The weight of evidence points to continued weakness in the near term. The 4-week cycle has peaked, another more important short-term cycle bottom next week. Finally, there’s the all-important 6-year cycle bottom scheduled for later this summer. The cycles have certainly made for rough sledding in equities this summer.

Once second quarter earnings start coming out from here, and assuming those earnings are negative, we’ll have another potential trouble phase which could end up being the final low for the year by the time the interim weekly cycle bottoms at the beginning of August. I don’t think we should get too caught up in “what if” scenarios at this point; instead we should continue taking things one week at a time as the short-term indicators dictates the directional bias.

Although things look bad for stocks right now, some observers think things will be even worse for the broad market. One particular scenario that has been getting a lot of mainstream publicity of late is the stock market crash warning published by the Royal Bank of Scotland (RBS). Here’s an excerpt of what RBS had to say in a release earlier this week:

RBS issues global stock and credit crash alert
By Ambrose Evans-Pritchard

“The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

“A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank’s credit strategist.

“A report by the bank’s research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as “all the chickens come home to roost” from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

“Such a slide on world bourses would amount to one of the worst bear markets over the last century.”

I don’t share the Royal Bank’s extreme gloom over the stock market, at least not to the extent that they’ve predicted. Normally when bearish warnings of this sort are highly publicized it means we’re very near some sort of major bottom. In this case I’d say “very near” is tantamount to the anticipated interim cycle bottom around the beginning of August. The bottom line is I don’t recommend swallowing the ultra bearish pill the RBS is peddling.

Back to the here-and-now: the hi-lo differential readings on the NYSE have been strongly negative. There were in excess of 300 stocks making new 52-week lows on Thursday and the recent internal weakness reflected in the hi-lo differential has caused the 60-day HILMO indicator to go into negative territory as of Thursday, following on the heels of last week’s plunge into negative territory on the part of 30-day HILMO.

The 30-day HILMO indicator, which signifies the dominant short-term internal momentum for the broad market, has also crossed under the 60-day HILMO, which is technically a bearish crossover signal. We’ll need to see some improvement from HILMO before we have the next confirmed buy signal. For now conservative investors should remain on the sidelines while the more aggressive traders are selectively short.

--Clif Droke
clif@clifdroke.com

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