"The target is marked by the burning LOH."

When I was an reconnaissance helicopter pilot in the Army many years ago, that was a popular saying that was passed down by the more experienced pilots, some of whom had flown during the Vietnam War.  It was meant to convey our own frailty, and the foolishness of being too eager about finding the enemy's location.

LOH back then stood for Light Observation Helicopter, either a Hughes OH-6 Cayuse or a Bell OH-58.  It was pronounced as "loach".  They were 4-seat commercial helicopters that were bought by the Army and adapted for use in scouting for enemy forces.  A pilot had little more than his eyes and his wits as weapons, and the .040" aluminum skin and Plexiglas windows were not much protection from enemy fire.  The idea was to fly low, using the terrain for cover and concealment, and try to find the enemy so that fighter planes or attack helicopters could be called in to deliver ordinance on the enemy's position. 

But given the fact that enemy soldiers are usually not stupid, and don't want to be spotted, often the first indication that a pilot had located the enemy's position was that he was taking fire from the enemy.  A lot of them got shot down.  So then another helicopter crew would step in to radio the fast movers and guide them into the target.  The fighter pilots would acknowledge that call, and the existence of enemy fire in the area, and then ask:

"Roger, how is the target marked?"  The question was about the possible use of colored smoke, landmarks, or other features that can be seen while zooming in at 500 MPH. 

And the answer would be, "The target is marked by the burning LOH."

There is a corollary to this in the financial markets.  Quite often at the end of a big price move, we learn about a big institution blowing up because they did not think that the trade would go so far against them.  The 2006 case of Amaranth Advisors would be a classic example, with its bankruptcy in late 2006 marking the bottom for natural gas prices ahead of the big commodity bubble in 2008.  There were several portfolios that blew up at the top of that bubble.

In this week's chart, I have labeled several notable news events that served as markers of important turns for T-Bond prices.  Back in 1994, Orange County, California went bankrupt because its treasurer, Robert Citron, had overextended his bets the wrong way in the bond market.  That bankruptcy marked the bottom for the big price decline.  Orange County was the burning LOH. 

In late 1998, the money management firm Long Term Capital Management (LTCM) famously made huge bets on T-Bonds that were based on the limits of how far price moves had historically gone in the past.  And the market taught them a lesson about how trends can persist longer than one can stay solvent.  The Federal Reserve had to intervene, lining up several major banks to help take apart LTCM's positions and keep it from cascading into a bigger problem.  LTCM's collapse was the burning LOH for that up move. 

More recently, the collapses of Bear Stearns, Lehman Brothers, and MF Global each coincided with peaks in bond prices.  Each was the burning LOH for its particular moment in history.

So now this week, we find out that J.P. Morgan Chase (NYSE:JPM) has suffered a $2 billion loss on financial derivative bets that went bad.  And this news comes as T-Bond prices are once again getting back up to the price levels seen at last year's MF Global collapse.  The implication is that the news of JPM's big loss is serving as the "burning LOH" of this current time frame, and the news arrives just as the stock market is about at the end of the corrective period suggested by both our eurodollar COT leading indication and the Presidential Cycle Pattern.  Subscribers to our twice monthly newsletter and our Daily Edition have been watching the current stock market correction unfold pretty much right on schedule relative to those models, and now we have a portfolio blowup to help mark the beginning of the end of that corrective process. 

When every other segment on financial TV is about the question over whether to "Sell In May And Go Away", it is natural to wonder whether the belief in seasonality has become overdone.  When everyone believes in something so thoroughly, especially about the stock market, can it still remain valid?

If you were to average together the market's performance in one year chunks of time, it might look something like this week's chart.  It is made up by averaging together the performance of the DJIA each year from 1976-2007.  I throw out 1987, just because the magnitude of the up and down moves that year tend to drown out the other voices to an extreme extent.  I also prefer not to include the most recent years, when the Fed has had its foot on the neck of the financial markets.  If you want to get an average picture of what "normal" looks like, don't include the abnormal and steroid-enhanced. 

The first point that jumps out at you about the Seasonal Pattern is that the very old saw about "Sell In May And Go Away" is off by a month.  The average seasonal pattern really tops out in June, or at least that has been the case since 1976.  This may be a change from earlier years when traders vacated New York City at the earliest opportunity to head to "the shore" in May and stay away for the entire unbearable muggy summer.  Now, thanks to the insights and advancements of Willis Haviland Carrier, traders can stay in New York and toil away well into June.

So the old saying about "Sell In May..." ought to get updated to "Sell In June, and, um, (something witty that rhymes with June)."  It is not quite as satisfying this way, which perhaps explains why the old version persists. 

So, now we know that we should not sell in May, if we are to believe the historical pattern.  But here's the problem: the current market is off schedule by a week.  If we were to align the current DJIA pattern with the average seasonal pattern, it does not come out quite right.  I've found that I have to offset the pattern by a week just to get the structures to line up.  And once I make that adjustment, they line up quite nicely:



The implication is that the current market is running a week behind schedule.  You can insert your own joke here. 

The further implication is that prices should keep on trending higher through June and into July.  That's if you believe the annual seasonal pattern.

The truth is more complicated, and it boils down to this: It's different in an election year.  



This chart of the Democratic Presidential Cycle Pattern substitutes the Seasonal Pattern's 1-year chunk of time for a 4-year chunk, averaging it together in the same way, but with a twist.  In this version, I am including 4-year chunks of time only from when a Democrat has been in the White House.  When viewed in this way, the whole rule about "Sell In May..." goes completely out the window.  May's mission in election years seems to be to convince everyone to sell, and May seems to have recruited all of the business news reporters to tell that story on its behalf. 

The real story during election years, especially when a Democrat is in the White House, is that May is a month for correcting, while June is a month for screaming higher.  The timing of the turns is more important with this tool than calculating the magnitude of the move.  Coming up just ahead is a bottom due May 14, which our subscribers have known about for the past month and so they have been anticipating its arrival.  There is also a bottom due at the end of the May, which helps to illustrate the point that sometimes a bottom is what prices go down into, and sometimes it is what prices go up out of. 

A big strong June and July is wholly contrary to the old saw about "Sell In May...".  Most of the time that rule does work, at least in part, but in election years a whole different rule goes into effect.  If the correlation persists this year as well as it has been doing up until now, we can look forward to a big rally in June before the market finally enters a plateau in July, when the media's attention is tuned to the campaign promises being slung by the presidential candidates. 

So I suppose that the revised motto should really be, "Sell In May And Go Away, Except If It Is An Election Year, And Seasonality Is Running A Week Behind, In Which Case Expect A May 14 Bottom, And A Really Strong Month Of June".

As far as mottos go, that one will never catch on.

I like to get the answers ahead of time, and one of the fun ways to do this is with price pattern analogs.  This is a technique that employs examining a price pattern from the past, and finding that it matches up more or less with what's happening now.  The implication is that if the correlation is good up until now, it should continue to be good into the future. 

The example this week compares the current price structure of gold prices to what gold was doing back in 2005-06.  You can see that it is not a perfect correlation, much like if Shaquille O'Neal tried to dance the Charleston like Fred Astaire.  One might be able to detect that it was the Charleston, but the two men would clearly have different dance styles.  So it goes with price pattern analogs. 

Analysts who use price pattern analogs like this have a variety of different ways of hunting for them.  I tend to be more visual, recognizing patterns that I think I have seen before, and then putting them together on a chart to verify that the relationship really is what I think I am seeing.  Some people like to let the computer do the work of sniffing out correlations, comparing a current market price pattern to all possible prior patterns to see which delivers the best number for a correlation coefficient.  That can be tricky, because trending moves can cause a phenomenon in the data known as "auto-correlation" which can skew the numbers. 

In my experience, the durability and legitimacy of a price pattern analog will tend to work better if there is a common theme for both periods.  So for example, if we were to look at the stock market in 2012 and compare it to other presidential election years, the common theme would be election year behavior.  That should make past election years a good place to start hunting for similar patterns, just as an example of finding common themes.

For this week's chart of gold, the common theme is the 13-1/2 month cycle in gold prices.  My research has found that this is the dominant long term cycle affecting gold prices.  I write about it quite frequently in our twice monthly McClellan Market Report newsletter. 

For the pattern analog comparison above, I have aligned the 2006 peak with the 2011 peak, each of which occurred at roughly the same point in that 13-1/2 month cycle.  The 2006 peak is visible at the left end of this chart:



We are now entering the initial upward phase of the next iteration of this cycle, which is a period when big gains for gold prices are typically seen.  A few months from now, we'll get to worry about just how this cycle's important mid-cycle low might have an effect on gold prices, but that is not the issue to be concerned with at this time.  Instead, we want to locate the true major cycle bottom in gold prices, which can arrive a month early or late and still be considered "on time" in the history of this cycle.  We also want to catch the initial upward phase of the new cycle, which is when the biggest gains are usually seen. 

Having the 2005-06 pattern as a guide can help us see where all the dance steps are from a complete prior instance, and let us see how the current market is following that rhythm.  If the current gold market follows those same dance steps, then we should see a nice rise up into a top due in early June, followed by another rise leading to a slightly higher top in late July. 

One additional point to understand about using price pattern analogs like this is that all analog relationship eventual fail and break correlation.  They are great fun while they last, but they eventually break up, and usually at the moment when you are most counting upon them to work.  So don't ever get married to the idea that an analog has to work exactly as you think.  Analogs are an interesting phenomenon of market physics, and fun to use while they are working, but one should expect them to be fickle and not completely trustworthy.

The Summation Index can give us important information about what lies ahead for the stock market, as long as one knows how to interpret it correctly.  For longer term comparisons like this, I like to use the Ratio Adjusted Summation Index (RASI) instead of the classic version, because the RASI factors out changes in the total number of issues traded on the NYSE. 

Back in January 2012, I wrote about the important bullish message that the Summation Index was giving us.  The RASI had just climbed up above the +500 level then, confirming that the up move was part of a strong new uptrend, and not just a failing rally.  If the RASI had failed to reach the +500 level, that would have been a sign of trouble.

Instead of stopping at or below +500, the RASI was able to climb all the way up to a peak at +1343 back on Feb. 9, 2012.  That super-high level says that there is a whole bunch of liquidity available to lift the market.  Strong liquidity is a condition that tends to persist for a long time, even as the market goes through the necessary corrective process that will set up for the next stage of the uptrend. 

We are in that corrective period now, and the RASI has done a nice job of decaying back down toward a neutral state.  Getting back down toward or through the zero level helps to un-stretch the rubber band, and set up for the next up leg.

Big uptrends almost never end on super-high Summation Index readings.  A few examples can be found in history, but they are very rare, and they usually involved the Fed or some other governmental action putting a thumb on the scale to kill the uptrend. 

Instead, the more typical action following a super-high Summation Index reading which initiates a new uptrend is that we see a fairly long series of lower Summation Index highs, each above +500, before we finally get to the final price top.  Seeing the major averages make a higher high with the RASI below +500 is a big fat warning of real trouble, and some examples are shown in the chart. 

This RASI behavior of signaling important things at the +500 level is not a new phenomenon.  Here is a chart showing the RASI's behavior from 1984 to 1996.



The key points to notice are first that the really high RASI readings of +1000 or higher tend to occur early in new uptrends.  Over time we see a progression of lower highs that are still above +500, as stock prices continue to higher highs.  The red circles highlight failures to get the RASI up above +500, and those mark important tops for the stock market that are followed by either a lengthy corrective period or an outright bear market. 

So the point to take from this now is that because the RASI is just now coming off of one of those really high readings above +1000, we still have a long way to go for the bull market.  We should expect to see a progression of lower RASI highs over the months or years ahead, and we should only worry about having a really ugly bear market at the point when we have seen that progression of lower RASI lows and we finally get to one that fails to get up above +500.  With the eurodollar COT leading indication calling for a powerful rally starting in June, I do not expect to see one of those +500 failures for a long time. 

When it comes to the overall stock market, there are only 2 fundamental factors which matter.  Forget dividend yield, earnings growth, book value, etc.  The only two factors which matter for the overall market are (1) How much money is there? and (2) How much does that money want to be invested?

This week's chart looks at a big contributor to factor #1.  It compares the SP500 to the size of the combined balance sheets of the European Central Bank (ECB) and the US Federal Reserve.  The ECB data are reported in euros, and so to combine that with the Fed's data I converted it all into dollars.

We can see that during the whole bull run from the 2003 low to the high in 2007, the two central banks were fueling both the stock market liquidity and the real estate bubble with growth in their balance sheets.  That's another way of saying that they were printing more money to liquefy the system. 

Then in 2008, just as the stock market was starting to stumble, the balance sheet growth came to a screeching halt, pulling away liquidity just as the markets needed it most, and exacerbating the severity of the decline.  Only when their combined balance sheet size started to go up again in 2009 did the stock market begin to recover.

We can see this relationship even more clearly when we look at a 3-month rate of change:



The data on both the SP500 and the balance sheet growth in this chart are monthly closing values, and we can see that surges and retreats in the balance sheet growth rate have coincided with rallies and pullbacks in stock prices.  Or at least that's true for the most part.

Something interesting happened in 2010, when balance sheet growth went negative, but the SP500 managed to continue going higher for a while.  Eventually the stock market came to the realization that there was a liquidity problem, because in May 2010 there was a rapid adjustment in stock prices which came to be known as the Flash Crash.  The SP500 started going up again after a bottom in July 2010, once the Fed and ECB combined balance sheet size started having positive growth again. 

Unfortunately, we cannot use this very well as a predictive tool.  The Fed reports changes to its balance sheet every week, and their balance sheet has been shrinking since a peak during the week of Feb. 15, 2012.  But the ECB reports its data monthly, and with about a 1 month lag.  So while reviewing this data can help us to understand why things have happened, it is not much good at telling us what is going to happen. 

For those who are curious, here is what just the US Federal Reserve's balance sheet growth looks like.  The falloff in the Fed's balance sheet growth since the Feb. 15 top appears to finally be starting to matter for US stock prices.  



Someday, we may return to an environment in which the big central banks stop interfering with the normal functioning of the financial markets.  But that is not the environment we live in now. 

There are lots of investments that are undeserving of investors' money, and T-Bonds are at the top of the list.  Even though the principal is guaranteed by Uncle Sam's (or Uncle Ben's) ability to print new money, the current yield on even the longest duration bonds is still at roughly the same level as the inflation rate.  So any interest you earn on your money gets eaten up by the loss in value of that money due to the Fed's unwillingness to do its job and achieve price stability. 

But in the financial markets, whether or not an investment is "deserving" often bears very little on whether people will invest in it.  Logic is not mandatory.

This week's chart makes the statement that T-Bond prices are headed higher, and it does so in a roundabout sort of way.  In the upper portion of the chart is the price plot of T-Bonds (continuous near month contract).  The lower plot shows an indicator derived from data in the CFTC's weekly Commitment Of Traders (COT) Report.  But rather than look at the data on T-Bonds themselves, which can sometimes give wishy-washy information, here we are looking at the commercial traders' net position in the Japanese yen.

Commercial traders are the "big money" traders who hold large positions.  How large is "large" differs among the various futures contracts, and the CFTC sets out the rules for those determinations.  Because the commercial traders are the big money, the presumption is that they are also the "smart money". 

Right now, commercial traders of Japanese yen futures are holding a really big net long position.  That means they think that the yen will go up in value versus the dollar, and so they have positioned themselves to profit from that expected move.

The whole reason why this is relevant for T-Bond prices is that there is a really strong positive correlation between T-Bond prices and the Japanese yen.  But this has not always been so.  The chart below shows that relationship, and you can see that before about mid-2001, it used to be an inverse relationship.  Somebody flipped a switch in 2001, and now it is a strong positive correlation.  



So because the yen does pretty much what T-Bond prices do, at least in terms of the direction of travel, we can make reasonable inferences about what lies ahead for bond prices by looking at what lies ahead for the yen.  When the commercial traders are holding their biggest net long position in Japanese yen futures in several years, the implication is pretty strong that the yen should head higher in the coming weeks.  And as the yen heads higher, T-Bonds ought to tag along, whether they deserve to go up or not.

Given what we have learned from another borrowed COT Report relationship, that positive period for T-Bonds is not likely to last beyond early June.  The inverse relationship between T-Bond price and stock prices is still working very well, so the opportunity for T-Bond prices to advance should only last as long as stocks are in a corrective mode, and that corrective mode is scheduled to be finished by early June. 

If you are interested in learning more about what the COT data can tell us, I feature an analysis of the relevant COT data every Friday in our Daily Edition. 

Here is an update to an article I posted in September 2011, describing the leading indication that lumber prices give for the shares of housing related stocks.  Back then, it was saying that a rally was ahead for homebuilders, building materials providers, and others involved in the housing industry.  And that opinion ran contrary to what was being voiced back then by a lot of other analysts. 

Now the commentary I hear on the business TV channels seems largely bullish toward housing stocks.  They cite the growing economy, falling unemployment, rising rental prices, and other factors that should benefit the housing sector.

In response, I just cite the message from lumber prices, which peaked a year ago and fell throughout the rest of 2011.  Because lumber's price movements tend to get echoed a year later in the HGX Index and other housing related sector indices, the implication is that we are at a top for housing stocks.  Perhaps lumber knows something that the economists don't.

This relationship does not always work perfectly, and that fact should be understood by anyone contemplating listening to it.  A notable difference in behavior was the refusal of the HGX in early 2011 to follow the path of lumber prices up to a giant spike top.  But it should be understood that this spike in lumber prices back in April 2010 was due to the earthquake in Chile, which disrupted production of lumber in that country and sent lumber buyers scrambling to lock in supplies.

The reason why this relationship seems to work is that market forces that are going to affect the prices of housing related stocks tend to show up a year earlier as market forces affecting lumber prices. Because the Chile earthquake was an anomalous event, and not a reflection of the interplay of supply and demand forces in a liquid market, that effect did not flow through to housing stocks a year later.

We have not seen a similar anomalous event in the past year that would explain the decline in lumber prices.  So it seems reasonable to expect that the market forces which helped push lumber down a year ago should be echoed in 2012 in the share prices of housing related stocks. 

The 40-year cycle for the stock market is not due to bottom until around 2022, and so between now and then it gives us the expectation of a sideways decade for the stock market, much like the 1970s or the 1930s.

At the same time, the leading indication for the stock market that is given by oil prices says we should see a strong upward trend for stock prices during the 2010s.  These two expectations are in conflict with each other, but I think I can resolve that conflict with this week's chart.

It looks at the SP500 Index level divided by the value for the monetary aggregate measure known as M2.  For the uninitiated, M2 consists of all of the currency in circulation and in bank vaults, plus travelers checks, demand deposits, other checkable deposits, savings accounts, and money market funds.  It is a commonly used measure of the total amount of "money". 

When it comes to analyzing the overall stock market, I like to say that there are only two fundamental factors which matter.  Forget earnings, dividends, book value, revenue, etc.  When it comes to analyzing the overall stock market, the only two factors which matter are (1) How much money is there? and (2) How badly does that money want to be invested?

That's where this week's chart comes in.  The Fed has been inflating the money supply in order to resuscitate the US economy.  Over the past 12 months, M2 is up 9.8%, and it has doubled since 2000.  So in terms of fundamental factor #1, the Fed is doing all it can to help lift the stock market.

But that money has not been feeling inclined to go to work pushing up stock prices, and the result is that this ratio of the SP500 to M2 is now back down to levels it saw during the big bull market of the 1980s.  And if the Fed keeps on inflating the money supply, as Fed officials have stated is the goal, then that will push this ratio down even further.

So that's how we can get a big uptrend for stock prices during the 2010s like the oil price leading indication suggests we should see.  But that is not necessarily a good thing, because along with all of that money supply growth comes inflation in consumer prices.  So far, the Fed keeps saying that inflation has remained low, but that is due in large part to the fact that housing makes up a 41% weighting in the Consumer Price Index (CPI).  If you factor out the depressing effects of the weak housing market, the price inflation in all of the other CPI components has been as high as 5% recently. 

One way to have stock prices go up is to have the companies backing those stocks become more valuable.  But another way is to have the dollars needed to buy those stocks become less valuable, so that you need more dollars to buy your favorite stock.  That appears to be the path that the stock market is now on, which explains how we can have a rise in stock prices in this decade, but not in real stock values. 

I love playing with correlations, and finding seemingly unrelated sets of data that seem to behave the same way.  I am always mindful of the admonition that "correlation does not mean causation", in part because so many people like to remind me of this anytime I mention correlations. But correlation of two data sets does hint at a common thread.

In 1993, when I was just starting out, I heard Jim Bianco of Arbor Research give a presentation at a Market Technicians' Association conference.  One of the fun charts that he shared was this week's comparison between the number of pages in the Federal Register and consumer price inflation. 

The Federal Register "is the official daily publication for rules, proposed rules, and notices of Federal agencies and organizations, as well as executive orders and other presidential documents."  So the size of the Federal Register is a decent gauge of just how busy the US federal government has been.  It is published by the Office of the Federal Register, and distributed by the Government Printing Office. The latest edition, if you got it in paper form, weighs over 340 pounds (154 kilograms). 

This week's chart compares the number of pages of the Federal Register to the raw Consumer Price Index for All Urban Consumers (CPI-U).  The 12-month change of this CPI measure is the most often cited inflation rate, although Ben Bernanke lately has expressed a preference for using the GDP deflator, perhaps because it is lower. 

If we were to look at rates of change for the Federal Register pages and CPI, it would look like this next chart, which uses a 2-year rate of change to smooth out the data more:



Generally speaking, inflationary periods for consumer prices seem to coincide with expansionary periods for government activity, as modeled by the size of the Federal Register.  Whether one is a response to the other is a much harder point to prove, but it is easy enough to see that there is a relationship there.  Wars also bring more activity in the Federal Register, as well as inflation, although if the government imposes price controls as it did in WWII and the Vietnam War, then the effect of that inflation on consumer prices can be delayed. 

Can we say for sure that shrinking the size and scope of the federal government's activities would necessarily bring about low inflation? Probably not.  But it would be an experiment worth trying, so that we can see what happens to the data, and for other reasons as well.

And as for why keeping inflation down is important, please see this 2009 article about the relationship between the inflation rate and the crime rate. 

On February 29, 2012, gold futures prices had a big one-day selloff, dropping by more than $100/oz at one point intraday.  Normally a big drop in gold prices will send gold ETF investors heading for the sidelines, but there was nary a reaction to that big drop. 

In fact, total assets in GLD and IAU, the two biggest gold bullion ETFs, actually rose slightly that day, and have continued upward in the days since then.  It is as if investors viewed that selloff as more of a buying opportunity than a reason for worry. 

What makes this interesting is that the crowd's view of that as an opportunity does not usually work out to be true.  This week's chart is one I have shown before, looking at the total amount of gold bullion held by GLD and IAU.  You can download that data yourself from the SPDR Goldshares and iShares web sites. 

It turns out that the actual really good buying opportunities occur when these ETF investors hold the opposite view.  When we see a very fast drop in ETF assets, that is the sign of public fear about gold prices that marks a good bottom for gold prices.  But when you see these assets rise as gold prices are falling, those instances are typically followed by a further decline in gold prices, to more completely scare people away so that the next uptrend can begin. 

After gold prices peaked in early September 2011, assets in these ETFs actually started to rise as gold prices were coming down from $1900/oz.  But the bottom of that decline did not arrive until late September, when a big fast drop in ETF assets showed that investors were fleeing. 

A similar response occurred in November 2011, when gold prices started downward again and ETF investors responded by buying more.  Only when another big fast drop in ETF assets came in late December did we get a bottom for gold prices.

So now we are seeing gold prices starting downward, and once again these investors are responding to the decline by increasing their investments into these gold bullion ETFs.  That is not a good sign for gold, and it strongly suggests that we'll see a further decline in gold prices.  At the point when we see investors start fleeing rapidly from these ETFs, then it will be a much better condition for seeing a bottom in gold prices. 

The McClellan Oscillator went below zero back on Feb. 14, and has remained negative ever since.  But that has not stopped the major averages from moving up to new multi-year highs. 

Having the Oscillator drop below zero can sometimes be seen as a "sell signal", but it depends on what else is happening in the market.  It is certainly not a positive factor to have higher price highs appear while the Oscillator refuses to confirm that strength. 

You can see in this week's chart that some of the instances of a higher price high with a negative Oscillator reading have marked really important tops.  Other times, though, these instances have not stopped the market's advance.  So like the Hindenburg Omen, this occurrence serves as a warning of trouble, but not a guarantee that a top is in. 

The McClellan Oscillator can be thought of as an accelerometer for the Advance-Decline statistics.  So a negative McClellan Oscillator means that the A-D numbers have been undergoing a downward acceleration.  That can mean actually turning downward, or just going up more slowly.

To help visualize how this works, this next chart shows the two exponential moving averages (EMAs) that are used to calculate the McClellan Oscillator.  We call them the 10% Trend and 5% Trend because that was the original naming convention of P.N. Haurlan, who introduced their use for tracking stock prices back in the 1960s.  The rest of the world seems to prefer to call them a 19-day and 39-day EMA, but we're sticking with the original terminology. 

Read more about McClellan Oscillator calculation here.



When the 10% Trend is above the 5% Trend, the McClellan Oscillator will be positive.  In recent days, the 10% Trend has been below the 5% Trend, so the Oscillator is negative even though both of these EMAs are still above zero.  Given where these EMAs are right now, the market will have to produce some really big positive daily breadth numbers (A-D) to get the Oscillator back above zero.  The reason is that the high positive A-D difference would pull both EMAs higher, and so it has to be enough higher to pull the faster 10% Trend up above the 5% Trend. 

It is much easier to get the Oscillator to turn positive once both of these EMAs have been pulled down into neutral or negative territory.

Seeing the price indices make higher highs with the McClellan Oscillator down below zero says that the former pace of the price advance is not being sustained.  It is like a Mercury rocket which has run out of fuel but is still rising, and the slowing pace of the rise is a precursor to splashing back down in the ocean.

You can watch the Oscillator level each day and see a chart at our Market Breadth Data page.

Here's something fun to try.  Google offers a free service called Google Trends.  You can enter any search term or set of words and get a readout about how that term has been used over time in search patterns as well as news stories.  So since oil prices are zooming up and the TV news crews are all talking about higher gasoline prices, I decided to take a look at what Google Trends is showing.

It turns out that people generally, including the news media, are not as excited right now about "oil prices" as a search term or news term as they have been at other times. 

To prepare this week's chart, I took the image that the Google Trends service generates, and pasted it onto a chart of crude oil futures prices.  A little bit of stretching and fitting was required to get the time periods lined up, but it was nothing too difficult for the state of modern computing capability.  It sure beats how we used to have to do this kind of thing years ago, with the enlarge or shrink functions on a photocopy machine with our paper charts. 

The upper blue line in Google's chart reflects frequency of searches that people do on the specified term or phrase.  The lower line reflects how often that the term gets used in news stories.  The alphabetic flags featured on the chart are links to news stories that Google considers to be relevant.  Google Trends also offers you the chance to export the results as a Comma Separated Values (CSV) file, so you can take the raw data instead of the image to use in a spreadsheet program.

Looking at the chart comparison, it is not surprising to see that a lot of people were interested in searching or talking about "oil prices" back in 2008.  That year's financial crisis led to a commodities blowoff that took oil prices up to a high of $145/barrel.  People were also really interested in tracking oil prices as a search and news item in 2011, when the "Arab Spring" protests were having an effect on oil production in the middle east. 

It is somewhat surprising now, however, to see that interest has not been picking up in recent weeks.  Perhaps there is just a lag between the price changes and people's awareness of it as an interest item.  But given that past blowoff moves in oil prices have almost all reached their peak when there was a pickup in search and news interest, the message here is that oil prices are just not yet at the point of reaching a top for the current move. 

Oil and other commodities are not the main focus of our newsletter and Daily Edition, but we do like to keep an eye on them, especially insofar as they can have an effect on the stock, bond, or gold markets.  In the most recent issue of our twice monthly McClellan Market Report, we took a look at how changes in oil production and consumption are unfolding in the U.S., and at what the current contango situation says about the recent up move continuing. 

To see sample issues and subscribe to the McClellan Market Report, visit our Market Reports page.

The Fed's Permanent Open Market Operations (POMOs) have a bigger effect on pushing stock prices up and down than most people would like to believe.  The financial media like to convince us that what moves the market up and down are earnings news, employment reports, or concerns about Greek debt.  But this week's charts reveal that the Fed's thumb on the scale has a big effect.

The New York Federal Reserve Bank is the agency conducting these POMOs on behalf of the Federal Reserve, and the NY Fed kindly publishes a lot of data about them.  They even give us a schedule of intended operations up to a month ahead of time, telling us the dates and projected amounts of the purchases and sales that they will be doing as part of Operation Twist.  That lets us have a road map for when those actions will have an effect on stock prices, and this chart is one that we have shared frequently with readers of our Daily Edition. 

Most investors remember the Fed's efforts to pump money into the banking system following the 2008 market debacle.  The first round of "quantitative easing", or QE, ended in April 2010 and was quickly followed by the illiquidity event in May 2010 that came to be known as the Flash Crash.  The Fed quickly geared up for another program of purchases that came to be known as QE2, which was a big hit for the stock market right up until it ended on June 30, 2011.  The end of that program was followed pretty quickly by the ugly decline in July and August 2011.  

During QE1 and QE2, all of the POMOs were purchases of Treasury and agency debt, pushing money into the banking system and taking debt instruments out of the hands of the banks.  That extra money went to work by pushing up stock prices, at least for as long as the additional money was flowing into the banking system.  At the ends of each of those rounds of QE, the market responded like a heroin addict going through withdrawal.  But rather than go back to the same well one more time with a QE3, the Fed decided in September 2011 to implement Operation Twist, which is an effort to change the shape of the Treasury yield curve by purchasing longer term debt and selling short term paper.

The amounts are supposed to offset each other, but the problem is that the purchases and sales are done on different days.  This lumpiness of the Fed's activities shows up in the stock market's price movements, as this week's lead chart illustrates.  The effect of these actions on stock prices has become a lot more muted lately, compared to the wider swings associated with POMOs back in November and December 2011.  It has helped, I suppose, that the positive liquidity effects revealed by the eurodollar COT leading indication have smoothed over the ripples in the liquidity stream. 

But now we are entering into a period when that leading indication says things should get a little bit rockier.  And the POMO schedule says that some big sales are coming up, events which will take money out of the banking system.  We can only see out as far as the end of February with this indicator, because that is as far ahead as the NY Fed has announced its planned operations.  I'll be checking the new operations schedule when it comes out on Feb. 29, and will share with our subscribers what the new road map looks like. 

Looking at federal spending and tax receipts as a percentage of GDP has become a hot new activity lately.  It's something that I have spent a lot of time on for the past several years, and shared with our readers.  A fresh look is appropriate now that it is getting wider attention.

Presidential candidate Mitt Romney has been getting a lot of attention for his call to cut federal outlays to just 20% of GDP, and to also balance the budget.  Washington Post columnist Ezra Klein characterized this as "severely conservative budget promises".  But the real problem is that neither man understands enough about the math involved, although Gov. Romney deserves credit for at least thinking about moving the numbers in the right direction. 

This week's chart takes another look at a chart I showed back in February 2011, comparing total federal receipts to total outlays, each expressed as a percentage of GDP.  The good news is that the total outlays over the past 12 months have fallen to their lowest level since February 2009.  The bad news is that this is still 7.96 percentage points above where total receipts are. 

It is tempting to say that total receipts just need to get jacked up to meet expenditures, and then the problem would be solved.  One problem with this logic is that the U.S. has never in its history been able to get tax receipts up above 20.4% of GDP, which was the peak seen in February 2001.  So trying to achieve a level of taxation high enough to meet current expenditures would involve going where no economic era has gone before.

The other problem with this logic is that taking tax receipts up too high hurts the economy, and thus hurts the very engine of generating tax receipts that everyone is counting on.  Congress seems to almostget this, which is why there has been wide support for keeping the payroll tax cut in place for a while longer, even though it continues to increase the size of the total debt.  



Historically, anytime that total federal receipts has gone up above 18%, it has hurt the stock market and thus the overall economy, including the last time that it happened back in 2007.  One rebuttal to that point holds that the U.S. was able to tolerate taxation up as high as 20% in the late 1990s, with no adverse effects on the economy.  But that rebuttal misses several important points.

The stock market continued upward during the late 1990s in spite of that high tax collection rate, moving upward all the way until 2000, assuming you believe the behavior of the major averages.  In reality, the pain was already being felt long before then.  The NYSE A-D Line peaked in early 1998, and did not reach bottom until 2001 when the first of the tax cuts went into effect.  And the total number of stocks listed on the Nasdaq peaked at 6136 all the way back in December 1996.  It is now down to less than half that amount.  The dismantling of the tech bubble started at that December 1996 peak in listed issues, and it continued all the way into the peak of the Nasdaq Composite in March 2000.  Destruction of capital due to those high tax rates was already at work long before it became evident in the major averages.

Aside from that exceptional episode, recessions have historically begun once federal receipts get up to above 18%.  So any plan to have federal expenditures set at 20% is 2 percentage points higher than the level of tax receipts which is proven to push the country into a recession.  It is not a workable plan for balancing the budget, let alone starting to pay back the $15 trillion debt we have amassed and will be leaving to our grandchildren. 

A more realistic plan would be to set federal expenditures at 16% of GDP or less, and using any surplus to pay down the debt, thereby shrinking government's share of GDP and increasing the private economy's share of GDP.  That has been proven historically as a way of stimulating economic growth by taking workers whose efforts would have been attributed to the government sector, and putting them to work in the portion that supports the government sector. 

Hopefully those in power (or hoping to be) will one day wake up to the realities of the math. 

Back in May 2011, I introduced Chart In Focus readers to the leading indication that I get from looking at Commitment of Traders (COT) data on eurodollar futures.  Since then (and also before) readers of our twice monthly McClellan Market Report newsletter and Daily Edition have appreciated getting to see this relationship on a more frequent basis.

For almost a year, we have known that a top was due to arrive in February 2012.  And sure enough, stock prices have been rising nicely in recent weeks as fulfillment of that expectation.

Now this leading indication says that things are going to get less fun for investors for a while.  The next 3 months show a sideways to downward structure in the eurodollar COT data, and the implication is that the steep price advance that we have been seeing should transition to a more sideways market.  That's great if one can be a swing trader, buying oversold opportunities and selling when prices get overbought, and then repeating.  But it is a lousy time to be a buy and hold investor.  How to play that chop is something that we will be sharing with our subscribers. 

The next major inflection point is due in early June, when this leading indication says that a big multi-month rally is due to begin.  By then, all of the bullishness that investors are expressing now in the various sentiment indications should have turned to frustration and pessimism, creating the right setup for a big new uptrend.  The hard task will be to remain patient until then, waiting for conditions to be right again. 

Some sentiment indicators work by analyzing what people say, such as polls and sentiment surveys.  Others work by analyzing what people actually do, and I tend to like those more. 

This week's chart looks at investments into QQQ, the ETF designed to track the movements of the Nasdaq 100 Index.  The lower line in that chart is the total number of shares outstanding of the QQQ.  It fluctuates each day as fewer or more people feel like owning shares.  Because of that waxing and waning of interest, the sponsoring firm (Power-Shares) issues or redeems shares to keep the share price close to the NAV. 

When the firm issues new shares, it goes out and buys the shares of the NDX component issues to back those ETF shares.  Not surprisingly, interest in owning these shares rises and falls along with the overall stock market.  When the overall market goes up, that makes more people want to participate. 

To help track where “high” and “low” levels are, I added 50-day 1-sigma Bollinger Bands to the chart.  That means that the upper and lower bands are drawn one standard deviation above and below the 50-day simple moving average, which is not shown.  Other settings for drawing Bollinger Bands could also be used for the same purpose; I just like these because they look about right, and give good insights about an overzealous or disinterested investing public when the shares outstanding number goes outside these bands. 

The current number of shares outstanding is not at an all time high, but it is the highest we have seen since all the way back in 2006.  And it is way above the upper 50-1 Bollinger Band, indicating that traders and investors are getting a little bit too interested in being invested in the QQQ.  That overly bullish sentiment condition begs for at least a short term pullback, to reintroduce people to the idea that stock prices actually CAN go down.

The QQQ and the Nasdaq 100 Index are just now breaking out slightly above their 2011 highs, but interest in owning the QQQ is well ahead of its corresponding highs in 2011.  That means that traders have been drawn in to owning this ETF to a degree even greater than what the raw price advance itself would suggest should have happened. 

In a September 2010 Chart In Focus article, I showed this same 3-decade rising trend channel in T-Bond prices.  The message then was that bond prices were getting up toward the "expensive" side of things, and afterward bond prices sure enough came back down to touch the bottom of that channel by the end of 2010.

Now the message is similar, except that all of the worries over European debt problems have pushed T-Bond prices up even higher toward "expensive" territory.  And now with a deal reportedly getting worked out between Greece and its creditors over the size of the "haircut", traders are concluding that the supposed safety of T-Bonds does not merit as much premium as it used to.

At the same time, commercial traders of both T-Bond and T-Note futures are getting to a point of being net short in the biggest way that they have been in years.  Commitment Of Traders (COT) Report data is something that I address every Friday in the Daily Edition.  And commercial traders are also net long the euro in the biggest way in the history of that future contract.  So the big smart-money traders are betting on a euro rebound and a T-Bond selloff. 

You can sign up to get the Daily Edition as well as our twice monthly McClellan Market Report by visiting our Market Reports page.  And new subscribers to our Daily Edition can get the first two weeks free. 

The Ratio Adjusted Summation Index (RASI) is back up above +500, and that is a bullish piece of news.  It takes a sustained period of positive breadth numbers to achieve this, and I like to say that gobs of positive breadth is almost always a good thing. 

The Ratio Adjusted Summation Index is much like the classic version, with one difference.  We factor out the changing number of issues on the NYSE in order to make long term historical comparisons more meaningful.  You can see the whole calculation method here.

Like the classic Summation Index, the RASI moves up and down with the trend of the market, and it gives important information about the state of the trend when it gets to very high or very low levels.  But the factor I like the most about the RASI is what it tells us based on how it behaves around the +500 level.  That is an important threshold for telling us whether there is strength to continue both an uptrend and a bull market. 

If you see a nice deep selloff that takes the RASI down below zero, then on the subsequent advance it is important for the RASI to be able to get back up above +500.  Failing to surpass that level is a sign that the uptrend cannot achieve "escape velocity", and prices are likely to roll over and head back down to the prior low, or lower.  From late 2007 to early 2009, there were several attempts but all rolled over short of that +500 level.

That is why it was important in October 2011 to see the RASI climb up well above +500 following the August 2011 selloff.  That action said that a new strong uptrend was being initiated. This was the point I was making back in the Oct. 14, 2011 Chart In Focus article titled, The Key To Watch For In November.

The other way that the +500 level is important lies in marking the end of an important uptrend.  Usually the initial rally of a brand new uptrend is where you will see the highest RASI readings, and so every subsequent RASI peak will be lower than that highest one, even though prices make higher highs.  These divergent conditions show a waning amount of upward impetus, but the strength of the market can still be enough to carry on even if it is not as strong as the initial upward impulse.  It is similar to how I'm not as fast of a runner as I was in my 20s, but I can still run. 

But at the end of a long uptrend, what is often seen is a failing RASI up move after several divergent lower tops, and that final RASI push reaches a peak at a level below +500.  A couple of examples are highlighted in the chart. 

So all of this leads us to the current RASI reading, which at +618.2 is above the +500 level but still below the peak of +763 seen on Nov. 15, 2011.  So it is a divergent lower high, but it is still high enough to say that the uptrend which started in October 2011 is not over.  There can be ordinary pullbacks along the way, but the message of the RASI is that the final highs of this current new uptrend have not yet been seen. 

In this week's chart, I take a look at an indicator which is featured in every issue of our Daily Edition.  It looks at each of the 30 stocks which make up the Dow Jones Industrial Average (DJIA), and checks to see what percentage of them have a rising Price Oscillator.

A Price Oscillator is calculated similarly to the McClellan A-D Oscillator, except that instead of using the daily difference between Advances and Declines, we look at the closing price.  See Calculating the McClellan Oscillator, and Calculating Indicators in Daily Edition Table.  To get this composite indicator, I do 30 different Price Oscillator calculations, one for each of the 30 DJIA component stocks.  Then I count how many of those Price Oscillators are rising. 

Those 30 stocks which make up the DJIA are generally well correlated with each other, but there will be slight differences at times which can give us important information.  That is what this indicator is designed to detect.  If all of the DJIA stocks are trending higher, then most or all of them will see their Price Oscillators rise.  Similarly, during a downtrending market, you can see a condition when most or all of them have a falling Price Oscillator, which takes this indicator down toward zero.  Interestingly, by the time the market gets all of them moving together in either direction, the short term move is likely done, because a large amount of energy must be expended just to get the herd all moving together.  So extreme readings above 80 or below 20 can show an overbought or oversold condition. 

The interesting indication we are seeing right now in the chart is that the DJIA has been making higher price highs as 2012 begins, but the DJI Oscillator Rising Index is making a pattern of lower highs.  This sort of divergence can be problematic, because it says that a smaller number of component issues are doing the work of pushing the index to a higher high.

Caution is warranted, however, because not every divergence like this turns immediately into a reversal for the stock market.  It is merely describing a condition, and there is no guarantee that prices will roll over right away just because the participation in the rally is waning.  Sometimes divergences like this can persist for several weeks before they finally matter.  You can see a great example of that at the left end of the chart, when the DJIA kept on trending upward in spite of a divergent condition lasting several weeks.  Eventually, though, that divergence did matter. 

So right now, we cannot leap to any conclusions about the market's direction just because we see a divergence in this one indicator.  But with other divergences already in place right now between stock prices and copper, and with the middle part of January normally a period of minor seasonal weakness, it is a concern to see this particular sign of waning participation in the advance. 

Turning such warnings into more concrete guidance about trend changes is what we do in every issue of our Daily Edition.  You can see samples, and sign up for a subscription at our Market Reports page.  New subscribers can take advantage of a 14-day trial offer.  If you have already been a subscriber or had the trial in the past, you can still take advantage of our normal pricing of $160/quarter, or $600/year, which is the same pricing that we started at in 1998 when it debuted as the "Daily Fax Edition".  It has been a while since we sent our last fax issue.

If you are in the Houston, TX area, you may be interested to know that I will be coming to town for a pair of speaking engagements. On Friday, Jan. 13 at 10:00 AM, I’ll be speaking to the computer investing special interest group of HAL-PC, which is the Houston Area League of PC Users. HAL-PC’s web site, www.hal-pc.org, has location and other information. 

On Saturday, Jan. 14 at 10:30 AM, I’ll be addressing the Houston Investors Association, http://houstoninvestors.com/wp/.  They meet at the University Center on the University of Houston campus. Small special interest groups meet at 8:30 and 9:30, and my talk will begin at 10:30.  Attendance is free for 1st time visitors.

Back in January 2011, I pointed out that copper prices had in recent years started to track very closely with whatever the stock market was doing.  But the key point about that relationship then was that when disagreements appear, it is usually copper that knows what the real story is.

That relationship continues to work to this day, with the two price plots mostly doing the same things, but with divergences usually working out the way that copper says that they should.  By that I mean that if the SP500 makes a higher high but copper makes a lower high, that is a bearish divergence with bearish implications for both of them. 

It is worth noting that there was a big "oops!" back in July 2011, when copper prices made a higher high as the SP500 made a lower high.  In that instance, it turned out that the stock market was right, but copper worked extra hard in the weeks that followed to make up for lost time and to plunge to a lower value.  Nothing works all the time. 

The higher high for the SP500 going into the end of the year has not yet been matched by a higher high in spot copper prices, and that is a troubling development.  But the problem with converting this observation into an actionable and tradable signal is that we never know exactly when such a divergence is actually going to start to matter.  Sometimes it happens after just a few days of divergent behavior.  Other times, the divergence persists over several weeks before it finally matters.

One other worry is a phenomenon I just shared with readers of our Daily Edition, which is the realization that a lot of currencies seem to undergo reversals around New Year's Day.  The end of 2011 arrives with commercial currency futures traders holding a huge net short position against the dollar.  Commercial euro futures traders have the biggest net long position in the euro in the entire 12 year history of the reporting of euro futures positions in the Commitment of Traders (COT) Report.  Commercial traders are also long the Swiss franc in a big way.  Analysis of COT data is something that is featured every Friday in our Daily Edition.

So what this all means is that we have a situation where an upward move for the euro (downward for the dollar) is likely because of what the COT data say, and because of the year end reversal tendency.  A big drop in the dollar would be bullish for copper prices, because a cheaper dollar would mean that you would need more dollars to buy a pound of copper.  So a potential big currency reversal could push copper prices upward, removing this current divergence between copper prices and the SP500.  Accordingly, this relationship will bear watching closely as we move into 2012. 

As you head off into the long holiday weekend (and I hope that yours is a joyous one), I thought I would give you something a little bit more fanciful to chew on.

This week's chart shows an interesting correlation, or perhaps I should say that it is a troubling correlation.  We have all been told by the financial media lately that the wild up and down movements of the stock market this year stemmed from investors' reactions to the various plans and announcements coming out of Europe, focusing on its debt problems.  But here we are seeing that the ups and downs of the DJIA seem to match the rise and fall of solar radio flux.

Flux is a measure of the energy output of the sun, and is an excellent indicator of overall solar activity levels.  It is associated with the 11-year sunspot cycle, but it varies a whole lot on a daily basis, as the chart illustrates. 

So why could it be that rising solar flux would lead to rising stock prices, and vice versa?   That is the deep and possibly troubling question.  Some people have theorized that the fluctuations in the amounts of charged particles hitting the wiring in our brains can affect collective moods, just as they can affect electrical power grids and microcircuitry.  That's as good of an explanation as any.  I usually operate on the philosophy that if the correlation is good enough, no explanation of the root cause is necessary. 

Here is something more to chew on: Perhaps it is not the radio flux that is really doing the job of affecting our brains' wiring, but rather the spikes in solar flares that seem to arise out of the low points in radio flux.  This next chart looks at the counts of "S Class" solar flares.



You can see that the biggest spikes in the numbers of these flares tend to coincide with meaningful bottoms for stock prices.  Those spikes also happen to arrive at minimum points for total radio flux, as if the surge in solar flares kicks off the next rising phase for that measure of solar activity.  The DJIA's rise up out of the minor price bottom on Dec. 19, 2011 coincided with an upward surge in the number of these S-Class flares.  Other spikes in flares in 2011 have also coincided with important lows, although not all price lows have flare spikes to explain them.

One trouble with identifying this relationship is that it is not much good for those of us in the forecasting business.  The relationship between solar activity and stock price activity seems to be a coincident one.  We know that it is related to the 11-year sunspot cycle, but even that cycle can vary from 9 years to 14 years.  Forecasting solar weather on a daily basis has proven to be very difficult. 

You can access the historical data at NOAA's web site and play with the numbers yourself if you are curious enough to delve into this.  You can also get daily updates at http://www.spaceweather.com/. 

I am certain that a lot of readers will have trouble accepting the idea that stock prices could in any way be driven by changes in solar activity.  I have some trouble accepting it myself.  But every once in a while, it can be worthwhile to take a look at a wild idea just to see if there is any merit to it.  The evidence here seems to be strong enough to demonstrate that there is something going on there, even if it is not good enough to figure out how to make money off of it.  One possibility is that if you see a big solar flare that is bigger enough than what has been happening around that time, then it is an invitation to a stock price rally in the days that follow.  But putting that effect into quantifiable terms and actionable information is more elusive. 

There is a growing chorus of analyst voices calling for an economic collapse in China.  This is based in part on how poorly Chinese stocks have done this year, and it sets up all sorts of worries about what an economic slowdown in China might do to prices of commodities, and to other world financial markets.

I have a different view, and it is based on the comparison we see in this week's chart.  The Baltic Dry Index (Source: bloomberg.com BDIY:IND) is an index of dry shipping lease rates.  In other words, it reflects how much it costs to rent a freighter for hauling non-liquid stuff.  The Baltic Exchange also tracks lease rates on oil tankers, and on specialized ships like Panamax ships designed to transit the Panama Canal, and Capesize ships that are too big to fit through the Suez Canal and which thus must go around Cape Horn.  The Baltic Dry Index includes pricing for Handymax, Supramax, Panamax, and Capesize dry bulk containers. 

Economists and analysts like to watch the Baltic Dry Index because its pricing reflects demand for shipping stuff across the ocean.  Because the supply of such ships is fairly inelastic, changes in demand will flow through very quickly into lease rate pricing.  It takes a while to build new freighters in response to high lease rates, and that is part of the explanation for why BDIY crashed in late 2008.  A lot of shipyards had ramped up production earlier that year, and then those new freighters flooded a collapsing freight market during the 2008 financial meltdown.  This is a classic case of what's know as the Avocado Effect, or the Hog Cycle.

It is not surprising to see a correlation between Chinese stock prices and some indicator of world economic activity.  China is a mercantilist country which seeks to export a large amount of what it produces.  So when there is a change in world demand for "stuff", that is going to affect the country producing the stuff.  And because stock price movements can often precede changes in GDP, the big drop in Chinese stock prices during 2011 has people understandably concerned.

But the Baltic Dry Index is not confirming that drop.  BDIY bottomed in January 2011 and has been trending higher, in direct disagreement with the Shanghai B Stock Index.  When the two disagree, I have found that it is worth listening to what BDIY is saying. 

BDIY did not confirm the higher highs in the Shanghai B Index in late 2010 and early 2011.  Now, as Chinese stocks are unwinding that big top, BDIY is saying that things are actually not as bad as the stock price decline seems to imply. 

Here is a riddle for you to ponder.  I'd like you to consider a hypothetical situation, with these economic parameters:  US unemployment is above 9%.  The federal government is running large deficits.  A summer decline has investors worried.  And this comes after several years of sideways price movement for stocks.

Now, into that environment, imagine that a populous country and important trading partner of the US announces that it is going to default on foreign debt equivalent to about half the size of its GDP.  And imagine that this default soon spreads to several other countries. 

So given all of these conditions, what happens to the stock market?  For the answer, see this week's chart.  The scenario I described was the default of Mexico in August 1982, which soon spread to defaults by 26 other countries.  See http://www.fdic.gov/bank/historical/history/191_210.pdf for the longer version of that story. 

The fascinating point about this comparison is that the current stock market price behavior matches quite nicely with what we saw after the bottom in 1982, a bottom which coincided with Mexico's debt default.  The current version of debt default is a "haircut" for Greek debt holders, unfortunately including customers of MF Global who did not even know that their "cash" positions were actually invested in troubled European debt instruments.  That whole episode is a story worthy of a book-length description that is beyond the scope of this brief article.

Why it could be that the default of Mexico could be good news in 1982, and Greece in 2011, could be good for the stock market is an interesting mystery.  But the correlation is there in the stock price patterns, or at least it has been ever since July.  Prior to July, when the Fed's QE2 program of bond purchases was in effect, the correlation between these two price patterns was not that good.  In fact, at times the patterns seemed to have a loose inverse correlation.  But the end of QE2 on June 30 resulted in a liquidity vacuum which seems to have jolted the current market price pattern into sync with that of 1982. 

The December 2011 price action does not match the 1982 pattern of higher highs, but the timing of the turns does match up, and that is the important point for watchers of analogs like this.  It is the turns that matters more than the price levels suggested by the slope of the prior pattern.  And the turns in the 1982 pattern suggest that we should see a big rally into the end of December, followed by some time to think about things. 

You can see a video of the discussion of this pattern and other topics that I had in an appearance before the Seattle Securities Traders Association.  Click on THIS LINK to watch the 72 minute video.

We'll be watching how it actually plays out in our twice monthly newsletter and Daily Edition, and invite you to join in by subscribing here. 

As gold prices push out toward the apex of a symmetrical triangle structure, gold ETF investors seem to be betting as a group on a big upside breakout for gold prices.  But that very uniformity of opinion may be what dooms the rally attempt. 

The two big gold bullion ETFs are GLD and IAU.  GLD got a jump by coming to market in November 2004, just two months prior to the launch of IAU. But that two month head start gave GLD a big advantage in terms of attracting investors.  IAU has been trying to catch up ever since, and it got a big boost in investor interest when it cut its fees to below those of GLD.  But GLD is still the assets leader.

I combine the two ETFs assets into a single indicator in this week's chart. The units are the total tonnes (1000kg) held by the two ETFs. The number of tonnes goes up and down with investor interest in being invested in gold, and the sponsoring firms issue or redeem shares as needed to keep the ETFs' share price close to the net asset value.  When they issue more shares, they immediately turn around and buy more gold bullion with the proceeds. 

So when you see the total assets rise, it means that more people are investing money into these ETFs.  Not surprisingly, rising gold prices tend to be what gets people more interested in investing in gold, and falling prices provide an incentive to cash out.  The key insight comes from being able to notice when that tendency has gone too far one way or the other. 

In the chart, we can see that total assets are all the way back up to where they were in August, when gold was building a big top ahead of its 16% decline.  And this surge in investor interest comes even though gold prices are still well below that August high, meaning that sentiment has swung farther toward the bullish side that the price movement might have justified.

At the same time we are seeing bullish sentiment reflected in the ETFs, there is another sign of a problem.  We recently featured a chart in our Daily Edition on Dec. 1 (subscription available here) showing that gold lease rates are climbing in London in a way similar to what we saw in September 2011, just before the plunge.  It appears that gold investors are getting bullish just as a squeeze is mounting in the gold lease market, which is a setup for a big drop like September's.  It is not a sign that such a decline has to start right away, just that the conditions are ripe.