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Stock market right on the edge

(May 5, 2002)

Black Monday, October 19, 1987: The Dow Jones Industrials suffered its biggest one-day percentage lost ever - losing 22% or 508 points. The DJIA had closed at 2,246 points the prior Friday (already 475 points off from its all-time high of 2,722 made on August 25), and after Monday's decline, it stood at 1,738, nearly 1,000 points off from its all-time high.

October 20, 1987: The DJIA immediately opened 200 points higher from the previous day's close, but as the day wore on, the index gradually declined. At its lowest trough, the index was over 120 points lower than Monday's close. By early afternoon, a handful of large institutions were not meeting their calls - they simply had no funds left in their coffers. Half of the Dow Jones Industrial stocks simply had no bids, and trading were halted in those issues. Virtually all the NYSE market makers were wiped out. Had it not been for the Fed, we would have witnessed a 1930's style financial collapse all in one day. It was the scariest day in modern stock market history, perhaps only equaled or surpassed by the Panic of 1907 (J.P. Morgan ended up bailing out the NYSE that day). The 1929 and the 2000 Nasdaq crash did not even come close.

Not long afterwards, people from all walks of life were predicting a 1930's style economic depression, but apparently, the bull market that began in 1982 had not yet run its course. From its 1987 closing high of 2,722 points, the DJIA managed to gain another 300% over the next 12 years, finally cumulinating in an 18-year bull market peak of 11,723 points on January 14, 2000.

This time, however, we would not get off this lightly. No, this has been the most speculative market of all time, and it will only end with the greatest bear market of all time. The Fed's motto has always been: "Inflate or die." But I believe it is now too late - even with an annualized 15% growth in M2 and M3. Our society is saddled with debt. As debt gets repaid and as individuals and companies become bankrupt in this difficult economic environment, money simply vanishes. Banks would become further reluctant to borrow. Remember the money-multiplier effect you learned in high school? Well, it is going to work in reverse, and instead of inflation, deflation will become the norm.

Short of hyperinflation, the Fed was never scared of inflation. What they are really scared about is deflation. In a deflationary environment, everything goes down in price. Housing, stocks, commodities, consumer goods, etc. Gold and cash becomes king (the former because gold is simply not a commodity, but real and "honest" money). Banks and businesses collapse, and unemployment becomes rampant. The 1930's was a great example, and I believe we are now heading towards that direction again.

Anyway, let's leave the above discussion for another day, as the main purpose of this commentary is to communicate to you what our short-term overview of today's stock market is.

Simply put: we are, again, right on the edge. All fundmental and technical indicator that I keep track of now says "BEAR." How big? Well, read what I have to say in the first and second paragraphs. I sincerely suggest you take out some cash and gold and silver coins and stash some at home, if not in your wallet. This is going to be one hell of a ride.

Make no mistake, the fundamentals have always been awful. The DJIA at 10,000, however, is now discounting a huge economic recovery in the next few months, but get this: I believe it is going to get much, much worse before it gets better. In fact, maybe another 4% worse (and that will take us to over 10% unemployment).

Valuation is still way above the peak of the last two bull markets, with the DJIA collectively trading at over 40 times earnings (and these earnings are questionable at best) and yielding less than 1.5% in dividends.

The DJIA has now broken down again from its 3-year HUGE distribution top. It is now below its up trend line from late September 2001, its 50-day moving average (DMA) and 100 DMA, the latter which has provided very good support for the last few months.

Margin debt, after spiking up a couple of weeks ago, spiked up last week again. Margin debt levels are now at their highest since immediately before the WTC attack on September 11.

The McCllean Summation Index is now saying we will retest the September lows, and the ARMS index is calling a bottom within the next ten trading days. The Nasdaq just plunged below its April 2001 lows on Friday - with support all the way down at 1,390, the late September 2001 levels.

Gold has increased in price for the last few months. Prior to the 1987 crash, gold was trading in the same pattern.

The US$ has now broken out of its intermediate up trend. The dollar basically crashed on Friday - declining over 1% during the day. FYI, the dollar also crashed prior to the 1987 stock market crash.

Both the VIX and the VXN are now in an up trend, indicating that fear has now spread into the markets.

Mutual fund inflows have been high for the last few weeks. According to AMG, the largest weekly inflow since May 2001 (right before the top of over 11,300 on the DJIA) was recorded three weeks ago. Another big inflow was recorded last week. The masses are always wrong at critical junctures, and they will be wrong once again.

The Committment of Traders (COT) report is in another record imbalance. The commericals are now in a record net short position in the S&P 500 contracts while the non-commericals are in a record net long position. Stanley Druckenmiller (the guy who managed Soros' Quantum Fund prior to his leaving in early 2000) took one look at the COT report on Friday afternoon, October 16, 1987 (which basically says what the report is saying now) and he immediately knew the market was going to crash on Monday (it would have happened him immensely if he had such knowledge before the market closed, since he went to a record long position before the markets closed on Friday - but nonetheless, he made money anyway since he sold all his longs right when the market opened on Monday and went short instead).

So there you go. Virtually every fundmental and technical indicator that I keep track of is now pointing to a huge decline within the next six weeks. The one remaining critical indicator which hasn't been flashed yet is the violation of the 200 DMA of both the Dow Jones Industrials and the Dow Jones Transports. The former stands at 9,930 and the latter stands at 2,648. When both of these levels have been breached, I believe a watershed decline will emerge - a.k.a. A STOCK MARKET CRASH.

What will the magnitude of the crash be? I don't know, but I believe the DJIA will at least retest its September 2001 lows, and if that is breached, look out below. In that scenario, I would not even try to guess.

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