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Correction or the Beginning of an Imminent Crash?

(March 23, 2004)

Dear Readers:

The divergence of the Dow Industrials and Transports that I pointed out three weeks ago turned out to be ominous signs - as the former declined 4.9% while the latter declined 5.2% from their respective levels of three Fridays ago.  Stock market analysts are now divided into two camps - with one camp calling for an imminent resumption of the bear market that began in early 2000 while another camp is calling the current decline a correction only - with new highs not far away for the various stock market indices.

The author does not claim to possess any "advance knowledge" of what the market will do over the next few weeks, and neither does he know over the next few months.  However, my stance on the stock market has not changed since early 2000.  I believe we are still in a secular bear market, and values deteriorate over time in a bear market.  Given this important assumption, there is a high probability that we will see new lows ahead for the stock market - the question is always: When?

The increase of the number of people calling for a top during the last few weeks does not surprise me.  This has been an emotional time but there is a time when the author of this website will have to take a stance for his readers.  In my previous commentary, I believe I have provided a good and thorough explanation of why new lows are not immediately ahead, and that we should be seeing higher highs in the stock market indices (with a possible non-confirmation in either the Dow Industrials or the Dow Transports) before this bull swing is over.  I am going to reiterate this argument today - with an update of my analysis from three weeks ago and an attempt in some new analysis.

First, let me reiterate that trading the stock market is all about gauging probabilities and determining the best position to take based on what you have evaluated from these probabilities.  The purpose of my commentary is to help my readers navigate this secular bear market - hoping that my readers will come out of declines (such as the ones during the 2000 to 2002 period) with their capital intact, and then investing that capital during severely oversold situations, such as those we had early last year.  Like I have said before, the author does not profess to know in advance what the market will do, but I have studied the 100 year-old history of the Dow Industrials and the Transports (formerly the Rails) and while I cannot say with certainty what will happen in the next few months, I can probably say with confidence as to what is most likely to happen during that time period.

Let's start with looking at a couple of weekly charts of one of most important primary indicators, the advance-decline line of stocks on the NYSE and on the NASDAQ:

NY Adv-Dec ($NYAD) NASD Adv-Dec ($NAAD)

As one can see, these charts still imply the trend is currently up for the broader market, despite the poor performance of the NASDAQ over the last few weeks (and yesterday).  Also, the number of new highs on the NYSE made a high as recent as December.  The number of new highs typically top out six to nine months before a top in the indices.  Based on this and the fact that the number of new lows (both on the NYSE and the NASDAQ) has not expanded, the author believes that none of the classic warning signs of an impending market top has emerged so far, and thus, the author believes that we have not yet seen the highs for the stock market indices in this current bull swing.

Long-time readers of my commentaries know that I have, at various times, compared the current bear market with the 1966 to 1974 bear market.  The 1966 to 1974 bear market was the second worst bear market in the U.S. in the post-Federal Reserve period.  I believe that it is an appropriate comparison for reasons that I will not go into detail here (however, one reason is that inflationary policies that is being carried out today makes the 1966 to 1974 period a similar comparison than the 1930s comparison - when the huge wave of deflation overcame any inflationary policies from the Federal Reserve.  There is also a possibility that the Federal Reserve's policy of inflation may fail, and if that's the case, you can stop reading this right now because the last thing you will worry about in that type of scenario is your stocks and other investments).  If the stock market resumes its decline tomorrow and go on to make new lows, then this comparison will be made null and void, simply because it will break all post-WWII records to the downside.  This will also suggest that the economy will experience worse things that what it experienced during the late 1960s to mid 1970s.  In fact, I will go one step further.  If the market is to resume its decline here and then go on to make new lows, we will probably experience the worst economic recession/depression since the Great Depression of the 1930s.  The laws of probability simply do not suggest that this will happen.  I believe you will understand why once you have read what I am about to write below.

I will begin my reasoning by posting a chart which I posted on this site three weeks ago.  Following is a chart tracking the amount of margin debt outstanding during the January 1966 to December 1974 bear market.

Margin Debt (January 1966 to December 1974)

The amount of margin debt outstanding is a direct reflection of the speculative nature and the optimism of Americans at any given point in time.  Note that during the bull swings within the 1966 to 1974 bear market, the amount of margin debt outstanding at the respective peaks have all made higher highs.  Also note that at the July 1970 bottom (which coincided with the bottom of various stock market indices), margin debt was approximately off 45% from its June 1968 highs.  At the December 1974 bottom, margin debt was approximately off 51% from its December 1972 highs.  More importantly, the margin debt outstanding in December 1974 did not break to a new low - the bear market ended with a margin debt amount of $3,840 million, $70 million above its July 1970 bottom.


At the bottom near the end of September 2002, the amount of margin debt outstanding was approximately $136 billion, 55% off from its high of $300 billion at the end of March 2000.  Today, this number is estimated to be approximately $190 billion, still very far away from its all-time high of $300 billion.  Following is a chart which tracks the current amount of margin debt outstanding which I updated from three weeks ago:

Wilshire 5000 vs. Margin Debt (January 1997 to February 2004)

Please note that I have not altered my comments in the chart from three weeks ago.  I still believe margin debt is in an uptrend.  If margin debt is to decline from here (which would happen if the market continues its descent here and makes a new low in the near future) then this will be a huge deviation from the 1966 to 1974 experience.  In a way, the huge decline of margin debt from $300 billion to $136 billion at the bottom has already broken some records, but it is close enough to the 1966 to 1974 experience so it does not make me feel too uncomfortable.  If the 1966 to 1974 experience holds, then we may have already seen the lows in the amount of margin debt outstanding.


Another great measure of the speculative nature and the general optimism of Americans is the amount of industrial and commercial loans outstanding at commercial banks.  Not everyone can tap the IPO or the bond markets, you know.  In a way, it is a lagging indicator of margin debt, as loans at commerical banks take a much longer time to process than loans that speculators get from their brokers.  Following is a couple of charts which compares the experience of such loans:

Outstanding Industrial and Commercial Loans at Commercial Banks (January 1966 to December 1976) Outstanding Industrial and Commercial Loans at Commercial Banks (January 1994 to December 2004)

The amount of industrial and commercial loans outstanding has stopped declining and has stabilized over the last six months.  Just like the amount of margin debt outstanding, I expect this latter chart to turn up and to maintain a sustainable uptrend starting in the next few months (similar to the post-1974 bear market trend).  A pause and another downtrend here would usher in a period of economic gloom and doom not seen since the 1930s.

Following is a chart of the Dow Industrials vs. the unemployment rate in the U.S. during the late 1960s to the mid 1970s period.  This is meant to serve as a "refresh" of our economic experience during and immediately after the 1966 to 1974 bear market.  Believe me, it was not pretty:

Unemployment Rate vs. Dow Industrials (January 1966 to December 1976)

Note how the Dow Industrials acted as a leading indicator for the unemployment rate during that period of time.  The fact that today's relatively weak job growth does not bode well for the stock market is a myth.  The stock market looks ahead; it is an attempt by the smartest individuals and companies to discount what it can see ahead for the biggest U.S. companies and for the U.S. economy.  Since the peak of the unemployment rate at 6.4% in June of 2003, the job market has experienced approximately eight to nine months of net job creation (not shown here).  If the market has topped out here, chances are that the unemployment rate would bottom at four to six months from now, and would then start to increase and make new highs. 

Again, such a deviation will imply a more severe recession than what we experienced during the late 1960s to mid 1970s.  This will only happen if the current inflationary and easy monetary policies of the Federal Reserve and the government fails.  Moreover, given the protectionist policies that are sweeping through Congress right now, I personally do not believe that unemployment would top out at 9% if it decisively turns back up here after only 12 months of net job creation.  Again, I am envisioning a scenario much worse than 1982 (when unemployment topped out at 10.8%); such a scenario may have the unemployment rate ultimately peak at anywhere from the 1982 peak to the 1933 peak of 25% (contrary to what the average American thinks, protectionist policies do not create a net amount of jobs in the long run.  The only reason why we did not implement more protectionist policies against Japan back in the 1970s was because of the long 34-month period of net job creation - which convinced Americans that Japan was not the cause of unemployment here in the U.S).  Such a scenario will not be pretty and I doubt even if the short-sellers would want such a scenario here.

To conclude this commentary, I believe what I have outlined is a very low probability scenario - a scenario which I do not think will happen given the inherent creativity and innovativeness of the American people and given the fact that I still believe the 1966 to 1974 comparison holds.  All my current indicators still suggest that it will hold.  In the meantime, the downside confirmation of the Dow Transports by the Dow Industrials suggests that we have more downside (or base-building) to go, despite the current severe oversold conditions in the stock market.  A strong support level for the Dow Industrials is the 9,600 to 9,800 level, which is very close to its simple 200-day moving average.  I believe we are now very close to the bottom - the author himself will be shifting his 401(k) money from a money market fund into the stock market over the next five to seven business days.

Signing off,

Henry K. To, CFA

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