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Claassen Research, LLC www.ClaassenResearch.com

April 30, 2010

Thoughts on the Intermediate Trend

“It’s different this time.”…. those famous last words carved into the headstones of thousands of lost investors of decades past. While we desire never to be caught with those wordsleaving our lips, in truth every market cycle has something different than the previous. Equallyimportant, each market cycle shares similarities to one or more past bull or bear markets. Underthat pretext, to best understand the current market we should consistently ask ourselves; how isthis market environment similar to past markets and how is it different?

I thought it prudent to step back and re quiz myself on the above when I came to realizefrom current readings that, after sixty weeks of advance resulting in a gain of over 80% in thebroad market, almost every market strategist and technician I know is bullish. In some caseswildly bullish with comments like “…any market correction must be at least a year away” and “themarket is nowhere near a top”. …Wow. Now, I like bull markets, especially this one, and I hope itwill continue. But, I am at heart a contrarian. So when I see a crowd leaning too far in any onedirection, with growing enthusiasm, I cannot help but search for a counter argument to forewarnand forearm myself against the surprised stampeding herd.

Many of the arguments for further market gains rest in historical norms of indicators used bystrategists for decades to measure the health of a bull market. Traders Narrative produced a well

written article that encompasses most of these indictors. In brief, the bullish arguments include:

1. The Advance Decline Line is at new highs, and it always declines before a Bull market high.2. The percentage of stocks above their 50 day and 150 day averages is high, showing full

market participation in the rally.3. The number of new 52-week highs continues to expand and is stronger than any time since

1982! Here, too, this indicator should begin to contract months before a market high.4. As long as small cap stocks are leading, the market is in fully bullish mode.5. Historical measures of supply and demand are too bullish for a market to peak.6. Breadth is more bullish than at any time in the last twenty years.

For the most part, the above are different measures of breadth. It is true that historicallymany, if not most bull markets peak after a prolonged period of breadth erosion. However, not allbull markets end so gracefully. What I will present in these pages is a basis for why it may beunwise to expect a graceful end to the current rally, and why market strategists should not beenthusiastically expecting the market to continue higher until sometime after their indicators havewarned of its potential demise.

http://www.tradersnarrative.com/technical-reasons-for-more-stock-market-gains-3995.html

http://www.tradersnarrative.com/technical-reasons-for-more-stock-market-gains-3995.html

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How is this market different than past markets?

When I first spoke of the coming secular bear market in the very late 1990’s, a period whenan investor’s idea of diversification was owning Intel, Cisco, AOL and Akamai in three differentaccounts, I was greeted with the verbal equivalent of tomatoes. I believe by now we can all agreethat the current environment is very different than a secular bull market. Our economic growth isfragile and our markets are not experiencing a prolonged period of earnings and P/E expansion,driven from an historical low base, as required for a multi decade advance.

Our current market is also not driven by typical business growth. Yes, the percent returnsof fundamental valuations are up from last year’s very deep trough, but still far shy of past yearsand the levels needed to support employment growth. (The Fed is not keeping rates low forentertainment purposes.)

The gorilla in the room is the Federal Reserve. We all know this cyclical bull market isliquidity driven. The unprecedented level of U.S. and global liquidity pumped into the economy

make this cyclical bull market “different” than the bull markets that ended in 1929, 1968, 1987,2000 or even 2007. As the dissenting FOMC Governor Thomas Hoenig is trying to warn,somehow somewhere, excess liquidity always finds its way into the markets. We have seen this inJapan since 1993 as each cyclical bull market is fueled by a new round of quantitative easing, thencomes to an abrupt halt. The same can said for China’s Shanghai Index, which advanced 108%from October ’08 to August ’09.

As a side note : After a 108.76% return off its October ‘08 low, the Shanghai Index is off about 18% from its August ’09 high and has struggled in a roughly sideways pattern since then.While many investors view the weak performance as a leading economic indicator for the US,

another possibility is that China’s equity market is enduring the same “investor rotation” as did theUS market in 2000. Readers may remember that US equities peaked in 2000 as the internetbubble burst, and the investment of choice switched from equities to real estate. Money flowingfrom the equity market drove the real estate bubble higher for another five to seven years(depending on your local). Although the US economy did experience a relatively minor recessionfrom March through November 2001, it wasn’t until the real estate bubble burst that the economyfell into the current Great Recession. With China’s rising real estate prices and declining equities,it appears to me that a similar scenario is unfolding; money is simply moving from equities intoreal estate. But, that is a discussion we can detail at another time.

How is this market similar to past markets?

If we define the current environment as a cyclical bull market within a secular bear trend,what are the similar time periods with which we can compare?

Certainly, Japan’s equity market from 1992 is filled with liquidity driven cyclical bullmarkets to which we might compare the current market rally. Unfortunately, we have very littledata other than price and volume. Thus, almost all we can say is Japan’s bull markets during the

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90’s averaged about 50 weeks with 50% returns. But here, I would note that the tops of theserallies were consistently an inverted “V”, not the rounded tops of which most current marketparticipants expect. The inverted “V” tops suggest there was very little warning, if any, of thechange in trend.

Nikkei 225 1990-2003 Weekly

We might also look at the US market during the previous secular bear from 1968-1982.Here, a simple examination of the Advance Decline line shows an environment nothing like whatcurrent market participants expect. Remember the Nifty Fifty? Market breadth peaked in 1959and fell precipitously from January, 1966 to January, 1975. It should also be noted that the cyclicalbull market peak of September, 1976 was not preceded by a top in the Advance Decline Line. Tothe contrary, the Advance Decline Line peaked in July, 1977, ten months later. Since the AdvanceDecline Line is a measure of breadth, we can conclude that breadth did not behave in a “typical”manner for an entire decade of the last secular bear market, and could not have forewarnedinvestors of the cyclical changes in trend. That alone should question what we currently perceiveas normal behavior for some indicators. But, this empirical evidence of “abnormal behavior” is just a side note compared to more recent and pertinent data.

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S&P 500 with NYSE Advance Decline Line 1960 – 1980 Weekly

The first chart below is of the NYSE Composite during the period just before and after theSeptember, 2000 bull market peak. In the bottom panel of the chart I have the NYSE Advance

Decline Line, above that the Percent of Issues Above their 150 Day Average and in the next panel a10 Day Average of Breadth (Advancing Issues / Total Issues) and its 150 Day average (red).

One can say that the Advance Decline Line led the market top. In fact the Advance DeclineLine peaked in the second quarter of 1998, before even the 1998 bear market. It was kind of along lead time to suggest its declining trend helped market timing. It appears that when coupledwith the 1960’s, we can say that the Advance Decline line’s behavior as a leading indicator is not asinfallible as many believe. But what I find most significant and possibly more relevant to thecurrent situation, is that the NYSE Advance Decline Line bottomed as the NYSE Composite wasforming its high, and began to climb in December of 2001. Yes, breadth was rising as the broadmarket declined.

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NYSE Composite 1998 -2003 with Breadth Indicators.

Just in case the Advance Decline Line is giving us an “off” signal, let’s look at the Percent of Stocks Above their 150 Day Average. The Percent Above indicators are valuable because they are

really a measure of the breadth of momentum. A stock can show up as a negative on an AdvanceDecline Line because of a bad day, but if it remains above its 150 Day average it can be consideredin a long term uptrend, its 50 Day average can represent an intermediate trend etc. Thus, thisindicator measures the percent of stocks with positive momentum and trend over various timeperiods. Here, too, in the case of the market decline from the September 2000 peak, the percentof stocks in a long term uptrend rose from a low in the first quarter of 2000 to over 80% more thana year into the bear market!

The next indicator on this chart is the 10 Day Breadth, also called Breadth Thrust. This is asimple measure of the percent of stocks advancing. In red, I have illustrated this indicator’s 150Day average. Certainly, if a bear market meant that most stocks were declining, this indicatorwouldn’t be showing us more advancing issues. But it is. The percent of Advancing Issuesgradually increased until about the same time that the Advance Decline Line and Percent Above150 Day Average Peaked.

How can this happen? It’s illustrated in the next chart.

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NYSE Composite 1998 -2003 with the S&P 600 and Breadth Indicators

The chart above of the NYSE Composite and indicators is identical to the first except wehave added the S&P 600 Small Cap Index in orange. While the broad market was declining from

2000 to 2002 there was a stealth bull market in small cap stocks. One need only think of thenumber of components in the Russell 2000 Small Cap Index relative the S&P 100 Large Cap Indexto understand there are a lot more small cap stocks in the NYSE Composite than large and mid capstocks combined. Small cap stocks are the engine of market breadth.

This was a very unique situation, and what made it unique is what makes it similar totoday’s market. But the market strategist or investor looking for breadth erosion to signal the endof a bull market, or for Small Cap stock performance to falter, or the Percent of Issues Above their150 Day Average to weaken would not have been able to identify the end of the bull market untilafter the fact. Even the measure of New 52 Week Highs in the chart below peaked after the

market, not before. And Lowry’s measure of demand, the Buying Power Index, posted its all timehigh in May of 2001 and a secondary test of that high in May of 2002 consistent with the peaks inthe small cap stock index. How can a measure of investor demand continue to climb for a yearand a half into one of the worst bear markets in decades? I believe the answer is in the chartabove.

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NYSE Composite with New 52 Week Highs and Lows 1999-2003

What does the bear market of 2000-2002 have in common with the current rally?

The answer: excess liquidity provided by the Federal Reserve.

Remember Y2K? As the clock ticked closer to the end of the century many individuals andbusinesses were in a near panic, afraid that the computers we have grown to rely on will notfunction when the clock struck 12:00 am on January, 2001. In order to ensure a functioningfinancial system the Federal Reserve distributed $80 billion in funds in the fourth quarter of 1999,compared to $23 billion a year earlier, in addition to special options that allowed excess liquidityfor January, 2000. After the Y2K issue was declared a non event, the Federal Reserve moved totake back as much liquidity as it could. But, there is no way the Federal Reserve can prevent theeffect of excess liquidity echoing somewhere in the economy.

The Y2K fear was not the only event that resulted in the Federal Reserve pumping liquidityinto the economy during the 2000-2002 bear market. We can never forget the tragedy of

September 11, 2001. As a result, the Federal Reserve once again pushed emergency liquidity intothe system in order to ensure its smooth function. In all the Fed injecting approximately $81billion into the government securities markets, loaned approximately $46 billion from the discountwindow and executed a series of currency swaps with the European Central Bank, the Bank of England, and the Bank of Canada totaling an additional $90 billion.

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Between the Y2K fears and the September 11 th tragedy approximately $275 billion of excess liquidity was fed into the system. It’s a number that pales in comparison to the liquidityprovided as a result of the recent Credit Crisis, but it’s still a lot of money. As noted earlier;somehow somewhere, excess liquidity always finds its way into the markets. Considering that inthe middle of the greatest bear market decline in nearly three decades and eight months after the2001 emergency liquidity, the S&P 600 small cap index made a new all time high. I suspect thatsome excess liquidity found its way into speculative small cap issues. As a result, the marketbreadth indicators, the Advance Decline Line, New 52 Week Highs and measures of demand allpointed to a broad market bull that didn’t exist. Breadth measures showed the market to bestronger than the indexes could possibly portray as the advancing masses of low priced small capsecurities overpowered their large and mid cap counterparts. Can you imagine what thosebreadth indicators would have looked like if all this occurred during a bull market? Perhaps that’swhat they look like today.

Conclusion

As stated in the opening paragraph; to best understand the current market we shouldconsistently ask ourselves; how is this market environment similar to past markets and how is itdifferent?

A characteristic of virtually every bull or bear market is to continue in one direction untilsometime after the majority of participants are convinced the trend is sustainable. Withbullishness of both individual investors and market strategists at extremes it is time to askourselves “how can this market fool the most people?” Should we really expect it to simplycontinue higher until sometime after the indicators so many analysts are watching give a sellsignal? Although past examples of liquidity driven rallies are limited, they consistently illustrate a

sharp inverted V top indicative of a change in trend with little warning.

The intent of this writing is not to discredit select technical indicators; I have faithfully usedthese indicators and others for decades. Rather, it’s to offer a reasonable alternative explanationof the extreme bullishness in indicators designed to measure the breadth and sustainability of themarket. In doing so, we also open doors to alternative scenarios that can help us identify how thismarket rally may end. What if stocks begin their decline due to more difficult earningscomparisons, but the Fed stays accommodative? Can we have a repeat of 2000-2002 bear marketin large and mid cap stocks with small caps leading? I would suggest the best method to avoid anypitfalls related to the possible effects of excess liquidity and small cap stocks is to monitor themarket by sector, industry, or capitalization segment rather than the focusing on the entire NYSEand expecting the market to follow.

My view is there is little doubt that the current record positive breadth is a result of theexcess liquidity provided by the Federal Reserve to combat this Great Recession. I also do notdoubt that when this bull market ends, the crowd will greet the initial decline as another buyingopportunity. Even more, there will be a select few who will hold onto the belief that the bullmarket is alive long after its demise because of the indicators they are so faithfully watching.

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The information contained in this publication was prepared from sources believed to be reliable, but is not guaranteedand is not a complete summary, or statement of all data pertinent to an investment decision. Opinions may changewithout notice. This report is published for informational purposes only and is not to be construed as a solicitation oran offer or recommendation to buy or sell any financial security. Trading and investing involves risk and pastperformance may not be an indication of future performance. Claassen Research, LLC and its author accept no liabilityfor any loss or damage resulting from the use or misuse of this report. No Quantitative formula, technical orfundamental system can guarantee profitable results. No reproduction allowed without permission from the author.All rights reserved. © 2010, Claassen Research, LLC.

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