Download Supercycle wave (1)

A detailed introduction to Exceptional Bear
The Year of the “Noah effect”
Benoît Mandelbrot, the father of fractals, passed away at age 85 last week. Mandelbrot
was the ultimate interdisciplinary scientist, who applied his findings across a wide array
of scientific fields including physics, biology, mathematical finance, chaos theory and
markets. A fractal is essentially a structure where the whole is echoed in its parts, and
in parts of its parts, while remaining the same no matter how much it is blown up or
scaled down. Below are two examples of fractals. In the snowflake, focus on the white
areas to find the floor plan of a Gothic Cathedral repeated in five progressively smaller
sizes.
Figure #1 Fractals
Fractals are inherent in Nature, as shown above and therefore in Stock Market patterns,
which closely model Nature. As Mandelbrot pointed out “all charts look alike - without the
legend you can’t tell if you’re looking at decade’s worth of data or an hour’s”. The corollary is:
A Bear Market is no more than a multi-year correction on a monthly chart, where the
identical pattern might last just a day or two on a 10-minute chart.
The chart below is the basic fractal, which serves as the template for the entire
Supercycle Bear Market.
Figure #2
Please take a moment to get your bearings, Supercycle Wave (III) is the March 2000
top, (labels are placed upon completion each segment) and we are on the way down in
Supercycle Wave (IV), an A-B-C, with only the C wave to go.
Figure #3 S&P Monthly
(in candlestick charts the wicks denote a retracement, or double pass; a hollow red
candle near the low indicates a bearish reversal, meaning the bottom is likely in, while a
solid black candle near the top means a bullish reversal, meaning the top is likely in.)
Figure #4 S&P Weekly
The weekly chart above is a magnification of the previous monthly chart, showing only
wave C unfolding. Once the second Diag II is complete, there is a Supercycle
Transition a complex a-b-(a), a-b-(b), to indicate the last wave returns to the higher
degree. The same degree that resulted in the longest Bull Market in history from 1982 to
2000, when the market price exceeded ten times the total price appreciation up to that
point, from the late 1700’s.
Figure #5 Hourly Dow October-November 2008
The identical Diag II structure is inverted above on the hourly chart, as “the correction of
a larger correction” as a fractal of the larger Bear Market. The hourly chart above
shows that Diag II in detail, with the sub-divisions 5-3-5-3-5.
The Diag > indicates a terminal move, as you see the a marked the top, followed by a
reversal to b
The chart below shows the previous Supercycle Transition that bean the longest Bull
Market in History. This time the Diag IIs come after the transition, rather than before it,
but the indication is the same the beginning of a long move, the more and larger the
Diag IIs structures, the more severe the subsequent move. If I am mistaken about the
total collapse, the minimum downside the area between S&P 128 and S&P 59, meaning
a return to 1983-1984 price levels, however the more likely is a return to 1940’s prices,
the same as 1909, severe Deflation. See Figure #8.
Figure #6
It was Mandelbrot who disproved the Efficient Markets Hypothesis, Modern Portfolio
Theory, the Black-Schools Options Pricing Model and the Capital Assets Pricing Model
half a century ago. Most financial equations continue to be based on these defunct
theories, since they use the “risk-free rate” as their cornerstone. Markets neither follow a
“random walk” nor do outcomes fall under the “bell-curve”. What’s more, although
markets reflect all known information much of the time, as shown in the chart on the
right below, in actuality, extreme outliers are far more common than a random coin toss
would infer. Mandelbrot distinguished between the “Joseph effects” (seven bountiful
years, followed by seven lean years) and the “Noah effects” – cataclysms like the
Great Flood or the Crash of 1929, and its likely repeat in 2011. While financial models
measure the “Joseph effects”, it’s the “Noah effects” which make or break investors,
since these outliers are responsible for the bulk of long-term wealth-building – namely
yours.
Figure #7
The 20th century saw 48 days in which the Dow swung more than 7% (equivalent a
standard deviation greater than 3.5%). Normal statistical modeling predicts such swings
would occur once every 300,000 years! While mathematical models tend to capture a lot
of reality, only a fool believes they capture all of it. Most investors continue to ignore
Mandelbrot’s insights by remaining fully invested “long” in stocks at his juncture, and
believing bonds are safe long-term, with the excuse that they “can’t time the Market”, or
that its “Time in the Market, rather than timing the Market” that leads to long-term wealthbuilding. The Market Crash ahead will likely blow the previous extreme standard
deviations out of the water and go down as the “Mother of Extreme Outliers”, the
proverbial “Black Swan”. Tho9se that remained invested between 1929 and 1932, had
not stocks of companies that went bankrupt, like the blue-chip NY Central Railroad, and
made no withdrawals, required more than 20 years to “get even”. If they made any
withdrawals in the midst of Depression, their losses became un-recoupable.
Unlike the first Great Depression, this Supercycle Bear Market has had to contend with
record amounts of fiscal and monetary interventions to postpone and restrain Nature’s
forces from unfolding – causing a counter-force of immense proportions to amass. Each
time the day of reckoning is post-poned, increases its eventual severity and enduring
effects. It’s doubtful that monetary policy has ever had more than a band-aid effect. So
desperate is Bernanke that he has resorted to manipulating “expectations”, in addition
to the market, (nearly the entire rally from the March 2009 low was manipulated by the
Fed buying Futures through the NY Fed’s primary bond dealers) since the market
forecasts the economy better than any economist, by manipulating the market the Fed
hopes he can pull off enough of a rally to “fool the market” and the economy back to
recovery.
While the previous outdated market theories would infer remaining “long” at all times, as
Mandelbrot proved, the risk of doing so at this juncture, is immeasurable under the
current mathematical paradigm. Most investors continue to believe the Fed is in control
of the economy and can pull off a slow recovery. Of course this time is different, “we
have a ‘Depression Era scholar’ directing the Fed”. Bernanke’s consciousness is 130 –
lower than even Hitler’s! The same “super blip” that will inflict misery and embarrassing
serial downsizing on many, will give new meaning to the concept of an “outlier, windfall
– the Noah effect” to an informed few.
Elliott Wave Simplified
Ralph Nelson Elliott discovered nearly 80 years ago that five waves up, labeled 1-5 in
the diagram below, mark man’s progress in every endeavor. Where wave 2 corrects
wave 1 and wave 4 corrects wave 3. (essentially three steps forward, two steps back)
Once 5 waves are complete they equal wave 1 of the next higher degree of trend. In
Elliott terms, 1909-1932 was Supercycle wave 2, and the Bear Market beginning in March
2000 is the corresponding Supercycle wave 4 of a huge 5-wave Supercycle advance. Like
the period between 1929-1932, we can expect a 90% plunge in stock prices, and
catastrophic losses for the vast majority of investors, and all pensions. Relevant
degrees of trend from high to low are Supercycle, Cycle & Primary.
What’s more, the market is a fractal, which like a recurring theme in music, the larger
structure is echoed in its parts. Thus waves 1, 3 and 5 called impulse waves, or what we
would normally think of as “bull moves”, are labeled with numbers, and each sub-divides
into another 5 and another 5, just like the Russian eggs, where there is always smaller
one inside, at all degrees of trend, from the multi-century to the 1-minute chart.
Corrective waves, 2 and 4, sub-divide into three waves or variations thereof, and are
labeled with letters. They tend to be far more complex, with more than 42 possible
permutations and combinations.
In the chart below you see the Century chart and the corresponding valuations the q
ratio measures the discount or premium to replacement value of a company’s assets,
while the cyclically-smoothed 10-year P/E ratio, sometimes referred to as P/E 10. As
you see once the valuations peak and start down, the minimum downside is a 60%
discount to their assets, but that’s at Cycle degree, or in multiple plunges in a
Supercycle Degree, but the trough in Supercycle degree, is the yellow line where
company assets sell for 10% of their replacement value, while stocks that earned $10
per share in the preceding 12 months sell for $2 per share.
Figure #8
Elliott’s only 3 Rules are:
1) Wave 2 cannot exceed the origin of wave 1
2) Wave 3 is never the shortest, and usually the longest
3) Wave 4 cannot overlap wave 1
Diag >s (read Diagonal Triangles) and Diag II & Diag II ( read Diagonal 2s) break all
three rules
Guidelines
1) Corrections usually retrace to the previous 4th wave of one lesser degree.
2) Diag > are terminal structures indicating dramatic reversal ahead, labeled
black to indicate a moribund move.
3) Diag II and Diag II to indicate bullish or bearish, are found at the beginnings
of long moves. When found in Impulse segments in either direction, they
indicate the beginning of a long trajectory. When found in corrections the
largest of these also signals a long trajectory, and usually the trough of the
entire correction once complete.
4) The larger the structure the greater the subsequent effect. For example, a
Diag II visible on the monthly or weekly chart, will be many times stronger
than one that’s visible only on the hourly chart.
5) When several Diag of the same kind are found in sequence, they compound
each other geometrically, as if their areas were multiplied, rather than added,
to magnify the force and velocity of the subsequent move.
6) The maximum number of Diags of the same degree that can appear in
sequence is 3.
7) Once complete, all Diags retrace back to at least the first touch point of the
originating Diag.
8) Alternation occurs whenever possible, for example if wave 2 is a simple
correction, wave 4 will be complex, if wave 2 is a sharp correction which
makes a new high, wave 4 will move mostly sideways and vice-versa. It also
applies to fast/slow corrections as between 2008 and 2010. So that those
expecting the identical outcome as last time always get thrown for a loop.
Why must the Market Plunge?
1) Despite the Fed, the market is a self-correcting mechanism; the primary reason
for a Crash now is a backlash to the Fed’s continued meddling. In order for
recovery to begin, the Fed’s entire credit creation, artificially low interest rates
and money supply expansion must be completely withdrawn first. A Crash
effectively accomplishes all three in a flash.
2) On a basis of its average 10-year earnings multiple, and in relation to corporate
assets the stock market is at least 50% overvalued and 99% of the S&P is trading
above its 50-day moving average. But rather than dropping back to merely fair
value, the market always overshoots from highly overvalued to highly undervalued.
3) According to Russell Napier’s Anatomy of the Bear, at market troughs stocks sell
at a 60% discount to replacement value and a P/E ratio below 6. At the March
2009 low, stocks were still selling at 13 times earnings - more than double that.
Meaning a drop far below the March 2009 low is assured - S&P 300 is likely the
minimum, from Friday’s close of 1345 equals a 78% plunge.
4) Carmen Reinhart, co-author of monumental work, This Time is Different, in a
paper delivered at the Jackson Hole Banker’s Symposium in August, provided a
glimpse of the future. Distilled from her research studies of 15 crises over threequarters of a century, including the Great Depression. Referring to 2008’s market
plunge, she concludes: “post-crisis, credit contracts by an amount equal to the precrisis surge”. But with the Fed continuing to pump out liquidity, the only way credit
can efficiently contract is through a Market Crash, where trillions of dollars vanish
into thin air virtually overnight, severely constricting the money supply and
reversing previous credit expansion. According to Reinhart, who reiterates the
principles of the Austrian School, “Quick (Keynesian) fixes, grasped by political
leaders impair, rather than improve the situation, by their unfortunate interventions,
and turn the crisis into a persistent malady of our own making.” The dust has not
begun to settle. Instead the shock from this crisis will likely be deep and
persistent.
5) The dollar is about to strengthen, almost as much as it has dropped from the
post-Greek crisis high. Given the current record volume in dollar shorts, the only
thing that could cause such a surge is a knee-jerk “flight to dollar safety” that
accompanies a Market Crash with its sharp contraction of the Money Supply.
6) Technically speaking, two colossal Diag II’s, which compound each other, signal
the beginning of a long move down to complete the C wave. The minimum likely
downside of ~S&P 300, retraces the Diag II which marked the pre-crash 1987
high. As Diag >s indicate dramatic reversal ahead, back to at least where the
lowest Diag began.
Figure #9 S&P Daily
Yet in the daily chart below you can see that a b wave will likely reach a slightly higher
irregular top. A bit more magnification in the Hourly S&P shows a Diag > in process
which should now retrace to at least 1320 and most likely to 1312. UPRO, our position
for timing services, shows nearly the identical pattern as the S&P above. We sold a
partial position at 81.25 on Friday, and will buy back in the area of 77-78.
I have a high degree of certainty that the end of the completion of the Supercycle
transition will likely take the S&P down in a “flash crash”. In Elliott an (a)-(b) transition
is analogous to crown molding which makes the transition from vertical to horizontal,
except the transition is from up to down. While crashes normally occur in wave 3, we
are already in the equivalent of wave 5, the second most likely spot for a Crash. The
transition back to Supercycle means a log degree or 10x bigger than everything that has
come since the 2000 Bull Market top. It should be very clear, but if “long” investors wait
for any further confirmation, there will likely be no exit, as in Sartre’s parody on Hell.
Like big paws on a puppy indicate a big dog later on, so a huge transition means a
severe collapse in the market. An (a)-(b) transition, far larger than any I have ever
witnessed, is highly consistent with a CRASH, especially coming on the heels of a
Double Diag II extending from 2007 to 2010, see figure #4 above.
At least a 75% plunge is all but certain. Given that market corrections “alternate”
between fast and slow, rather than the gut-wrenching slow decline we had in 2008,
which was mistakenly called a crash in the press, a true Crash is like 1987’s, which was
over in 3 days, or like May 2010’s “flash crash” on a much grander scale. While its
human nature to discount this forecast as outlandish, when you recall that a 50% plunge
has already occurred twice this decade, such a projection should seem very
reasonable.
Crashes are sudden realizations of Reality
Crashes are sudden realizations of reality - realizations such as “the entire ‘green shoots’
rally from March 2009 has been a Bernanke-manipulated fraud”. If the green shoots had
been real, we would have had lush foliage by now, meaning job increases of 200,000300,000 per month. Instead we have chronic unemployment, mass deleveraging,
depressed bank lending, mounting foreclosures, and plunging Real Estate. As we
continue in denial to look for “less bad” economic results, rather than improvements, we
are setting ourselves up for the Mother of all Crashes.
VIX about to Spike up
The VIX, sometimes called the fear index, which measures volatility, is inversely related
to the S&P. When the S&P plunges, it Spikes. Lately we’ve seen a tremendous drop in
volatility, like the calm before the storm. In the chart below you will note that the same
Supercycle transition as in the S&P, but in the opposite direction obviously. Diag IIs
indicate the beginning of a long move up. What is highly significant is we are beginning
a Supercycle wave (5), which will most likely spike up at least 1.612 times and possibly
2.618x the length of Supercycle wave (1) to either 145 or 235. These are Fibonacci
multiples, named after Leonardo Fibonacci, a 12th century genius, from Pisa, who
introduced Arabic numbers to Europe, and re-discovered “golden section”, phi, the
fractal used to build the Great pyramid of Giza. Phi mirrors nature’s proportions in
everything from the DNA molecule to the human body’s proportions.
What’s more, this chart indicates the “Noah effect” is right upon us! It should be all over
no later than the end of December. Waves (1), (2) & (3) trace out the same 5 wave
stylized progression in figure #8.
Figure #10
Figure #11
Finally the dollar has begun and intermediate-term rally, it’s in wave (ii) correction shortterm, while wave (iii) to follow should just reach 79 to retrace the beginning of the Diag
> as marked by the green dashed line.
Not the worst “Recession” – but rather Great Depression II
Rather than “the worst recession since the Great Depression”, as we keep hearing from
the press and the likes of Ben Bernanke and President Obama, this is the Second Great
Depression, which like the first, won’t be officially recognized until after the Crash.
Sovereign Risk in US Treasury Bonds
Soon Bond vigilantes will impose market discipline on Treasuries to compensate for
heightened default risk, the result of run-away fiscal deficits approaching 90% of GNP,
pitted against plunging tax revenues, meaning Treasuries are guaranteed certificates of
confiscation as rising interest rates translate into catastrophic losses on presumably
“safe government bonds”. This is déjà vu - a replay of the AAA-Rated Collateralized
Mortgage Obligations whose bubble was likewise instigated by the Fed, and ended up
being worth 20-30 cents on the dollar once mass defaults became evident. However, as
stocks begin to cave in, initially bonds will surge in knee-jerk “flight to safety”, before
it dawns on bond investors that default is all but inevitable. Perhaps a month after
stocks crash, bonds will follow. The dashed blue line in the RSI (relative strength)
shows bonds are as oversold as they were at the previous April low. From here we rally
back to the green dashed line (to fill the gap in the chart) before crashing as well. The
Diag II in wave i indicates the beginning of a long way down, but first it must be retraced
almost completely in wave 2 to the dashed green line, as shown. In the next move
bonds should drop back to the lower red dashed line before beginning the big move up.
The minimum upside in Treasury bonds is 107, afterwards a plunge below 87, while in
the ETF the min upside is 52 as shown, although first a drop to the dashed red line
should occur.
Figure #12
Insider selling, Emerging Markets, Banks
Insiders - the smart money, have sold their stock in record numbers 30, 40 and 50 to 1
over the last 12 months - they are rarely wrong. Emerging Markets have not decoupled,
they have merely gone temporarily “out of phase”, and will plunge hard, right along with
the developed economies – to which they owe their export-derived growth. Overly
optimistic fiscal authorities are over-estimating tax revenues, while federal, state and
municipal governments are on the brink of defaulting on their bonds. Rather than
temporarily illiquid, our banks are permanently insolvent. Instead of another wave of
monetary stimulus stretching out the road to recovery, anticipation of the next stimulus
wave is already spurring on the Crash.
Expert Market Timing employing leveraged, inverse ETFs
In 2008, Exceptional Bear’s performance exceeded 360% for 2x leveraged Trader
accounts (360% beats the all-time, best-ever performance by a money manager, John Paulson,
who’s accounts appreciated 300% with far more leverage in 2008, and implied risk) In nonleveraged Pension accounts our performance was over 240%. Since the net market
plunge was under 39%, to arrive at 240% we hit nearly every single market turn on the
nose) The next 12 months should easily surpass that benchmark. How did we do it?
Expert Market Timing. Since markets plunge many times faster than they rise, you can
earn more in one year of a Crash, than you’ve made cumulatively in the last ten, far
more.
Doesn’t it seem like the Fed is insulting our intelligence by targeting higher inflation,
while leading us to believe that it will buy Treasuries to lower nominal bond yields?
Like TIPS even a slight uptick in inflation turns bonds with already ultra-low yields,
into certificates of guaranteed confiscation This is the logic of a mad man.
"Make no mistake, the next 12 months will be profitable beyond your wildest dreams.
On the other hand if you remain long, you can expect catastrophic losses, from which
there will be no recovery”
At the trough, you will be able to buy stocks and bonds at ten cents on the dollar, when
no one else has any money, just before another Bear Market Rally kicks off, with most
assets appreciating very quickly back to peak prices in 5-7 years.
Your willingness to act now, or do nothing, will determine your standard of living and
that of your family for the rest of your lives– most people will have to severely tighten
their belts, many will experience unimaginable financial hardship, but a few will
prosper beyond your wildest imagination. Which will you be?
Markets are governed by Nature’s Laws - not the Fed
Inflation is totally inconsistent with 8-9% unemployment. By its very nature,
unemployment pushes down the prices of everything, which in turn perpetuates a
deflationary spiral. That’s why we’re in cyclical a Deflationary Depression. Let’s face it,
another round of the Fed’s monetary experiments, is unlikely to dig the US economy out
of its current hole, any more than an appreciating renminbi, and is as irresponsible as
the Chinese currency manipulation. With record-low interest rates already in effect, the
economy is certainly not being held back by interest rates. Ultra-loose monetary policy,
coupled with extremely high fiscal deficits is precisely the wrong response to the Bear
Market. The length of a bull market in years corresponds with the median human
lifespan, which was ~72 years in 2000, at that point a Depression began to rid the
market of past excesses, so it can renaissance as a new Bull Market. Like the seasons
and the tides, Bear Markets and Depressions are governed by the intractable Laws of
Nature, which must be endured. Attempts to keep the boom going by artificial means
are delusional and exorbitant delays to the day of reckoning, bearing monumental,
long-term social, psychological and economic costs.
The Time is Now
We focus on just the three highest return probability ETFs, and their inverses, which of
course is very different from three stocks, since each covers an entire industry or in the
case of Emerging Markets, all of the investible Emerging Markets.
You can find my Market Letters published on the internet with one month delay, under
Exceptional Bear, you can Google it.
Foreclosures and Banks
There is increasing evidence that there will be mass foreclosures in the year ahead as
mortgages successively go underwater and former owners walk away. In many states
homeowners do not owe the banks anything more than the keys to their home if they
default on the mortgage. Since many who bought at the peak paid no money down,
there’s little holding them back with these homes now 30% underwater. Negative equity
will accrue to the banks and the government agencies Freddie Mac and Fannie Mae.
It’s happening now and these are not unemployed, many are gainfully employed, and
taking the opportunity to get free rent while saving some money or pay off their debts,
while they await eviction. There are potentially millions of homeowners with negative
equity who will be walking away from their homes after a market crash. When this
backlog of homes that’s now building up with the foreclosure moratorium is lifted and
the homes finally sold it will be at drastically lower prices. Once people lose faith in the
value of their home recovering, they will simply throw in the towel and move to a much
cheaper rental. Of course this means another collapse of the real estate market
together with commercial real estate likely as bad a shape, given the necessary
refinancing due in 2012. This will mean monumental losses in real estate and for the
banks who own the mortgages. There’s no better forecaster than a good Elliott count.
Eduardo Mirahyes
Market Analyst