Dow 32000 remains on track
Posted by Danny on November 3, 2014
Markets continued to surge last week, racing right back to new record highs for some indexes. With the month of October behind us I am updating my Dow 32000 scenario, which just refuses to go away, and we will also look at potential causes for a final mania. But first we take our weekly look at the Nasdaq (click on chart to enlarge):
The current market situation is quite similar to last February, when the market recovered equally quickly from a sell-off. The current rate of change cannot be sustained for very long, and overhead resistance is now looming near 4650 and 4700. Technically my Earl indicator is just turning down and the MoM is reaching very overbought +8 territory. But just like in February the slower Earl2 still has a lot of room to rise. The market may hold up near current levels for a while, or it may start another leg down like it did in March-April, there is no way to tell at this point.
I don’t think we will get an exact repeat of March-April. I would rather look for a quick drop to ~4500 and then another rally attempt.
The LT wave chart for November looks like this (click chart to enlarge):
The LT wave was not perfect in October (it never is), but it signaled some downturns and correctly showed the strength in the second half of the month. For November it shows renewed weakness in the first two weeks, followed by a stronger period with a peak value around the 20th-22nd.
I have also updated the Dow comparison with 1920s for October (click chart to enlarge):
Despite ebola and geopolitical tensions around the world the Dow just keeps mimicking what it did in the roaring 1920s. Amazing? Well, the roaring 20s came on the heals of a deflationary shock that saw the stock markets drop some 50% in two years. The 1920s had historically weak GDP growth per capita. And the 20s had an overactive Fed which kept interest rates very low for a long time. And of course, investors remained very skeptical about the rising equity markets. In other words, pretty much the same as what are having since 2009.
We have now come to the point where the stock market took off again. For the scenario to stay on track the Dow will have to climb to ~20000 by next spring. If the Fed sticks to the 1920s playbook then it will start raising rates in summer 2015 and that will cause the stocks to make a blow-off top over the next 12 to 18 months. Of course, that would be in a perfect universe…
But why would stocks make such a moonshot when interest rates start to go up? Well, that’s why. Who wants to hold long term bonds when interest rates are set to go up? Long term bond prices are artificially inflated by the Fed’s QE programs, which were designed to push long term rates down. What happens when that manipulation stops? Right, the price of bonds will probably go back to a more “normal” level. What could that level be for long term treasuries? Here is a weekly chart (click to enlarge):
Before and after QE1 (Nov 2008 – Jun 2010) the long term bonds (ZB) hovered between 115 and 120 (pink oval in the chart), which means a long term rate of about 4.5%. Subsequent QE programs have pushed ZB up above 140, which means a current very low long term rate of 3%. I think ZB could easily fall back to the 115-120 area without the support of further QE programs. Long term bond holders then face a 20% loss. Once this starts happening investors will realize that it is better to be in cash or stocks until bond yields are more attractive again. We already got a taste of it three times since 2009: every time bonds have declined stocks have been doing very well:
*Jan2009 – Apr2010: bonds down 15% -> nasdaq up 56%
*Sep2010 – Apr2011: bonds down 12% -> nasdaq up 34%
*Jul2012 – Dec2013: bonds down 18% -> nasdaq up 42%
My long term chart now suggests that bonds have peaked out once again. There is a broad bearish divergence in my Earl indicator and the Earl2 has turned down recently. If bonds ZB drop back to 115-120 in 2015-16, then where will stocks be? Higher? Much higher? Dow 32000, after all?
The big risk with QE was probably never that stocks would crash when the program ends. The risk has always been that stocks could surge when QE ends, thus forcing the Fed to raise rates to reign in a runaway equity market. But raising rates could drive even more money out of bonds and into rising stocks, further destabilizing the situation and feeding into a speculative stock mania. The bond market is nearly twice as big as the stock market, so when money starts fleeing bonds it can have an outsized effect on stocks. That’s what we got in the 1920s and that’s what we now risk getting again. QE is a stingray, dear readers, all the poison is in the tail end.