Wednesday, April 15, 2009

How Low Can You Go? Elliott Wave and Q Ratio Style.

Within technical analysis, Elliott Wave theory is one of the most useful indicators to try to forecast major market trends. While very controversial - as no indicator is always right and conclusions among analysts can vary - it draws legitimacy from the fact that human nature, specifically oscillations between greed and fear, is repetitive. And as such, it is predictive.

As Elliott Wave International explains, "It reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific and measurable patterns. One of the easiest places to see this phenomenon at work is in the financial markets, where changing investor psychology is recorded in the form of price movements. If you can identify repeating patterns in prices, and figure out where in those repeating patterns we are today, then you can predict where we are going in the future."

The Elliott Wave experts currently believe that we are in a primary up wave (i.e., countertrend rally / retracement wave) within the context of a secular bear market. While there may be a very near-term pullback, the expectation is for prices to retrace a previous wave pattern to around 10,000 on the Dow. Near this level also represents a valid Fibonacci retracement level, which could add credibility to it as a final target.

But make no mistake, this bullish frenzy will end.

While this bear market could be halfway done in terms of time, it is likely less than halfway over in terms of price decline. And it is extremely naive to assume that prices will quickly rally off of the ultimate lows when they are formed. Neither the technical, nor fundamental picture makes this probable. Anything is possible. But probable? No.

A supercycle (think Kondratieff) ascending price channel on the Dow that has held up for 80 years has now been broken. It appears that the lower channel support sits between 3800 - 4000 on the Dow. This would be bad enough if prices were expected to halt their decline at this level.

That is not the case.

Based on the historical breach of the Wave 5 channel line in the Great Depression - Elliott Waves move in 5 wave patterns and the Dow just completed its 5th wave prior to the current decline - that support may hold as well as a swimming pool surface can hold off a diver. While prices may retest those levels as new resistance, they are not expected to be successful.

There are renown analysts that are forecasting bottoms in the 1000s, 2000s, and 3000s. Tobin's Q Ratio is one of those tools that makes this case.


A global stock slump may have further to go, according to Tobin’s Q ratio, which compares the market value of companies to the cost of their constituent parts, CLSA Ltd. strategist Russell Napier said.

The ratio, developed in 1969 by Nobel Prize-winning economist James Tobin, shows the Standard & Poor’s 500 Index is still too expensive relative to the cost of replacing assets, said Napier. While the 39 percent drop in the index this year pushed equity prices below replacement cost, history suggests the ratio must sink further as deflation sets in, he said. The S&P may plunge another 55 percent to 400 by 2014, Napier said.

“The Q has come down to its average, however it’s not always stopped at the average,” said Napier, Institutional Investor’s top-ranked Asia strategist from 1997-1999. “It has tended to go significantly below that in long bear markets.”

Napier, who teaches at Edinburgh Business School and advised clients to buy oil in 2002 before it tripled, based his S&P 500 forecast on the Q ratio for U.S. equities as well as the 10-year cyclically adjusted price-to-earnings ratio, another measure of long-term value.

Before the trough in 2014, investors are likely to see a so-called bear market rally for the next two years as central bank actions delay the onset of deflation, Napier said.

In the long run, stocks will become even cheaper,” said Brian Shepardson, who helps manage $1.9 billion at Xenia, Ohio- based James Investment Research. The firm’s James Balanced Golden Rainbow Fund beat 98 percent of similar funds this year. “There’s a likelihood of some type of rally and further pullback surpassing the lows we’ve already set.”

The Q ratio on U.S. equities has dropped to 0.7 from a peak of 2.9 in 1999, and reaching 0.3 has always signaled the end of a bear market, said Napier, 44, the author of “Anatomy of the Bear,” a study of how business cycles change course. The Q ratio for U.S. equities has fluctuated between 0.3 and 3 in the past 130 years.

"At the end of the four largest U.S. bear markets in 1921, 1932, 1949 and 1982, the Q ratio fell to 0.3 or lower, and history is likely to repeat", said Napier.

“Bear markets always end for exactly the same reason, and that is the market begins to price in deflation,” he said. “The results are always horrific.”

As a final word on the article above, the opponents of the Q ratio argue that for it to be relevant now we would have to experience widespread deflation.

Well, as I have argued for 2 years, that day is now here.

1 comment:

  1. great post.

    FYI: Elliot Wave International's "bottom" is 400 on the DOW, repeat DOW. This equates to the survival of USA incase you are curious to the extent of the bottom. For those who are doubtful the DOW topped in 1929 at 381.17 (our dollar used to have 98% more purchasing power then too) and the DOW bottomed at 41.22. This is an 89% decline over 4 years.
    see chart

    If the DOW were to drop that much (89%) it would land around DOW 1550.
    Our credit problems are much worse than the events that lead to the GD, DOW 400 is a 97% bottom.

    I find that hardly possible (no way) but the events that happend over the past 18 months, 18 months before then; I would of thought of highly impossible. In fact some of the events that occur that don't catch MSM, I still can't believe are going on!

    We are sheeple and yes the emporor has no clothes.

    As the author of this blog has stated many times before.

    Welcome to the Banana Republic.
    400 DOW target