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This Rally Is Over, and Here’s Why

by: John Lee September 05, 2008 | about stocks: DIA / QQQQ / SPY    

John C. Lee

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Yesterday, the markets dropped 3% on heavy volume signaling a major one-day reversal, and a break in the nice, comfortable rally we’ve had since mid-July. Investors and traders should not try to hope for anything this time. I’ve been calling for the rally to end since I wrote An Investor’s Guide to Bear Markets.  

The Economic Picture

Unemployment/ Initial Jobless Claims

The U.S. Department of Labor reported yesterday that initial jobless claims rose to 444,000, up 15,000 from and were expected drop to 420,000, a 6% difference from the estimate and a 5% difference from a reported 429,000 reported last week. The four-week MA for initial jobless claims fell to 438,000 from 441,250, down 3,250 from last week. Initial claims were at 320,000 a year ago. Currently, unemployment is at 5.7% and the unemployment rate should be over 6% by the holiday season this year. Economists need to adjust their guesstimates to accommodate the increasing deterioration in employment.

The Labor Department is releasing its Employment Situation Report this morning (8:30AM EST) and here are its expectations:

  • Non-farm payrolls: -75,000
  • Unemployment Rate: 5.8%


Last month indicated the seventh consecutive drop in non-farm payrolls. The declines were lead by the construction (no surprise) and manufacturing industry with a total of 57,000 losses. The service industry is typically the last to fall in a recession, and that happened in July, down 5,000.

No other indicator can reveal the true state of the economy or move the markets more than the employment data on the labor market. The data is key because employers are not only showing what their current expectations are for the economy, but also their view of the future. The numbers are getting worse and the future doesn’t look too bright.

A Very Little Known Indicator: The ISM Non-Manufacturing Employment Diffusion Index

Don’t even think for a second that the ISM Non-Manufacturing Employment Diffusion Index is the “holy grail” of economic indicators. It’s not, but it’s pretty close. The index is created by survey responses as to whether corporations intend to add or cut jobs. A number above 50 represents that more than 50% of institutions intend to add jobs, and conversely, a number below 50 represents intentions to cut additional jobs. Historical data indicates that recessions began pretty close to when the number declined below 50.

This is different from the ISM Non-Manufacturing Survey that was reported yesterday with a reading of 50.6 because I only took the employment index and not business activity, new orders, or supplier deliveries. The number for the entire survey increased from 49.5%, but like I mentioned, no other indicator is more important than the employment situation.

This should tell you where we are at and where we are heading. This party isn’t over yet.

Retail Chain Store/Same Store Sales

August chain store sales rose 1.7% in August vs. a year ago, no doubt hurt by continued non-essential consumer spending. July sales increased 2.6% vs. a year ago. June sales increased 2.7% and May sales increased 3%. This trend in slower growth should continue.

Same-store sales dropped 8.3% and analysts expected a drop of 1.7%, a huge difference. Sales fell to $119.8 million from $123.5 million.

ADP Employment Report

The ADP Employment Report didn’t look too good either. The change in August was -33,000 vs. an estimate of -30,000. Large companies (500+ employees) cut 28,000 jobs, medium companies cut 25,000 jobs. This was offset by a 20,000 increase from small companies. I expect the trend to continue down.


The Technical Picture

Excerpt from my article An Investors Guide to Bear Markets:

In the early stage of a decline, the volume is pretty light. The professionals and the “smart” money are selling, while the public are still asleep. In the second phase, the big money is still selling, and the public starts to unload, but not entirely. The heavy volume that’s present at the third stage is due to a selling climax as now the mass of retail investors are dumping everything that they own creating heavy volume. In the fourth stage, there’s a reaction due to short covering and professional buying, however, the retail investors are still not finished selling, even at the beginning of a rally. Price tends to follow volume, and volume confirms price action.

Volume has gotten weaker and weaker since the rally started in July. Notice how the volume for each of the major indices tapered off considerably in the past three weeks:

 

 

Obviously, the volume has never confirmed price action and you’re getting this all too familiar pattern where the volume drops on the rallies and increases on the drops. Two weeks ago, volume for the up days dominated the volume on the down days. The lack of institutional demand is causing this ship to sink, and it’s going to get worse. We have now started the third primary leg of this bear market and the drop will come quicker than the previous drops.

The rally that we saw here is only a secondary reaction, a counter-trend move and not the new paradigm to a new bull market. Here’s another excerpt on primary legs and secondary reactions:

Every bear market has always been made up of 2 or more major downward swings, or primary legs down, and at least 1 secondary reaction between 2 legs. The purpose of the secondary reaction is to correct oversold levels and to reduce speculative activity brought on by new investors. The problem with identifying when a secondary reaction begins is that a primary leg may or may not end on high volume, therefore as with trying to find a bear market bottom, identifying the start of a rally may be difficult. However, when capitulatory volume is present and the market has made a near vertical parabolic move down, then it may signal that the primary leg has ended.

The secondary reactions in most cases take lesser time and may swing with more volatility than the primary leg itself. We are currently in a secondary reaction due to the fact that the price is divergent with volume. As volume declines further, we should see a reversal. Afterwards, we should again see heavy volume resume on the down days.

A secondary reaction ends as bullish sentiment starts to wane. First, people don’t believe that the rally is ending, but slowly and surely, more and more people start to believe. Once the majority changes their opinions, the next primary downward swing is underway.The rallies may end at the 50% retracement level, as most people like to believe, however, that’s not true in most cases. These reactions can be as little as 10% or 99.9%, and as history has shown me is that only 7% of reactions end at the 40-55% level. 27% retrace 55-70%, 8% retrace 70-85%, and 14% of secondary reactions retrace past the 85% level.

Notice how the indices churned at the moving averages. The DJIA and S&P 500 have made four rally attempts at the 50-day MA and the NASDAQ failed the 200-day MA as it did in May and June. My short guidelines for any stock is to short anything that has churned at a major moving average three times or more. After three rally attempts, the chances for a move higher are very slim.

Given continued deterioration in economic data, especially the employment picture, as well as the technical breakdown in the major indices, it’s safe to conclude that the market is heading lower.

Today’s Employment Situation report (8:30AM EST) will paint a clearer picture of where we are going forward.

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This article has 12 comments:

  •  
    Sep 05 09:48 AM
    It's amazing that by just looking at charts one can predict the future and make bold statements such as "This Rally Is Over".

    I wonder if there are other forces in life which could affect iron clad chart trends, and perhaps make "This Rally Is Over" sound a bit more uncertain.

    Nah. Wishful thinking on my end.
    Reply
  •  
    Sep 05 09:59 AM
    On the ISM/EDI chart, a question: what are all those valleys on the chart, that are outside of the red boxes? And how is one certain that the current decline in not another of these same situations?
    Reply
  •  
    Sep 05 10:30 AM
    The fundamentals always take over and now this is what were seeing....real economic distress in the USA. Its obvious we have a long way to go to restore our equilibrium in energy and economic opportunity.....until this happens or at least appears to be our future we have only negative markets going forward. Looking forward to at least ten years to get rid of what this present administration has caused. Until then no investment is safe...even the mattress could have bugs as the value of our dollar buys less food.
    Reply
  •  
    Sep 05 10:34 AM
    Lets face it...the stock market is just doing a great job of getting rid of excess liquidity. If you have excess liquidity stick around and the problem will be corrected.
    Reply
  •  
    Sep 05 10:38 AM
    Didn't get very far in this one:

    "...initial jobless claims rose to 444,000, ...a 5% difference from a reported 429,000 reported last week."

    (444,000 - 429,000)/429,000 = 3.5%
    Reply
  •  
    Sep 05 10:55 AM
    Good comment and your employment data from ISM is useful to anyone looking for the second leg down. What you did not say is that this leg usually is the more violent and protracted. In this leg unemployment leads to manufacturing lay offs and that further hurts P/E. The recession or worse is confirmed by Institute for Cycles Research indicators showing we have entered the recession area and will be moving out in a couple of months, if the government does not go of the cliff with programs to fix things. We need to let this one wash out the market excesses however much it hurts. With the election coming the prospects are not good.
    Reply
  •  
    Sep 05 11:19 AM
    August is traditionally a low volume month. I agree that the market is heading lower, but won't make a major decison till after the results of the election. I can see us break July support levels and finding a new support in the S&P1150-1200 range till the election is over. Then the real fun begins.
    Reply
  •  
    Sep 05 01:02 PM
    "...the unemployment rate should be over 6% by the holiday season this year."

    I wasn't expecting 6.1% to come today.


    BS Detector - absolutely right on 3.5%. It was 2am

    Redbaron - The first thing I said was "Don’t even think for a second that the ISM Non-Manufacturing Employment Diffusion Index is the “holy grail”. They're slowdowns in growth, but not full recessions. As with any indicator, to answer your question, nothing is perfect, but shows how we're doing vs. historically.

    Whidbey - correct. The market moves forward before the economy improves obviously, so if we'll be in a recession for several months, the markets aren't going higher from here.
    Reply
  •  
    Sep 05 01:36 PM
    Excellent information in this article. The next move down will be sharp,quick,drastic and soon. The bad news is piling up every day. The Fed can't control it and needs to let the excess blow off. In my opinion the DJIA goes to 7,500 within 12 months, getting that average much closer to historical patterns over the past 50 years.

    Jay Fredrickson
    chicagocheap.com
    Reply
  •  
    Sep 05 06:49 PM
    At some point, in the grand demographic scheme of things, it stands to reason there be more net money coming OUT in retirment withdrawals than going IN? Kinda like Social Security? I think we may have seen a peak in equities and it could be a long, long downhill slide.
    Reply
  •  
    Sep 08 07:56 AM
    The rally today may change a few things.

    If it's a bearish gap up with intra-day selling, the trend is broken. However, if buying momentum stays throughout the day as it did in Asia and Europe, then the trend is still intact. Gotta love the Treasury.
    Reply
  •  
    Sep 09 04:03 PM
    Yesterday was a bearish gap up.

    Junkyarddog - Not wishful thinking. If you think the rally isn't over, go long with everything you have. I'm up 13% for Sept alone being 100% short.
    Reply
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