Weak ISM Misses Expectations by a Mile

On Monday the US stock market was waylaid by an unexpected 'miss' in the manufacturing ISM data. Since this was once again the weather's fault, there's absolutely nothing to worry about. However, the market which had already been weak at the open, was less than enamored by the data release. According to Reuters:


U.S. manufacturing activity slowed sharply in January on the back of the biggest drop in new orders in 33 years while construction spending barely rose in December, pointing to some loss of steam in the economy.

Economists largely blamed frigid temperatures for the chill in economic activity and said they expected a rebound in the months ahead. However, they also cautioned that the economy was receiving some payback after a strong performance in the second half of 2013. "The disappointing data provide further confirmation of a dramatic slowing in economic growth momentum," said Millan Mulraine, deputy chief economist at TD Securities in New York.

The Institute for Supply Management (ISM) said its index of national factory activity fell to 51.3 last month, its lowest level since May 2013, from 56.5 in December.

Bad weather also appeared to hurt U.S. auto sales in January, with Ford Motor Co, General Motors Co and Japan's Toyota Motor Sales USA reported a slide in sales for the month. U.S. stocks fell sharply on the manufacturing data, with the Dow Jones industrial average off 1.5 percent and the S&P 500 losing 1.7 percent. The yield on the benchmark 10-year Treasury note hit its lowest level since early November and the dollar dropped against a basket of currencies.

Mulraine, however, said "to the extent that this weakening can be attributed to weather-effects, we expect activity to rebound meaningfully in the coming months."

January's ISM figure was also well below the median forecast of 56 in a Reuters poll of economists, missing even the lowest estimate of 54.2. Readings above 50 indicate expansion.”


(emphasis added)

Naturally the above raises a few questions. If the weather was at fault, does that mean that the economists making these forecasts have somehow missed what was going on with the weather? Maybe someone should give them a thermometer – just saying. Of course we all know how these forecasts are arrived at – namely by extrapolation of the most recent trend. Turning points will always be missed.

The stock market currently actually needs no particular reasons to sell off. It simply became too overbought, overloved and overvalued late last year, so it was ripe for a sell-off. Further below we will take a look at the fact that it continues to track George Lindsay's 'Three Peaks and a Domed House' template (which is quite eerie actually) and show what could happen if this is indeed the path the market is taking. Incidentally, weak Mondays are often followed by a rebound on Tuesday, which would also be in keeping with the model. We have no idea why the market seems to follow this template – we merely note that so far, it happens to do so.




A big decline in the ISM diffusion index – about five points below the average expected by economists – click to enlarge.



ISM new ordersThe steep fall in the new orders component (the largest month-on-month decline in 33 years) is what probably spooked market participants most – click to enlarge.



The Yen Soars

Yesterday prior to the open we pointed out that the yen continues to move closer to our minimum retracement target. Once the stock market started to fall out of bed, it certainly got an extra move on. Once again it needs to be pointed out that the yen is not a 'safe haven'. Its negative correlation with 'risk assets' owes more to the closing out of carry trade positions and repatriation (in both cases, actual and expected, whereby it is difficult to say how big a role mere expectations play).




His perkiness, the yen – still moving closer to the target level – click to enlarge.



Another Look at the Three Peaks + Domed House Formation

Please note that one must continue to take what follows below with a big grain of salt, especially as crashes are very rare at this time of the year (of course that also means that no-one believes a crash or mini-crash is possible, so it would be an almost perfect surprise).

The longer the market follows George Lindsay's template, the more seriously one must take the potential implications, if only because it could potentially turn into  a self-fulfilling prophecy. There are also psychological considerations that come into play: the 3P+DH formation becomes dangerous as soon as certain support levels break that involve a fairly large number of investors who have bought at higher prices getting 'trapped'. Since the formation includes several run-ups and corrections that have been put in place in the wake of a sizable rally, there is a fairly large number of positions in the market that are likely subject to sell stops if/when these supports give way. In this context one must also keep in mind that margin debt has recently reached a new record high, with a large expansion occurring just in November-December and throughout 2012-2013. It is a truism that such a huge amount of outstanding margin debt ($445 billion on the NYSE at last count) vastly increases the risk of abrupt and large market losses.

Looking at a long term chart of the SPX, it can be seen that the recent decline is a mere blip so far, in spite of its rapidity and the associated 'surprise factor'. The basic assumption should remain that the correction is essentially a warning shot. However, the SPX has also declined below the lower rail of the 2012-2013 wedge – not by much, but the break is definitely discernible:




SPX weekly with 50 and 200 week moving averages. The recent decline has broken a support trend line of the wedge that has been put in place over the past two years. If the decline is a run-of-the-mill correction, it should soon end (its extent is close to that of several corrections that have previously occurred) – click to enlarge.



Regarding the 3P+DH formation, there is no logical reason why the market should follow a certain pattern. It so happens that the pattern in question could be detected on a number of historical occasions, but that is not an explanation for its recurrence, it is merely a statement concerning empirical observations. With all the caveats in place, the question is: what would happen if the market continues to follow the template? Let us first look at where we currently are according to Lindsay's schematic:



3PDH schematic-where we are

The template of Lindsay's 3P+DH formation. The market is currently close to point 26 – click to enlarge.



Recall that Lindsay created this pattern from the market's behavior in the run-up to the crash of 1929. Essentially, the 1928-1929 period served as the template, and then he went through the charts to see if he could find previous and later appearances of the pattern (we have listed his findings here). The other occasions when the pattern could be observed were often not following the template precisely.




The DJIA from 1928 to 1930 – as can be seen, this is the market period the template was created from – click to enlarge.



Here is a close-up of the 1929 crash (which omits the 'three peaks' and begins at point 14 in the pattern). We have highlighted the two days which produced the decisive shift in market psychology from hope to fear (up until that point, it was still widely assumed that a garden-variety correction was underway):



USDJIND1929crA close-up of the crash of 1929 that inspired Lindsay's creation of the 3P+DH topping pattern. Note the two days highlighted above: first the support put in place by the lows of the 'three peaks' first was hit, the next day it was undercut. This was when the market psychology underwent its greatest shift, as a large number of traders had become entrapped at higher prices (and many were on margin). The attempt by a banking consortium to 'save' the market ultimately failed – click to enlarge.



It is worth noting that the Fed was tightening policy shortly before the crash, in spite of the fact that it was determined in hindsight that the economy was most likely already in a mild recession (it has reportedly begun in August, precisely the month when the Fed decided to hike its discount rate from 5% to 6%). Note by the way that this was – contrary to the story still being propagated inter alia by the Fed itself – preceded as well as followed by extremely loose monetary policy. According to Frank Shostak:


“[…] at some stages monetary injections were massive. For instance, the yearly rate of growth of government securities holdings by the Fed jumped from 19.7% in April 1924 to 608% by November 1924. Then from 0.3% in July 1927 the yearly rate of growth accelerated to 92% by November 1927.”


Right after the crash, the Fed resumed implementation of an extremely loose policy. Not only was the discount rate cut to the bone, but the central bank's balance sheet was vastly expanded:


“The extent of monetary injections is depicted by changes in the Fed's holdings of U.S. government securities. Thus on January 1930 these holdings stood at $485 million. By December 1933 they had jumped to $2,432 million—an increase of 401%. Moreover, the average yearly rate of monetary injections by the Fed during this period stood at 98%.”


So much for the idea that the Fed was 'tight' in the early 30s (the money supply declined anyway, but not because the Fed didn't do anything). However, we mainly wanted to point out a parallel to today: a slight tightening in policy occurred in 1929, after the stock market bubble had reached quite extreme levels in terms of valuations, while at the same time, economic activity had already begun to weaken.

So what would happen if the DJIA were to continue to track this template today? We think the probability that this happens is very low, but it would imply a decline to slightly below the 9,000 points level by about mid March/early April. It would look roughly like this (actually, the decline would be a bit larger than indicated on this chart – there was not enough room to draw an exact replica):



Doomed house projection

What would happen if the DJIA were to keep tracking Lindsay's 1929-derived template – click to enlarge.



In the short term, the market should bounce for about a week or two, and thereafter it should resume its downturn from a lower high. If so, at what point should one really get concerned? As soon as it breaks below the lows established by the three peaks – i.e., the lateral support line situated approximately at the 14,700 level.



It remains quite eerie that the market keeps following the 3P + DH formation (it is also quite astonishing that Tom DeMark forecast that this would happen many months ago already). The probability that it will continue to follow it is quite low, but it is not zero. One should definitely keep an eye on this.



Charts by: BarCharts, StockCharts, Sharelynx, Decisionpoint, Carl Futia, St. Louis Federal Reserve Research




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One Response to “Stock Market Pummeled Again – How Bad Can It Get?”

  • What do you call tightening credit? I would think it would be going to the other side of zero and selling securities by the Fed instead of buying. I don’t think the Fed can raise rates without either selling a lot of securities, raising the reserve requirement or raising the rate they pay on reserves on deposit with them. They have created too much money to merely decree the rate is going up. We could be zero bound for a long time.

    As far as the 3 peaks and a dome? This market is priced much higher than 1929 and it has been artificially juiced for the past 5 years. Plus, I think the primary cause of crashes is the memory of those involved of steep losses in the recent past. There were a lot of dives in the stock market between 1900 and 1929 and we have had 2 bear markets, 2000-2002 and 2008 that are still fresh in the minds of many. Put in the amazing debt bubble that has been created worldwide and we have the makings of something the central banks can’t begin to handle after shooting so many bullets.

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