No Comments Written by Anthony Truong on July 13, 2008 – 9:19 pm

This ‘Major Market Update’ recaps market action since September 2007. We have republished charts that were produced throughout the past 10 months, not only to give our readers an indication of how accurate our forecasts have been, but to emphasise the fact that the financial markets are in a long-term bear market. The final half of 2008 should prove to be a momentous 6 months, as global equities are on the precipice of a significant fall.

Before we discuss the current situation in global markets, we will review what has occurred over the last year or so. We have been anticipating a major top in equities for some time.

The charts above were first published on 21 September 2007. At the time, this was our secondary count (hence the question marks on the blue labels on the chart of the Dow Jones Industrial Average [labelled ‘Wall Street Cash’]), as our primary count was expecting a more complicated 4th wave correction (blue labels for the DJIA, green for the S&P500 [as represented by ‘US SPX500’, which tracks the S&P E-mini]) to form.

Subsequent price action, as depicted in the next few charts, solidified this view as the primary one. Furthermore, the Dow and the S&P500 roughly topped in the region indicated by the arrows on the charts – the Dow made its historic high on 9 October 2007 at 14,198 and the S&P500 topped on 11 October 2007 at 1576.

This occurrence of historic highs in these two US indices was replicated across the globe in October 2007, essentially placing all dominoes into a perfect position for it all to come tumbling down. Market action from October through November 2007 in both the Dow and S&P500 traced out what now looks like a ‘leading diagonal triangle’ as their first leg down (see following charts); given the relatively ‘choppy’ behaviour of this triangle, and the wave 2 rally which followed, it was quite difficult at the time to be calling a top in equities and (what will be) the greatest bear market in recent memory. This all changed early in December 2007 and through January 2008, as volatility picked up and selling pressure overwhelmed traders. Many indices (especially those in the developing/emerging markets) fell into what economists describe as ‘bear market territory’ – an arbitrary level (20% fall) chosen as confirmation of a bear market. Of course, we have to keep in mind that once this level is reached, the markets have already sustained a 20% drop, and therefore quite a large missed opportunity.

The US markets did not hit the 20% level in January 2008, and so most economists and analysts merely brushed aside the fall in prices as a ‘correction we had to have’. They were right, in a way – it was a correction ‘we had to have’, given the amount of price inflation (mainly due to a massive credit bubble spanning across all major asset classes) that has occurred for decades. But they were gravely mistaken in thinking that the correction was over and that a new bull market was about to begin. The above chart of the S&P500 shows what we had been expecting to occur following the January 2008 sell off. This is an example of when our analysis was ‘wrong’, as prices did not continue to fall as illustrated, but instead bottomed soon after and began a short rally into March 2008. However, the labelling also shows that we were considering alternate counts, namely that a low of some degree had been struck during January 2008.

The rally through February 2008 into the start of March 2008 gave most analysts hope that the worst was over; we knew better though. As shown in the chart above, prices had rallied up into the upper trend-line of a channel drawn from the low in October 2007 (red ‘1’) and the low of January 2008 (blue ‘1’). There was also a cluster of resistance levels just above this trend-line (as shown by the red lines). We immediately issued the forecast as depicted by the black arrow; although overly ambitious (we were expecting a ‘3rd wave decline’, which would have been relentless and brutal, but this did not occur), we did manage to pick a significant top and prices fell substantially, as shown in the chart below.

Although the patterns seemed to be presenting a perfect ‘1-2, 1-2’ set up, thereby signifying a ‘3rd of 3rd wave’ drop, sentiment in the market had not become positive enough for a proper 3rd wave crash. Instead, market action continued along a very prolonged and arduous path, first falling in March 2008 to form a new low (if we were to exclude after-hours trade) for the S&P500…

… before rallying in a choppy fashion throughout April and May 2008.

Note in the ‘S&P500 Daily Chart – 17 March 2008‘ above the count presented in green labelling. We have not been able to continue using this count, as the low in mid-March 2008 did not surpass the low of mid-January 2008, hence wave 5 did not surpass the low of wave 3. However, if we were to exclude after-hours trade in long term charts and analysis, the low hit in March 2008 was lower than that in January 2008. For the time being, we will continue to include after-hours trading data.

We continued to label the primary count as being ‘1-2‘, ‘1-2‘ (purple labels in the Dow chart, blue labels in the S&P500 chart above). As the month of May 2008 began, we noticed a confluence of factors that caused us to make a significant call for a top: as shown on the charts above, both the Dow and S&P500 were entering regions of high resistance. Firstly, they were both encountering the upper trend-line (orange for the Dow, purple for the S&P500) of the channel formed by the tops in October 2007 and the wave 2 top of December 2007. There were also key resistance levels just above this area (red lines). In the S&P500 chart, red boxes were drawn to emphasise how market action responded when daily stochastics reached overbought levels. The rally from the low of March 2008 through to the top in May 2008 contained the most overbought stochastic signals, without the indicator falling back into an oversold level, since the wave 5 high of October 2007. We subsequently issued the forecast that prices were finally going to fall drastically in a ‘3rd of 3rd wave’ (see black arrow).

On 9 June 2008, we reviewed our count and reissued the bearish forecast that prices were about to endure a large sell-off not seen since January 2008. The small ‘1-2’ and ensuing drop confirmed the count, and we alerted subscribers to the event. On a more short-term basis, we published the following charts as evidence of our count:

The impulsive appearance of each leg down, followed by very choppy action to the upside, further strengthened the view that the overall trend was down.

The fact that the Dow was far weaker than the S&P500, falling much deeper even in the early stages of the drop, continued to confirm our forecast, as markets tend to diverge at key turning points in a trend.

As you can see in the chart above, prices came up to test the orange upper trend-line of the channel formed from the October 2007 and December 2007 highs, but could not muster enough strength to push through. This was a very bearish signal.

Following on from this forecast, the Dow and S&P500 managed a meagre rally (closely adhering to the black arrow depicted in the chart above), before continuing its descent. The Dow closed on Friday 11 July 2008 at 11,100.5 and the S&P500 at 1239.5, over 1,700 points and 160 points lower respectively since our major bearish forecast was published 6 May 2008.

So what does the near future hold? The descent from the 19 May 2008 high is forming ideal 5-wave structures (i.e. impulsive) to the downside, and it appears that a temporary low is about to form. We expect one more up down sequence to complete a ‘4-5’ structure to complete wave 1 of a larger degree wave 3 (that began 19 May 2008) of an even larger degree wave 3 (which began at the December 2007 top) before a corrective rally forms to relieve the current intense oversold level.

We are looking for the ‘4th wave’ to top in the region of 11,550 to 11,650 in the Dow and the equivalent 4th wave in the S&P500 to top at 1,280 to 1,290 in the next week, before the falls continue to around 10,700 to 10,800 in the Dow and the region of 1,200 in the S&P500. Once these bottoms occur, a wave 2 corrective rally should carry prices back up; at the moment, we do not have targets for this rally, but it will most likely top somewhere above 12,000 in the Dow and above 1,300 in the S&P500. If we can identify a completed wave structure once the rally has lasted a few weeks, we will attempt to call another near term top, which should be an ideal time to add to short positions.

We must be mindful that we are currently in a very large bear market, one that should send the world into depression, in economic terms. Therefore, it is expected that downside ‘surprises’ will occur, as the rug is pulled out from under investors who are holding on to their stocks for dear life. Thus the target ranges for the bottom in the Dow and S&P500 should not be viewed as gospel; the market may choose to surprise us and crash when no one is looking. In either case, our overall long-term view is DOWN DOWN DOWN, so it would not be advised to take on long positions, even if a bottom appears. Tops should be targeted to ride the bear down.

To finish off this market update, I thought it would be interesting to mention the situation with Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan and Mortgage Corporation). It is rather amusing that recent media in Australia has decided to cover these two government sponsored companies, when most Australians would never have heard of them nor do they know what these entities do. Essentially, Fannie Mae and Freddie Mac are the largest buyers of mortgages in the US. Banks and other mortgage providers sell the mortgages from their customers to Fannie and Freddie to free up capital on their balance sheets to lend more to customers; Fannie and Freddie borrow money (at attractive rates, as they are deemed ‘safe’ due to being backed by the US Government) to buy these mortgages, guarantee them and then securitize them to sell on to investors. As such, Fannie and Freddie combined are responsible for approximately half of the $12 trillion mortgage market in the US.

Now, they have been in headlines recently due to the fact that over the past week, their respective share prices have halved. In fact, on Friday 11 July 2008, during early morning trade their share prices dropped by around 50% (from the previous day’s close), before recovering to close at a 22.4% (Fannie) and 3.1% (Freddie) loss. However, to illustrate the problems that these companies will face (i.e. BANKRUPTCY), please view the following link, which is a chart of Fannie Mae:

http://au.quote.com/us/stocks/chart.action?s=FNM&chartUi.period=M&chartUi.bardensity=HIGH&chartUi.bartype=BAR&chartUi.size=800×550&chartUi.minutes=

As you can see, it is not very pretty. The chart of Freddie Mac is similar. Why have the media only started covering these companies now? Because they are always notoriously late to the party. Only after their shares have dropped over 90% in the past few years do the mainstream media begin to notice that perhaps these ‘safe’, government backed companies are experiencing a few issues. EWI have been following the demise of Fannie Mae and Freddie Mac for some time; please view the following link, which chronicles Elliott Wave International’s coverage:

http://www.elliottwave.com/blogs/freeupdates/ShowPost.aspx?blogid=1&year=2008&month=07&day=10&fname=Housing-Freefall-Creates-Bigger-Problems-for-U.S.-Economy.aspx

So how does this affect the markets? Fannie Mae and Freddie Mac do not in themselves influence stock market movements, as psychology is the primary driver of what occurs in financial markets. However, if either company went bankrupt, it would have a massive effect on the mortgage industry in the US, therefore assisting the US (and the rest of the world) to move towards a depression.

Fannie Mae and Freddie Mac guarantee the mortgages they control; in other words, they guarantee to investors who buy the bonds created from the pooled mortgages that they will receive a regular coupon and in due time will receive their initial investment (principal) back. However, they are extremely leveraged, i.e. they borrow enormous amounts to fund their operations and to buy mortgages. The amount of debt that they have to sustain to continue running as a business and to continue purchasing mortgages is not viable for the companies, without continued capital raisings either through the issuance of bonds or equity. But doing the former will lead to more debt; and committing to the latter dilutes the value of the current share float, which could lead to a backlash from shareholders and loss of confidence in the companies (i.e. further selling of stock).

It is clear that Fannie and Freddie are heading towards default. If they default on their obligations, trillions of dollars will be lost as the securities (derived from mortgages) held by investors will essentially become worthless and will be written off. This in itself will be catastrophic; add to that the fact that these companies buy and guarantee around half of all mortgages in the US, and you can see that the mortgage industry would almost disappear with the companies. With no government backed entity to take mortgage obligations off a bank’s balance sheet, why would a bank want to take on the risk, especially as the mortgage market in the US is crashing and foreclosures and defaults and delinquencies are at historic highs? Without banks lending to prospective home owners, who will have the capital to buy property? And without buyers in the property market, what will stop prices from collapsing much, much further?

Exactly.