An Elliott Wave Warning

10/09/2002 12:00 am EST


Steven Hochberg

Chief Market Analyst, Elliott Wave International

“I don't believe in an afterlife,” said Woody Allen.  “But just in case, I'm bringing a change of underwear.”  Whether one agrees or disagrees with a negative market outlook, it is always better to be prepared than to be caught unaware.  Few advisors are as bearish as Steve Hochberg, who along with his partner Robert Prechter, are considered the market’s leading experts in Elliott Wave theory. All investors–even those who disagree with their deflationary outlook–will be well-served by understanding their arguments.

In his The Elliott Wave Theorist, Robert Prechter says, "Despite a 50% drop in the value of the average stock as measured by the Wilshire 5000 and the S&P 500, there has been no serious reversal of market psychology. Right up to today, there are more bulls than bears among advisors, money managers, and economists. The public hasn't sold even 2% of its holdings. The aggregate opinion of strategists and portfolio managers today is hardly different from that at the top of 2000. When the bottom is at hand, the majority will be gun-shy and cautious. 

In addition, the housing mania topped in August. It's over. In fact, housing has been little more than an outlet for the credit liquidity that became available when interest rates crashed last year. That liquidity has now been spent. Real estate today is where the stock market was right after the high in early 2000."

In his The Elliott Wave Financial Forecast, Steve Hochberg says, “As of late September, the bear market had ravaged a third of the value of the Dow industrials and three quarters of the NASDAQ. And investors are still bullish. At a major low, shaken investors will be so bitter toward the market that they will not even admit to owning any stock. At intermediate-term lows, the destruction should at least convince participants that the market’s intermediate term prospects are not good. Neither condition is present in the market today. Reuters’ latest survey of 90 global equity analysts found that their median year-end forecast for the S&P 500 is 1000, or a gain of about 20% in three months. 

This conviction is confirmed by Richard Bernstein’s Consensus Sell-Side Indicator, which shows that Wall Street strategists still have 68.2% of their assets allocated to stocks–one of the highest readings in the indicator’s history. Based on this percentage, Bernstein’s model indicates that the expected 12-month return from equities should be minus 16%. We think that’s conservative.

So far, this leg of the decline has taken back the entire countertrend rally from July 24th in a series of first and second waves that are still just laying the groundwork for the biggest part of a third wave of primary degree in the S&P 500. Since the March 2000 peak, the NASDAQ has experienced two 50% declines, and a bottom is not in place. Another 50% decline would carry the index to the triple digits–below 1000–as anticipated.

The next several months promise to be violent ones for the debt markets. The flood of defaults we have been forecasting are already rolling in even though the economy is just starting to turn down. Loan delinquencies at all US banks hit 2.76% in June, their highest level since 1994. At the same time, home foreclosures hit a record of 1.23% of all home mortgages. And, these figures are from the end of the second quarter when the economy was still growing and the housing market was on fire. A downturn is now probably underway, which means that in coming months the rise in defaults and the fall of debt levels should accelerate to a rate that astounds observers.

US Treasuries–at all points in the yield curve–have closed up for six months in a row. Paul Montgomery of Universal Economics notes that a similar streak in 1998 led directly to a spike top in the summer of 1998, when bond prices declined 23 points and yields hot up from 4.69% to 6.75%. In another throwback to 1998, Market Vane’s Bullish Consensus for bonds has risen to 90%, the same percentage that accompanied the 1998 bond top. At 94%, the bullish percentage on Treasury notes is even higher. The recent peak in bond prices would be a fitting end to the multi-decade rally. A new multi-decade move, this one a decline that should carry yields well above 15%, should be in its infancy.”

As for stocks, Hochberg and Prechter believe the intermediate-term trend should continue until the market falls below Dow 6000. The long-term cycle projection calls for a low below 4000. Should their forecast for a supercycle depression occur, the target would be for significantly lower levels. I must emphasize that their goal is not just to scare people. Rather, Hochberg and Prechter are sharing a sincere warning about potential deflation and the importance of capital preservation. In making my own long-term decisions, I know how important it is to understand both the bullish and bearish arguments for the markets–particularly given the current economic and political uncertainties. If an added sense of fear compels readers to emphasize safety in their long-term portfolio decisions, then perhaps that alone warrants considering their advice.

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