Monday, August 10, 2009

Merrill Forecasting 15% to 20% Pullback in Stock Market

"The Dow Jones Industrial Average closed above its January high in late July, and the Dow Jones Transportation Average closed above its January high on Friday. According to the Dow Theory, this signals a new primary uptrend and is a bullish indicator for the market," according to a Merrill Lynch research, this morning.

BUT, Merrill's research notes that the momentum indicator known as breadth thrust, which focuses on the proportion of advancing to declining stocks, shows a pull-back of 15 to 20 percent this fall when combined with the Dow Theory buy signal.

The breadth thrust indicates when the market moves from an oversold condition when a gauge of the proportion of advancing stocks moves above a certain level. Merrill's analysis shows that significant corrections have followed strong rallies when a breadth thrust has occurred at the market bottom.

Here's what I think has been going on. The market rally has been fueled by an extreme oversold position. An oversold position can be equated to a strong demand to hold cash. The Fed money printing that started in late September 2008 and ended in early 2009, provided money that reversed, somewhat, the downturn in the economy and stock market. I caught this money printing and was bullish during the first leg of the market rally. But this money printing has stopped for months now.Thus I turned bearish after three months of extremely slowed Fed money printing. So why hasn't the market cracked yet, despite the slowed money growth?

Because of the better economic numbers fueled by the earlier money printing.

The better numbers have added a powerful "additive" to the earlier money supply fueled spurt in the economy, by changing market sentiment positively. In other words, it has caused a declining demand for cash, or in stock market terms, it is creating a huge over-bought situation. An over-bought situation can go on for sometime, but without added fuel (M2 nsa growth), it doesn't last. That's what Merrill is picking up with its "breadth thrust" indicator.

In normal times, this kind of up move doesn't continue forever, Merrill's model shows a 15% to 20% correction. I'm guessing that Merrill's model includes periods of money slowdown and money growth, but never such a dramatic change from 15% growth to near zero growth. Thus, if anything the size of any future decline is likely to be even more severe.

This is no time to be chasing this market, short-term and medium term trouble looks to be right around the corner.

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