The Tide May Have Turned

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Quite a fortnight! On July 19 with the Dow Jones Industrial Average at about 12,600, we sent our second quarter commentary to clients (2nd Quarter Commentary). We made the case that the long weak cycle that began in 2000 was likely to continue for another five years or more. While it would likely include both rising and falling phases, we suggested that current conditions could easily soon lead to the next major declining phase.

Just two days later the Dow closed at 12,724. In the eleven market trading sessions since then the Dow plummeted almost 1600 points, or 12.5%, to today’s low. In the process, the Dow and all other major stock market averages gave up all of their year-to-date gains, broke down from “head and shoulders” tops, broke below their respective 200-day moving averages and violated their trendlines from the 2009 market bottom. Some analysts contend that the decline also confirmed a Dow Theory sell signal. None of these technical indicators by itself guarantees that the next major decline has begun, but in the aggregate they suggest that conclusion. The single strongest technical indicator that still points to new market highs comes from the venerable Lowry Research Corp.’s supply and demand computations.

It is noteworthy that the market decline we’re experiencing is hardly restricted to the United States. Stock market indexes for all major world markets are negative for 2011. And the leading emerging markets of Brazil and India are down in excess of 20%. China is down more than 50% from its 2007 high.

Problems are not limited to failing technical conditions. Employment, housing and consumer and business confidence in this country are at recession levels or worse. Still-surging corporate profits are the shining star in the fundamental picture. But measures of economic activity, both domestically and worldwide, are weakening dramatically. Another recession has become a very real possibility. And excessive debt burdens throughout the developed world are in the news daily.

Price declines have been so intense over the past two weeks, however, that stocks are extremely oversold and in a position from which at least short-term, potentially explosive, rallies can launch. That makes the day-to-day forecast highly problematic. On the other hand, longer-term technical and fundamental conditions are sending out clear warning signals. Investors need to evaluate carefully their exposure to risk. The last two weeks testify clearly to the speed with which markets can decline when conditions turn sour and investor confidence wanes.

Major European banks are beginning to have difficulty borrowing needed funds. Some traditional funding sources are closing. A similar liquidity squeeze was a prime contributor to the 2008 banking crisis which brought the financial system to its knees preceeding the government bailout.

As the markets sank over the past two weeks, cries became louder for further rounds of stimulus or rescue, both here and in Europe. While such rescue attempts have done little over the past two years to improve the world economy, they have been marvelous supports for the world’s stock markets. While further stimulus could promote another stock market surge, it is far from guaranteed. As repeated efforts to boost world economies are becoming increasingly ineffective, faith in the efficacy of such government efforts will logically diminish. At some point stock markets will reward only conditions that are likely to promote sustainable economic growth. Potential upcoming government aid is unlikely to have such a salutary long-term effect.