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The massive 4?
thick Webster?s dictionary holding down my desk defines the word
waterfall as, ?a steep fall or flow of water in a watercourse from a
height, as over a precipice?.
Waterfalls in
nature are certainly an awesome sight to behold. I am sure
virtually everyone reading this has shared my awe in visiting a
waterfall and drinking in the intense sensory stimulation. From the
immense thundering sound that resonates deep within your very chest,
to the cool foggy mists, to the wondrous spectacle of countless tons
of water freefalling and then furiously smashing into a pool below,
waterfalls truly stir our souls.
In the financial
markets, the word waterfall plays on the visceral experience of
observing the real thing in nature in order to explain a distinct
bear-market phenomenon.
A financial
waterfall is a relentless decline in a market for weeks in a row,
almost always carving out new interim lows when it finally ends. In
a financial waterfall selling pressure builds and builds, powerfully
driving an index lower and lower. Eventually the selling pressure
reaches a temporary climax in a short-term capitulation panic and
then a textbook V-bounce is born from the ashes.
The term waterfall
is so useful not only because of its raw descriptive power, but
because it ensures that the crucial distinction between an all-out
crash and a much slower decline is emphasized. While classical
crashes are catastrophic 10%+ daily losses for a day or two,
waterfalls are relentless declines that run their full courses over
a month or two, about 20x slower than a true crash.
In
market history
the only times true crashes erupt is shortly after major long-term
bubble tops are reached. Waterfalls, on the other hand, happen most
often deep within the bowels of major secular bear markets.
Waterfalls are the final stage in major downlegs before a temporary
fear-laden V-bounce is carved.
As the title of
this essay suggests, I do believe that the S&P 500 is in for another
waterfall decline, for many technical and fundamental reasons
outlined below. Waterfalls are emotional times for the financial
markets so it is far better and vastly more profitable to know about
a potential waterfall ahead of time rather than failing to recognize
it until too late, after it?s over.
Another potential
S&P 500 waterfall means this flagship American index could
relentlessly fall for a month or more. This would carry it well
below its recent October 9th closing low of 777 and ultimately carve
out a totally new interim bottom. This next waterfall will form the
left leg of the long-awaited V-bounce in the index.
The incredibly
dangerous emotions of greed and fear are the arch-nemeses of all
speculation, and a coming S&P 500 waterfall will be hazardous for
both the longs and shorts. Hence it warrants some discussion and
psychological planning in order to successfully weather it intact.
For the longs, an
S&P 500 waterfall is a nightmare scenario. It is like a month of
trading days in a row of financial torture exquisitely crafted by
the Great Bear to sow uncontrolled terror deep in their hearts. If
they succumb to fear they will panic and sell near the V-bounce, at
the worst possible moment, and hemorrhage a lot of valuable capital
in the melee.
For the shorts, an
S&P 500 waterfall seems like a dream come true at first.
Unfortunately the waterfall deftly lays devious emotional traps that
can slaughter the shorts too. Towards the end of the waterfall as
the V-bounce nears and a major new bear rally prepares to spring
forth out of the short-term fear ashes, greed utterly consumes many
shorts. They fall into the foolish trap of believing that the first
late-bust crash in history is near so their greed seduces them into
not selling near the interim bottom. They too lose a lot of money
by succumbing to greed at the V-bounce.
For speculators on
all sides of the game, the imminent S&P 500 waterfall and its
implications bear careful consideration and psychological
preparation. Speculators must strive to be emotionally neutral
through this awesome event, neither growing too scared nor lusting
too greedily after profits.
Our first chart
this week, and indeed this whole essay, was inspired by a fantastic
graph a speculator friend of mine, Robert Fisher, graciously shared
with me a few days ago. Mr. Fisher is an active private speculator
who has lately been focusing his attention on researching moving
averages as tools to execute superior trades.
Mr. Fisher noted
that in the last few bust years the 50-day moving average (50dma) of
the S&P 500 has consistently flashed an outstanding warning signal
for impending waterfall declines. This incredibly bearish
development just reared up again and speculators should carefully
heed its ominous tidings.
In this graph the
S&P 500 index itself is rendered in blue and its 50dma in white. As
the secular S&P 500 bear market has unfolded in recent years, each
time its 50dma nosed over and headed south, a vicious waterfall-type
event followed in the near-term future, within a couple months. The
most recent three of these very bearish short signals are flagged
with solid-white arrows.
Mr. Fisher?s
excellent observations went much deeper however. He showed me that
there is a subtle secondary signal that the 50dma flashes slightly
after the very beginning of each waterfall. It is not as easy to
see but after you examine the graph a bit it will really stick out
at you, kind of like those computer-generated 3D illusion books that
look like visual noise at first but if you stare hard enough
eventually a picture materializes.
Mr. Fisher noted
that each time the S&P 500?s 50dma makes a new all-bust low
following a major bear rally, it is all over. Within days or weeks
after such a new all-bust 50dma low, an ugly new S&P waterfall
continues accelerating down a steep slope carving the left-hand leg
of the famous V-bounces. The dotted-white arrows above mark these
new all-bust lows in the 50dma.
This fascinating
phenomenon happened in every waterfall above, which are labeled in
blue. The 50dma tops and then turns south shortly after a major
bear-market rally fails. Then, a month or two later, the 50dma
stealthily makes a new all-bust low and the waterfall accelerates.
A new 50dma
all-bust low after a major bear-market rally begins failing is a
rock-solid short signal, an unambiguous warning to get out of Dodge
in terms of long positions or face horrific losses.
Following the
latest October 9th V-bounce labeled as ?Rally 3? above, the S&P
500?s 50dma achieved an all-bust low of 867 in mid-November. Then
the 50dma dutifully turned higher on the spectacular bear rally and
peaked at 908 by mid-January. Then, as is evident in the graph, the
S&P 500 index itself began to fall rather rapidly in recent weeks,
unceremoniously dragging its 50dma lower.
As
anticipated,
this latest major bear-market rally is rapidly imploding before our
very eyes. And yes, all the graphs in this essay and this whole
analysis fully considers Thursday?s impressive short-covering rally
in the indices on the good tidings of a potential war delay by
Washington.
Last Friday, March
7th, Mr. Fisher?s imminent waterfall signal was triggered, and
bullish and bearish speculators ought to take careful note of this
provocative development. On March 7th the S&P 500?s 50dma closed at
a new all-bust low of 866. By Thursday March 13th of this week,
after the sharp one-day anti-war stock-market relief rally, the
S&P 500?s 50dma closed under 860, another fresh new all-bust low.
And so it begins!
Each time this
signal has been flashed in the bust to date, it has warned of an
imminent waterfall decline approaching. I suspect the signal will
prove valid yet again today. You fellow shorts, rejoice but don?t
get greedy and be ready to cover near the V-bounce. You remaining
longs, get ready for some excruciating pain if you insist on staying
long through this waterfall.
This coming S&P
500 waterfall will blast through the old October 9th low of 777 as
if it didn?t exist. The next potential V-bounce will probably
materialize somewhere around 667, a potential short-term target for
which we discussed the logic and rationale behind recently in our
popular Zeal
Intelligence newsletter for our subscribers.
Interestingly, an
S&P 500 level of 667ish sometime in the next 6-8 weeks would bounce
right off the heavy lower support line drawn above just like the
past V-bounces have. It is always encouraging to see short-term
targets computed by totally different methodologies line up nicely!
Now that you have
had the opportunity to observe Mr. Fisher?s powerful
waterfall-imminent warning signal, like me you probably know a huge
number of folks who are still ragingly bullish this very day. The
awesome mini-bear rally on Thursday the 13th certainly stoked these
fires! The bulls are out in force and they seem to think that the
destruction and waste of war will somehow magically unleash a
fantastic new bull market in US equities.
Personally my
tolerance for this perma-bullish drivel is wearing rather thin.
Monday March 10th was the three-year anniversary since the NASDAQ
bubble topped, and if investors and speculators can?t take the time
to learn how post-bubble bear markets work in three long, hard
years, then they probably fully deserve to be gutted by the Great
Bear.
While the
perma-bulls have already chosen to lobotomize themselves by ignoring
the facts as their fortunes are flushed away by this ravenous Great
Bear, it is important that speculators understand the inherent
goofiness in the perma-bulls? perpetually hyper-optimistic market
predictions. The endless Wall Street hype has already cost so many
so much, yet like undiscerning sheep people are sadly still swayed
by it.
The perma-bulls
are now claiming that the S&P 500 is carving out a super-bullish
triple bottom around 800, and you can see what they are talking
about in the graph above. Yet, upon careful examination this theory
doesn?t seem to hold much water. In the rest of this essay I will
discuss the strong technical and fundamental case against this
wishful thinking.
As all speculators
are forced to learn sooner or later, major interim bottoms only
occur on great fear, a short-term capitulation panic marking the low
point of V-bounces. If you look at the red VIX line in the graph
above, you will note that a huge VIX spike above surrounding
technical terrain was conspicuously Missing In Action this week.
The
VIX, a great
gauge of general fear, is recording no extreme fear at all today!
This week?s S&P 500 slump showed no fear, meaning that odds are
vastly in favor of the hypothesis that it is not a valid
interim bottom.
A real, solid
interim bottom will occur on a monstrous VIX 50ish or even 50+ spike
that will leave no ambiguity whatsoever. The perma-bulls? arguments
for a triple S&P 500 bottom near 800 launching a fabulous new bull
market are specious and easy to dismiss at this point in the game.
Technically there has been no solid ?third bottom? yet!
The bulls also
amazingly claim that recent short-term technical action is bullish,
something that utterly blows my mind. As this next graph shows,
recent S&P 500 behavior is anything but bullish. This is an indexed
graph, indexing the three latest major bear-market rallies circled
in yellow on the graph above. It converts each rally into common
terms so they are perfectly comparable.
While this unique
methodology is thoroughly explained in ?Bear-Market
Rally Autopsy 2?, it is easy to quickly grasp. Each major S&P
500 bear rally is converted into a common scale from 0 to 100, with
0 marking the preceding V-bounce and 100 marking each bear rally?s
ultimate top. The X-axis shows the number of trading days before
and after each bear-rally top, which is classified as day 0.
In perfectly
comparable indexed terms, the dismal failure of the latest
bear-market rally in the S&P 500, the blue one above, is
phenomenally bearish. Not only is the recent post-rally downtrend
in the S&P 500 sloped steeply downward in a laser-sharp line, but
the index has already witnessed two bearish technical failures below
this important support.
85% of the ground
gained from the latest V-bounce low of 777 has already been lost.
The S&P 500 is once again trading within spitting distance of these
important levels and it won?t take much fear to push it through.
Once the S&P 500
closes below 777 for a few days, a blizzard of sell orders will hit
as confidence crumbles. In addition, many speculators set
stop-losses right under recent lows in order to protect themselves.
As these stops are triggered the waterfall will accelerate
dramatically, feeding on itself and breeding even more frantic
selling. 777 truly is the Moment of Truth when popular bullish
fairy tales boldly heralding the end of the Great Bear will face
their ultimate acid test.
If I was long this
market today like the bulls, the chart above would deeply disturb
me. If everything is so wonderful in the US equity markets as the
perma-bulls claim, why does the current decay curve in the flagship
US equity index line up exactly with past S&P 500 behavior right
before previous waterfall declines to new lows? Why is the trend
down, with lower lows and lower highs, rather than the other way
around? If the markets really believed that war was somehow
positive wouldn?t they anticipate this and rally ahead of the
fighting?
This week, three
long and painful years after the NASDAQ bubble topped, it defies
belief that so many investors and speculators still don?t understand
the central issue behind bubbles and busts. Things like the coming
Iraq war, economic releases, news, and single-day movements are
totally irrelevant. They are merely useless distracting noise.
The immensely
powerful driving force behind bubbles and busts is valuation. If
stocks get way overvalued in a spectacular bubble then they are
going to inevitably be ground down to way undervalued levels in the
bust that follows. This is the way markets have always worked in
history and the way they will probably always work in the future.
Until the US
equity markets are officially undervalued relative to
multi-century-old historical average valuations in terms of
price-to-earnings ratios and dividend yields, the remaining
perma-bulls? unbridled optimism will be proven premature. Our final
graph builds on this crucial central market truth which was
discussed in great detail in ?Long
Valuation Waves?, ?Valuation
Wave Reversion?, and ?Dividend
Valuation Waves?.
History plainly
teaches that until the US equity markets are undervalued, any chance
of a long-term secular bull once again emerging is purely wishful
thinking. As the P/Es and dividend yields at various stages in the
S&P 500?s bust-to-date clearly show, the Great Bear is simply
working to eliminate the gross speculative excesses of the bubble.
The S&P 500, the
biggest and most important stock index on Earth, was trading at a
breathtaking 55x earnings and only yielding 1% near its bubble top!
Several years later, after immense losses of capital and incredible
financial pain, the index is still trading at 21x earnings and only
yielding 2%. To the best of my knowledge a major secular bull
market has never launched from general valuations anywhere near this
high in all of financial-market history!
All of the major
long-term bottoms in US equities in the last 70 years or so have
occurred at an average P/E ratio under 8x earnings and an average
dividend yield over 8%. 8x and 8%! To get to such historically low
and immensely bullish valuations today, the S&P 500 will have to
plunge far, far lower than anything we have witnessed to date.
If the combined
earnings power of all 500 elite S&P 500 companies today is used as a
baseline, the flagship index would have to grind down to 325 before
it would be trading at 8x earnings, the historical super-bullish
long-term bottoming level! 325!?!
If the combined
dividend payments of all 500 elite S&P 500 companies today are used
as a baseline, the flagship index would have to grind down to 210
before it would be yielding 8%, the historical super-bullish
long-term bottoming level! 210!?! Yikes.
Now I do doubt the
S&P 500 will plunge quite this low in the coming years because
earnings and dividends generally rise slightly over time slowly
addressing the rampant overvaluation problem, but I have no doubts
based on my many thousands of hours of financial-market research
that the ultimate S&P 500 bear-market bottom is far lower than the
October 9th 777 levels! There is simply no way the index bottomed
above 25x earnings while yielding under 2%! Preposterous.
Based on history,
anyone who thinks a long-term bottom has been reached before the S&P
500 trades under about 10x earnings and before it yields around 6%+
is ignoring the core valuation problem. To borrow a famous 1990s
Democratic campaign slogan, the ultimate issue driving the financial
markets today is not the war, not economic reports, not the news,
but ?It?s the valuations stupid!?
Whenever you hear
the perma-bulls, who have been catastrophically wrong for three
years in a row now, brazenly proclaim that another ?ultimate bottom?
has been reached, you ought to check on valuations to see if they
even have a realistic hope of being right. If you want to stay on
top of current valuation levels as all investors and speculators
should, we painstakingly calculate and track these valuation numbers
every month in our acclaimed
Zeal Intelligence
newsletter for our subscribers.
The S&P 500 won?t
carve out a long-term bottom, and a new secular bull market won?t
begin galloping, until the flagship index once again trades well
under fair value (14x earnings and a 4.6% dividend yield). This
unpleasant aftermath is the price we all have to pay for the
euphoria and absurdly high valuations reached in the bubble. Sadly
it is like winter after summer, inevitable.
With valuations
still far too high, the probability that the October 9th 777 low
will hold in this downleg is pretty darned close to zero. As Robert
Fisher?s excellent 50dma signal showed, an S&P 500 waterfall decline
is almost certainly imminent.
For one final
perspective shooting the perma-bulls? pet idea of a triple S&P 500
bottom near 800 out of the water, please note the white volume data
in the graph above. Any major interim bottom is marked by a large
volume spike above surrounding levels, a temporary short-term
capitulation panic on high volume. The S&P 500 lows of this week
did not correspond with a high-volume spike, betraying that they are
almost certainly not real interim lows and merely daily market
noise.
All signs today
point to an imminent S&P 500 waterfall decline. Get out if you
remain long and get ready for some serious action if you are already
playing the short side!
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