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September 2, 2014

The most important aspect of commodity trading that commodity speculators must learn if they are to be successful: not losing is the key to winning. The reason, it is too easy to lose money when trading a highly leveraged instrument even if one is right about the trend. In many cases, short-term counter trend moves can wipe out initial margin. Therefore, speculators must possess enough discipline to avoid initiating new positions in the direction of the trend after an extended move without a correction. Sophisticated speculators know that entering new positions after an extended move without a correction can be fatal. Though potential profits may be lost waiting for a correction, large potential losses are avoided.

We bring this up because equities are entering the period (September and October) that has been known for major downside moves, and the worst of these have occurred when markets were trading at or near all-time highs. First, we are not suggesting the market is going to crash as it did in 1929 and 1987. However, if a major correction is to occur, probability suggests it more than likely to take place in the September-October period than at any other time.

We will not be discussing any of the old familiar narratives such as the end of quantitative easing, Europe sliding into a recession, East-West confrontation, terrorist threats etc. What we will show is that market data suggests we are much closer to a correction, even though markets may continue to levitate higher in the immediate term. Additionally, we did some research on the 1929 in 1987 crashes and the market action that led up to these debacles.We found markers that both markets have in common.

We are increasingly concerned about major divergences occurring in many of the major US indices. For example, the S&P 500 cash index and the NASDAQ 100 cash index made new closing highs on August 29 of 2003.37 and 4082.56 respectively.

The Dow Jones Industrial Average (DOW) made a new 52-week high of 17,153.80 on August 26, but has been unable to close above the July 16 closing high of 17,138.20.

Of more concern is the performance of the Dow transportation index, which made its all-time high and closing high of 8468.54 on July 23. The Dow transports are significantly outperforming +13.61% versus the Dow +3.15% and the S&P 500 cash index +8.39% year to date. The transports  and the NASDAQ 100 are performing nearly the same year to date, 13.61% versus 13.66% for the NASDAQ 100. However, it appears the previously strong Dow Transportation index is faltering as fewer indices make new all-time closing highs.

The S&P 400 cash index made its all-time high on July 1 and its all-time closing high of 1445.16 the same day.

The New York Composite index made its all-time high and all-time closing high of 11,104.72 on July 3.

The Russell 2000 cash index made its all-time high on July 1 and its all-time closing high Of 1208.15 on July 3.

This is not to say the indices cannot find renewed strength and possibly make new all-time highs. However, the under performance of the Dow, Dow transports, S&P 400, New York composite index and Russell 2000 index during the past 2 months suggest the market as a whole is getting tired. In our view, this means continued advances will be incremental in nature, which calls into question the wisdom of being heavily long at this juncture. In short, investors must ask themselves: is the risk of potential significant downside worth the potential upside in a mature 66 month bull market. The answer is no.

According to Merrill Lynch, there have been 25 bull markets since 1929. The average length of the 25 bull markets was 30.7 months and the average gain was 103.52% for the S&P 500. There have been only been 2 bull markets since 1929, which have exceeded the duration of the current bull market. The first occurred from June 13, 1949 to August 2, 1956 lasting 86.9 months which produced a total return of 267.08% The second from December 4, 1987 to March 24, 2000, which lasted 149.8 months and produced a total return of 582.15%. The current bull market began on March 9, 2009 and through August 29, the S&P 500 has produced a gain of 196.12%, dramatically above the average gain of 103.52% for 25 bull markets.

Of course the major differences between the two major bull markets and the current one is that economic conditions during the two bull markets were robust and characterized by low unemployment, low inflation and significantly lower debt, both public and private. In short, the current bull market has nothing in common with the two great bull markets of the 20th century.

We are deeply troubled about the economic scenario for Europe going forward and the major stock indices are indicating further weakness ahead. For example, the FTSE 100 made its 52-week high on May 15 and on August 29 is trading 1.09% below that high. The FTSE 100 made its closing high on May 14 at 6878.49. It appears likely the 50 day moving average of 6747.68 will cross below the 200 day moving average of 6708.17

The DAX 30 made its 52-week high on June 20, and is currently trading 5.78% below that high. It made its closing high of 10,029.43 on July 3. The 50 day moving average of 9564.12 is about to cross below the 200 day moving average of 9516.20.

The CAC 40, made its 52-week high on June 10 and as of August 29 is trading 4.73% below that high. Additionally, the 50 day moving average of 4327.25 just crossed below the 200 day moving average Of 4342.13.

The Euro Stoxx 50 is showing a dismal performance as well and made its 52-week high on June 19 at 3314.80. On August 29  the Euro Stoxx 50 closed at 3172.63, down 4.3% from the 52 week high. The 50 day moving average of 3156.04 will soon cross beneath the 200 day moving average of 3131.87.

One of the tools we use to determine overall market strength is the New York Bullish Percent, which measures the percentage of stocks traded on the New York Stock Exchange that are on point and figure buy signals. In short, if the market is strong the bullish percent should be rising with it. The bullish percent made its major high on July 3 at 70.14 and on August 29 closed at 60.12. This means on July 3 approximately 70% of the stocks traded on the New York Stock Exchange were on a point and figure buy signals and this declined to a bit more than 60% by August 29.

This kind of action would be expected if the major indices were declining, but from July 3 through August 29, the S&P 500 advanced 17.93 points or +0.90% and the Dow advanced 30.19 points, or +0.18%. However, the New York Composite index lost 58.37 points, or – 0.53%, but this did not stop the New York bullish percent falling from 70.14 to 60.12. In other words, the number of stocks on buy signals were declining significantly while the New York Composite index was only fractionally lower. This is negative.

Even when taking into account the recent strength of the indices, the New York bullish percent has barely moved. For example on August 4, it stood at 59.62 and by August 29 had risen only fractionally to 60.12. During this time, the S&P 500 advanced 64.38 points, or +3.32% Dow Jones Industrial Average gained 529.17 points, or +3.19% and the New York Composite index tacked on an additional 279.68 points, or +2.60%. Yet the percentage of stocks on a point and figure buy signal increased only fractionally. Last week, the 50 day moving average of the New York bullish percent moved below the 200 day moving average, which indicates that fewer and fewer stocks are generating new point and figure buy signals over the longer-term.

It should be noted that the high in the New York bullish percent on July 3 coincided with the market highs of the S&P 400 (July 1) New York Composite (July 3), Russell 2000 (July 1 and 3).

In summary, the data is showing it is becoming increasingly risky to be heavily long. We think it is prudent to cull losers along with positions that show only marginal gains. Also, we think it is wise to initiate long put protection in the indices or stocks of your choosing.


1929 and 1987: 

We have identified markers common to 1929 in 1987 that readers can use as a guide.We are using the Dow in our examples because it was the dominant index during 1929 and its applicability extends to 2014 as well.

During the month of August 1987, the Dow Jones Industrial Average (Dow) advanced 3.53%. The gain during August 2014 was 3.23%. The Dow made its closing high on Tuesday August 25, 1987 at 2722.42 and crashed on October 19, or 38 sessions from the high close (August 25) to October 19. During the month of September 1987, the Dow closed down 2.50%

During the month of August 1929, the Dow advanced 9.38% and made its closing high on Tuesday September 3 1929 at 381.17, the day after Labor Day. Forty trading days elapsed between the September 3 high close and October 29, (Black Tuesday). During the month of September 1929, the Dow closed down 9.70%.

Many people do not know, or remember that in 1929 and 1987, the DOW was showing significant weakness before their respective crashes.For example, from October 6 through Friday October 16 1987 (9 days), the Dow lost 15.83%.However, when the September loss of 2.50% is added, the Dow had already lost 18.33% by October 16 and was already on the cusp of a bear market (20% decline from the high close), the Friday before the October 19 crash. From August 25 (close 2722.42) through October 16 (close 2246.73), the Dow lost 475.69 points, or 17.45%. On the day of the crash, the Dow lost an additional 22.61%. However, the low on October 19, actually represented a point of temporary capitulation because on October 20 and 21, the market had a counter trend rally totaling 16.03%

During 1929, the Dow was showing significant weakness prior to the crash similar to 1987. As mentioned earlier, the Dow lost 9.70% during September 1929, but losses increased dramatically before the official date of the crash (October 29).From October 15, through Friday October 24, 1929 (8 days), the Dow fell 15.45% to close at 299.47, off  81.70 points from the September 3 high close of 381.17. In short, the Dow entered bear market territory on October 24, 1929 when it closed at 299.47 and yet the worst was yet to come. On October 28, the Dow fell 13.47%, and on Black Tuesday October 29, fell an additional 11.73%. October 29 was a point of temporary capitulation similar to October 19, 1987 as the market rallied strongly on October 30 and 31 for a gain of 18.16% during the two-day rebound.

There are a number of similarities between 1929 in 1987. First, it should be noted that exceptionally large market crashes do not come out of the blue. Both 1929 in 1987 markets showed ongoing weakness prior to the crash. Second, before the crashes occurred, one market was already in a bear market(1929), the other close to it. Third, the crashes of 1929 and 1987 occurred approximately 5 1/2 weeks after the all time high close. Fourth, there was a major period of weakness (-15.45% in 1929 and -15.83% in 1987) that occurred over several days before the crash.