Saturday, October 20, 2007


There are a few things that I wanted to post about this weekend and rather than do one long post it seems to make more sense to break it up. First, everyone is talking about how the market did a "re-enactment" of the 1987 crash on Friday (on the 20th anniversary Oct 19th 2007). The media is very good at making excuses, but the reason the market tanked really had alot more to do with disappointing earnings from major industrial companies like CAT (my feelings have not changed), MMM and HON rather than some superstitious traders. We actually had the cfo of CAT say the US is "near to, or even in a recession" led by an "ongoing recession in housing." Oh and thats not to mention oil at new record highs (priced in US dollars) and then theres crashing bank stocks. Well here's a look at the Dow Jones ETF (DIA):

For months now there has been significant distribution in the DIA with record volume days and no forward progress. The market has made higher highs but always on lower volume followed by much higher volume selling (and no net progress since late May). In the IBD method this type of action is very important to investment decisions and they track the number of recent distribution days as the "M" in the CANSLIM investing system. According to IBD:

"One way to spot that trend is to pay close attention to distribution days — days when the market is down more than 0.2% on higher volume than the previous session.

When the market piles up four or five of these over a few weeks, chances are that the market may reverse lower."

You can find their current count in the weekend issue paper and currently they show "4 for Nasdaq and S&P 500, 3 for the Dow." In other words we are getting there, and if you take into account the significant distribution that occurred in February and August then it certainly gives need for caution.

The DIA chart above shows that we smashed through support at $136, the 50 dma and lower Bollinger band to close down 2.8% Friday. Certainly, the action was intensified by options expiration and it is very rare for a trend to be sustained outside of the Bollinger bands. I suspect we will stabilize Monday but the Dow Jones is looking really toppy here, and why shouldn't we top?

Sure, US stocks are worth more as the dollar drops but it ain't dropping fast enough to make up for a recession. And inflation really is bad, by the way. From Wikipedia some of the negative effects include:


  • Increasing uncertainty may discourage investment and saving.
  • Redistribution
    • It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation.
    • Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax.
  • International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
  • Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
  • Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
  • Relative Price Distortions: Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods.
  • Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
  • Bracket Creep (also called fiscal drag) is related to the inflation tax. By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. Commonly income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.
On the other hand, tech stocks remain strong and for good reason it seems. GOOG posted blowout earnings last week with other tech bellwethers reporting strong growth. The Nasdaq 100 tracking ETF QQQQ looks much better than the DIA but also shows clear signs of distribution. The QQQQ could fall quite a bit further before it started to look toppy like the DIA, heres a 2 year weekly chart:

More later.

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