That statement is an idea I read from one of Ayn Rand’s works. It may not be an exact quote but the sentiment is accurate. Another concept that has served me in good stead is: “(Whenever in doubt), check your premise”.

I have often found that when events are not unfolding as I imagined, the error has lain in  one or more of my assumptions underlining the analyis.

I mention this because from the time I first identified the high in the US Stock Market, my underlining assumption has been: we are forming a scenario akin to 1966 to 1982 - a period when an irregular correction formed. It was irregular in the sense that it formed a broadening sideways congestion (similar to a broadening top except that it broke to the up side). 

Notice that the market would break to new highs and fail, break to new lows and fail. By fail I mean the breakout would result in a return to congestion. This persisted until 1982 when the 1982 to 1999/2000 secular bull market began.

Figure 1 shows the pattern.

FIGURE 1 12-M DJIA

So, why am I starting to sense that this market may be a different animal?

The first source of the unease is the fact that 30-Year Bonds have given a 12-M sell signal. However since I have long held the view that some time next year, we’ll see a sharp rise in inflation, this could not be the answer.

The questions I pose are: if my assumptions were wrong, what could the market be doing this time? And, if this alternative scenario were correct, what would have to happen to prove it right?

The main alternative scenario is that the commodity complex is not forming a 12-M correction but has entered into a new 12-M bear market. A bear market in the commodity complex at the same time as the stock market would suggest this is not a recession but a deflation/depression. Since the commodity complex currently is led by Crude Oil and Gold, their respective positions would be important.

Figure 2 is a 12-M swing of Crude Oil basis CSI’s Perpetual Contract. On Oct 19,  there was about a 200 pip difference between it and the Dec contract (Perpetual closed 88.86, Dec closed 86.62). The key level on a monthly close basis is the 66.67% retracement at 84.59 (about 81.39 basis Dec).  A monthly close below this level suggests at least a 12-M congestion between 145.63 and 54.08 (basis Perpetual Contract); it can also indicate a bear market.

FIGURE 2 12-M Crude Oil

Figure 3 is the 12-M Gold basis the Perpetual Contract in the 1966 to 1982 era. Notice that Gold topped out in 1980 and in 1982 the DJIA bottomed. In my view, this is what should happen in a ‘normal’ recession. Should gold also form a top at the same time as the DJIA, we are more likely to be experiencing a deflation/depression rather than a recession. In such a situation, all asset classes will form bear markets.

FIGURE 3 Gold 12-M 1966 - 1982  

The key level for Gold is the $640.00 (50% retracement) basis the Perpetual Contract. While theoretically Gold has to accept below the 66.67% ($512), acceptance below $640.00, will suggest acceptance below the 66.67% because of Gold’s affinity to the 50% support/resistance. Figure 4 shows the levels.

FIGURE 4 12-M Gold 50%

So, now I have three benchmarks: the Maximum Extension on the 12-M DJIA, Gold’s 50% and Crude’s 84.60.

Figure 5 shows the 12-M S&P.  I have included it to show its Maximum Extension. Its chart is more bearish than the 12-M DJIA: if a top has formed, the latter will probably form a V-top while the S&P has signaled an Upthrust Change in Trend. The Upthrust is the more reliable of the two change in trend patterns.

FIGURE 5 12-M S&P

If we are to see a deflation, how does this reconcile with my inflation view in 2009 and beyond? It’s a question of sequencing: the inflationary pressures will be dealt with too late by the FED - a case of too much, too late. Like the sub-prime, the FED’s actions will lead to the very event Bernanke fears most.

Refer this blog post to a friend or colleague…