Saddam’s statues are falling… and the American stock market is next

Protect yourself now from an imminent -33%
re-rating of the S&P 500

As I sit down to write this, the Baghdad circus is over. Now the mind of the herd will inevitably turn back to thoughts of bread. In other words, once again, “It’s the economy, stupid.” I use James Carville’s famous slogan quite deliberately, as a potential repeat of Bush père’s stinging loss to Carville et Cie after basking in the ostensible glory of GWI (Gulf War I) will become the one of the principle forces acting on the market over the next two years.

Now the herd rolls its collective dull-red eye back to the perceived reality of the home front, and more and more, that reality is sad. Let’s take a quick survey of the main factors burdening the market’s sagging shoulders:

On the industrial capacity front, we are currently running at about 75%, the lowest level in the past two decades. More than 2.6 million private sector jobs have evaporated since Bush fils took office. This number has been offset by approximately five million new hires by the central government. But Washington’s largesse is about to run into a major stumbling block as the bills for homeland security mandates, tax relief and the aforementioned geopolitical games hit the federal purse.

Dark clouds on the horizon

Meanwhile, any economist not directly employed by the Treasury department (and even a few of them, if you promise not to repeat their names out loud) are downgrading the rosy expectations of 3%-plus growth in 2003 that powered last November’s rumblings of a V-shaped bottom. The Institute for Supply Management recently weighed in with its index of activity in the non-manufacturing portion of the economy, indicating a tumble from 53.9 in February to 47.9 in March, the first indication of contraction since January 2002. The institute’s index for manufacturing has also shown a similar sharp swing from expansion to contraction.

2002 new home starts totaled 1.7 million units, 7% higher than in 2001 and 9% higher than in 2000; meanwhile, existing home sales were a record 5.6 million, up 6% from 2001 and 9% from 2000. This boom, fueled by record low mortgage rates, has been the central prop of the economy since the tech stocks crashed and burned.

Now word is circulating that by historical measures, home prices have overshot values by 15%. Even the most optimistic prognosticators are speaking in terms of a flat resale market. Pessimists are talking bubble, as in “about to pop.”

“Sub-par”

Well, there’s always international trade, right? Wrong! The Pollyannas at the International Monetary Fund have been unusually negative of late, describing global economic growth forecasts as “sub-par.” In its semiannual World Economic Outlook, the global über-bankers called for 3.3% growth for 2003.

According to Chief Economist Kenneth S. Rogoff, “It is not just the war—a number of other risks weigh on the outlook.” Rogoff went on to cite the lingering impact of the burst stock market bubble as one of the main factors that will continue to hamper growth in the year ahead, and cautioned against expecting a rejuvenation of major economies anytime soon. “As near-term uncertainties over the conflict recede, the question of the hour is whether present sputtering global growth will suddenly lunge ahead into an immediate strong recovery.”

All this grumbling must sound awfully familiar to the president, who has told many of his confidants of his shock and awe at how quickly control of the great gestalt slipped away from his father. The battle is over, now the real war, the one for the hearts and souls of America, begins. Arrayed on one side are the forces of Karl Rove, easily the match of the social and political dwarfs the DNC fielded two years ago. Lining up on the other side is an array of similarly stunted political sharks who smell blood in the water.

The battlefield

The first thing you will note as we survey the map of the war to come is that we are dealing with the S&P 500 instead of the more familiar Dow Jones Industrial Index chart. With its broad underlying assets and deep liquidity, it has become our target of choice for the next phase, both for market analysis and exploitation. Bryan Bottarelli will cover this in more depth in his column.

On to the details: the most obvious feature to catch the eye (one that has been of great concern to WaveStrength traders of late) is the nine-month range-bound run commencing last July. This run has been one of the more difficult I have experienced when it comes to pulling serious cash off the table.

It’s not that there are no tools for capitalizing on a steady-state market of this nature. Rather, these tools are higher in risk than many of our readers’ accounts will allow, as they involve selling both put and call contracts at the beginning of a play rather than reselling them at the end as we currently advise.

Too much risk

This form of trading in essence bets that nothing extreme will take place over a limited time period. The catch is that while buying contracts only exposes you to the risk of losing a portion of the money you have already placed on the table, selling contracts limits possible gains to the amount you are paid for the contract, but exposes you to nearly unlimited losses should you become obligated to cover it.

But our more conservative strategy is about to enter another golden period, as the form on the chart for 09/02-04/03 is not actually a range-bound rectangle but a pennant that is rapidly coming to a close. And that close is right on time, as the total run of that aforementioned pennant also represents the “upleg” of an arcing waveform, part of a wave train with well-established parameters. That horizontal run is about to hit a virtually unbeatable resistance node at the confluence of the post-bubble bear trend top and the Fibonacci -61.8 retracement of the 1994-2000 rally.

The probability of a substantial breakdown in the next 30 days is almost overwhelming, perhaps as high as 80%. The parameters of that breakdown are equally overwhelming. Should the next downleg match the previous one (03/02-07/02), we can expect the S&P 500 to drop to at least the one-quarter mark of the falling trend, peeling off 265 points from current levels.

Burning down the house

In other words, another -33% re-rating of the American market’s broadest list of stocks. We’re not just talking over-pitched tech stocks here. No, this would be an across-the-board burnout.

Not that there aren’t support points below this, points which I thoroughly expect the White House and its supporters on Wall Street (supporters—ha! a technical joke!) to defend. Look for strong oscillations around the nodes at 800 and 700 to be major skirmishes, with “mystery” buyers making major long future bets at these key potential turnaround points. (For more historical context on these “mystery men,” I refer you to Ron Chernow’s fine biography, “The House of Morgan.”)

The question is, will they succeed, and my call right now is no, not until the plunge hits the trend’s one-quarter mark at 600 some four to six months from now. (This is actually an optimistic call. I do believe that the White House may actually get some traction before the ultimate trend bottom at 500.)

In a nutshell, I strongly recommend placing 80% of your allotted cash on SPX puts, with a small reserve in either stocks or, preferably, out-of-the-money calls to hedge against the chance of some kind of holding action at or around the support node at 800… with an unlikely but possible move to the recent high at 950. Properly constructed, this hedged basket ought to reap substantial gains, with limited exposure to “upside risk” in the event of some new propaganda ploy. •