Prechter: Next Wave Down May Be Bigger

Posted by urbandigs

Wed Aug 12th, 2009 08:28 AM

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A: The Elliott Wave International founder that was a bear turned bull in Feb 2009, just weeks before the market made its most recent lows and started a fierce 50% surge lasting 5 months, is now turning bearish again. The wave technician is most famous for calling the 1987 market crash and most recently telling shorts to cover in FEB as he predicted a sharp rally in the S&P to about 1,000 - 1,100. Well, we hit just above 1,000 and now he is changing his tune again calling for a bigger wave down. Is he right? Will the next wave be bigger than the first?

Now Prechter has not been so good at his short term calls for equities and recent calls for gold, so lets not just ignore the critics of his calls. But to get the general calls right starting from the rally into the summer of 2007, turning bearish in July 2007 (a bit early) and then turning bullish in late Feb 2009 (spot on) predicting a large B-wave rally, is noteworthy. Now he expects the rally to be near its end and for a larger wave down to be ahead of us. The problem with technical analysis is the backward nature of it and the lack of clarity upon making interpretations. What may look like an a-b-c corrective price movement could in effect prove later on to be something totally different. So, you always must use caution. Nevertheless, calling to take profits and to exit long positions after a 50% move up is simply very hard to argue; even if you miss out on another 10% upside.

Before the next wave down comes though we must first get through the 'restocking of inventories' and the natural leveling off of the pace of economic declines (the so called second derivative). The fierceness of destruction we experienced simply was not sustainable. As you see data get less worse, markets equalize and appear to be on the road to recovery - behavior changes and optimism grows further feeding the move. It seems the 'less worse bull market' that Jeff predicted over a year ago has been in full gear since early March - a 45% move higher and here we are wondering what's next?

If anything, I think the next wave down will be more drawn out and will usher in the next phase of this crisis that gets into the unintended consequences of policy actions already taken to stem the first wave of this crisis - at the same time that we have fundamental pressures with balance sheets. This is where you see bankruptcies soar, unemployment reach its peak, defaults reach their peak, state budget issues coming to a head, govt contraction of jobs after almost 2 years of surging job creation, rising tax implications of such high deficits, spreading of toxic assets to higher quality debt classes, fed unwinding of stimulative policy, and accounting changes reversed that helped us through the first wave. I am still in the deflation camp for 4 major reasons, with inflation concerns largely just that, only concerns, right now. Commodity inflation is quite different than inflation created by credit expansion, wages rising, and capacity constraints causing too few goods - just because the price of oil rises, doesn't mean we face inflation problems like we did in the 70s; we learned that lesson big time last year. I recall many arguing to the death that speculation played no role in $145 oil, and that it was all supply & demand - ha, yea right! How could you have inflation when your dollars today can buy almost twice as much house (in the most hard hit markets) and only a few months ago almost twice as much stock as you could near the 2006 & 2007 peaks respectively? Food for thought.

I think this episode of severe debt deflation will come in stages and the next stage may be defined by pressures on banks in the following ways - again, timing is the unknown:

PRIMARY PRESSURES

a) whole loan (accrual) book marks coming down as these assets do not have to be marked to market
b) commercial mortgage back securities
c) prime, jumbos
d) financed private equity LBOs

SECONDARY PRESSURES

e) off balance sheet accounting changes that may see assets moved back onto balance sheet, and affecting capital ratios
f) HELOCs
g) continuing problems in alt-a
h) alt-a recasts, NOT resets
i) loan modification re-defaults
j) credit cards

Now, should these pressures manifest itself in another wave we will likely see the following happen as traders start to trade out, delever to raise cash, and rush to safety:

1) Dollar Will Strengthen
2) Treasuries Will Rise

Recall Fisher's Debt Deflation Theory that sees dollar strength during the course of the deflationary episode. A strengthening dollar can put pressure on future earnings for the large multinationals and that could feed the down move further - recall that during the period of July 2008 to March 9th, the US Dollar rallied about 25% while equities fell about 45%. Clearly the markets didn't like a strong dollar as the fear level hit its peak and investors rushed for the safety of the almighty greenback.

In regards to the fed printing and the dollar negative policies of the administration, that is where I am torn. On one hand, I think that these policies are very dollar negative and will produce unintended consequences yet on the other hand this money is being partially sterilized and hoarded in excess reserves - not lent out; therefore it is NOT producing the multiplier effect that our fractional reserve banking system was designed to do. So, if credit is contracting, defaults/unemployment rising and printed money is being hoarded, how could you support an inflationary argument? If we do have another wave down the deleveraging process that is usually ridden with fear will have the 'Lutnick Effect' of constraining treasury yields. So a rush to dollars and a rush to treasuries may make credit indicators once again go out of whack, thereby feeding the animal behaviors that engulf the tradable markets.

I dont think the wave down will be nearly as fierce as what we just experienced, but I do think it could be more drawn out and painful as the real effects of this debt deflatonary tsunami take hold. We just need to go through it and heal balance sheets by writing down toxic loans properly, getting through the defaults, restructuring, and reorganizing the business to this new world. We cant expect a 'less worse' dynamic to yield a sustainable new boom; thats just silly. Markets are not always rational and they may temporarily ignore the depth of this crisis that will last years, not quarters. If all was well again with our banking system, we would not need a zero interest rate policy, a quantitative easing policy, and 19 other credit facilities to help provide more liquidity to the credit markets. Yet we continue to see those policies in place. Why? Because the banks continue to need to be recapitalized back to health and the fed is trying to engineer an environment suitable for that to happen. The unwind of all these policies and the rising of rates may in fact be the catalyst that sends us into that double dip. The question is when do we feel it?

For the record, I do feel that the recession that started in DEC 2007 is likely over or will be declared to be over within a month or two from now. That would put this recession length at about 21-22 months or so, the longest since WW2. Looking ahead, we can easily see stimulus / restocking of inventories induced growth for 3-4 more quarters before seeing that die down and the pressures I noted above revealing themselves again - fundamentally you can't call America healthy yet. Don't forget how much money the banks raised over the course of this rally that could get them by for a while longer. Looking ahead, double dippers will have to push out their predictions for a 2nd, less fierce recession to the 2011 - 2012 timetable. That is about where I am at now.