Jaws of Death

In a recent post, "When Help-To-Buy Will Become Just Help,"  I attempted to articulate why it is feckless to encourage young people to buy a property when interest rates are at 320 year lows in the UK. There are more problems though, ahead.

It is clear to many of us that there is a worrying negative divergence between QE fuelled asset prices across the risk spectrum and the reality of spluttering global GDP growth, or indeed it's complete absence. For many of us who have been through this in previous iterations, 1987, 2000 and 2007 for example, there is an elevated level of concern yet unsurprisingly, it has little resonance with investors given prices continue to climb and indeed, in some cases accelerate which is a sure and certain sign of a blow off top.

It may be the case that the current 55 month cyclical bull market in shares runs for considerably longer. Deep into 2014 would not be out of the question, at least from a technical perspective. There are unfortunately, some long term patterns in markets that are maturing and are signalling "caution!" 

Let's take a quick look 

 This is not a short term or even intermediate forecast. It is a long term, heavy duty predictive pattern which historically has a high degree of accuracy and is ominous in the extreme. 

The pattern in textbooks is known as a “megaphone pattern.” A technical analyst called Dr McHugh coined the “Jaws of Death,” phrase to describe it and is probably the messiah of this structure. It appears both at tops and bottoms and is seen when the trend heading into it is going to reverse. The series of higher highs and lower lows that create the pattern are telling us that investors are becoming increasingly uncertain about the correct valuation for the stock market. In effect, it’s doping nothing more than mapping investor emotion and indecision which itself reflects changing investment metrics.

The current pattern is 23 years in the making which is telling us a very severe sell off will eventually occur. 

According to previous research, (Encyclopedia of Chart Patterns by Thomas N Bulkowski), the statistical probability of a failure in this pattern is 4%. Obviously then, the probability of a reversal is 96%. It is a five point reversal pattern and as you may note above, we are coming to the end of the fifth point. When the reversal kicks in the downside target is the lowest point in the pattern which in this case is point D which was the 2009 low at 6,547 which would also probably lead the S&P down to the level it reached in 2009 which was around 676. However, shares can easily extend below those “lowest point,” targets and given the sheer size of this pattern they will probably do so. Eight previous patterns in the last 100 years did exactly that.

The Dow has perhaps 5-10% of upside to complete the pattern although touching the trend line is not a requirement and not doing so would not invalidate the pattern. It may truncate and reverse earlier but from where we are, the odds currently favour more upside.

If this pattern follows through, the impact such a seismic move will have on economies is simply calamitous. It will make the reversals of the last twenty five years look like gentle dress rehearsals and the prevailing child like belief in the ability of central banks and governments to protect investors will turn to dust. Most market people would accept that the current environment works only if everyone sticks together and collectively perpetuates a number of economic myths. The moment people start to question why markets aren’t matching their daily reality then things unravel rather quickly. I am convinced the mortgage guarantee scheme in the UK for example, is a pernicious political scheme to lift the housing market and distract consumers from the growing cost of living and taxation burden. Political cowardice got us to where we are and political cowardice will drive us over the edge. The “Jaws of Death,” is then, warning that all is not well economically.

Let’s take a look at some historical precedents. 

The pattern in 1929 formed over 3 months before the Dow almost halved in the following 2 months.

1957 saw the pattern form over 3 months . The 20% fall in the Dow kicked off a recession that eventually saw JFK being elected.

1965-66 took a year to form and although less imperfect it still had the required 2 x pivot points to make the pattern valid.

The 1972-73 pattern preceded the oil crisis, the 1973 Arab/Israeli War and Nixon’s resignation. The pattern is imperfect yet the two required pivot points are there. A 26.5% fall was followed by a 21.9% fall over the subsequent 4 months.

1987 - It took 3 months to form but the 2 month 41% drop wiped many firms and individuals out. Anyone who tells you it wasn’t scary has forgotten what it was like. The creation of multiple market intervention tools and successive rounds of money printing which led to a vast transfer of wealth to a small number of banks all stem from this event.

1998-99 was a perfect pattern and again reminded us that the severity of correction is usually correlated to the time taken to form the pattern. In this case, a 20% fall was followed by continuous withering declines over 2 years, recession and war.

2008 had a 4 year gestation period and the severity of what followed was and continues to be, self evident.

The common characteristics that mark the aftermath of this pattern in the last 100 years are in fact, plunge – recession – political change – war. Pondering over these charts though, you can now perhaps begin to see why the implications of a 21 year formation period for the “Jaws of Death,” that is of current concern, is quite as ominous as it is. Does that mean we could see stock market falls of more than 50% and what exactly would that mean not just for valuations but for example geopolitically, economically, socially and so on? In the short term however, we can expect the Dow to top out perhaps between 17,000-18,000 into 2014, (perhaps even 2015), with the chance of a mild overshoot. If the market were to go parabolic and hit the potential highs much sooner then risk would correspondingly be elevated.

A drop, when it comes, could be sudden and precipitous. I suspect though, our long term tools will provide some warnings; they usually do and this is the first of those.

Dr McHugh's recently published book, "The Coming Economic Ice Age," should be avoided by readers of a nervous disposition. Anyone else concerned with capital preservation and longevity of hard earned wealth, such as it might be, should consider buying it immediately. 

Am I being sensationalist? Not really, there is nothing new in these cycles. Markets always ebb and flow and occasionally do so dramatically. The difference this time is that they have been artificially elevated by central banks and that will make the fall out much more severe than otherwise might have been the case. In fact, the subsequent economic nuclear winter will be very rough, especially on the people who least deserve it to be so and that is criminal.