An Important Week Is Upon Us – says Larry Pesavento

It appears that each week we enter has been of increasing importance. Here, I offer three reasons why this upcoming week ranks as an important one. The first is due to the fact that we have now completed four near-perfect cycles in which stocks have made a high on the new moon and a new low on the ensuing full moon. Recall that this is the exact opposite of the findings from the high profile research from the Royal Bank of Scotland. Their research, which covered data over a 90-year period, showed that buying on the new moon and selling on the full moon was quite a lucrative strategy. However, this system did not work in bear markets (a scenario we discussed last fall) since the pattern essentially shifts into reverse and it becomes better to sell into a new moon and buy on a full moon, which is the situation we are facing now.

This situation is unlikely to continue indefinitely so given that we have gone through three perfect repetitions of these price cycles, we should expect a different outcome this time. Note that I am speaking from experience here, not from statistical validation. Nonetheless, the upcoming full moon is on May 17. There are also additional cycles that are due this week, particularly on Monday and Friday.

The second reason for this being an important week is the fact that Commodities Research Board (CRB) index has taken out its March lows. Because this index has a very high correlation (i.e. over 90%) with the stock market, this is likely to be an indication that we are ready for the same downward move in stocks. However, the March lows for stocks are considerably lower than where we are now with the major indices. Should this move materialize, the levels we would be anticipating are 11,500 for the Dow Jones Industrials and 1,250 in the S&P 500.

The third and final reason this week could be significant is due to the fact that despite all the movements in the market that have occurred over the past 26 months, we have retraced to the low of August 15, 2007. Coincidentally, this was also around the time that I started my working relationship with Tom O’Brien and the team at TFNN. A key point is that the long term cycle marked by August 15, 2007 had only happened one other time in the entire history of the market that dated back to the 1830s. That cycle was the starting point of the banking crisis that eventually led to the panic of 1837. For unknown reasons, markets tend to come back to major cycles such as this. I am still of the opinion that we are going to have more problems and a potential financial crisis sometime during the remainder of 2011 and 2012.

Treasury Bonds

Treasury bonds have now fully completed the AB=CD pattern that we mentioned in last week’s letter. In addition to our long position on TBT (the short ETF for U.S. Treasuries), we are going to add a short position in MUB (ETF for municipal bonds) described in our Trade of the Week. Although this represents a double position against bonds, our decision is based simply on the fact that the patterns are complete and offer a good entry opportunity. Of course, whether this turns out correctly or not is a matter of probability, not certainty.

Foreign Currencies

The U.S. dollar has the potential to complete a major AB=CD pattern on the long-term charts. Practically the whole world has been bearish on the dollar and yet it has managed to rally several points in the past weeks and reached the key level at 75 that we have been watching for weeks. In fact it finished close to 76 on Friday. One must remember that the U.S. dollar index is composed of many different components, primarily the Euro, British pound, Japanese yen, Canadian dollar, and Australian. Since each of these also trade independently, there are many crossrates that make up the foreign exchange markets and each must be looked at separately. This is why these markets are such fun to trade and offer so many different opportunities on both short and long time frames.

In the meantime, the Euro is should enjoy really strong support at the 1.38 level as shown on the enclosed chart.

Precious Metals

The last retracement in silver stopped at the 0.382 level of the last low ($33 per ounce) while gold found the 0.786 of its last low ($1,465 per ounce). As long as they hold above these figures, these markets still have a chance to maintain their bullish state. However, a move below these levels could spell trouble. Bullish consensus on gold and silver remain very high, but being bullish at the wrong time can be very painful. Remember that the past has a tendency to repeat itself and we are looking at gold and silver very cautiously.

Speaking of the past, this week I have enclosed the charts for silver from 1980 when it formed its last major top in January. These charts do not show the actual prices for silver futures that reached over $50 per ounce during that same period. The first break in silver prices (on a weekly basis) took the market down almost 10% during that time. By comparison, this year’s break took the market down nearly 25%, which suggests more weakness may be on the way. Thirty years ago, most people reading this letter now were not trading, so keep in mind that the 1980’s represented some of the most serious economic times in this nation’s history with inflation near 18%. With the appointment of Paul Volcker to the Federal Reserve board, interest rates increased from a prime rate of 11.5% to 21% in 1981. While President Jimmy Carter’s many other problems with the economy and the Iranian conflict overshadowed these developments, historians and economists alike generally recognize that it was the right thing to temper inflation. What we see in inflation now is as small part of what we experienced in 1970’s and 1980’s. As such, a recovery in silver at this point is not a given.

Crude Oil

Crude oil has stopped at the 61% retracement of its last low, i.e. at $95 per barrel. As long as it holds above this level, we can expect to see a rally in crude oil prices. However, any significant move below 95 would signal much lower prices to come.

Trade of the Week

Our Trade this week will be to sell MUB, the ETF for municipal bonds, using a stop at 106 as illustrated on the chart below. In my opinion, this trade has a good risk reward potential.

This week we have also included a few things to watch for on a long term basis. The first of these is the corn market. It is evident from the enclosed chart for December corn that we have completed two near-perfect corrections and are attempting a third one. Hardly a year goes by that we don’t have a crop scare. This year is even more important as tight supplies worldwide. Should December corn make a correction into the $6 per bushel range, it would be a good place to enter as a buyer.

There is a similar situation taking place in natural gas futures. They have now completed some patterns on a long term basis. If natural gas falls to the 3.75 level, it would offer a relatively low risk entry point for a long position. We will be watching natural gas along with the corn market as they unfold. Should these scenarios arise, we will keep you informed through a special report.

Technical Corner

This week we cover one of the most common things in the financial markets: opinions on the market (including my own). Several months ago one of the more prominent figures of Wall Street, Meredith Whitney came out with a bearish outlook for municipal bonds. While this caused a great deal of fear initially and sent prices down for a few days, they rallied in subsequent months, effectively negating her opinion and probably leading some investors to part with their money. Clearly, someone out there knows municipal bonds better than either this writer or Miss Whitney. The lesson here is simple yet particularly important: a person’s opinions are exactly that. They are not facts, which are found within the charts. Irrespective of opinion, the charts are indicating that now would be the time to sell. Municipal bonds were previously in a down trend. They are now likely to resume their drop as they are completing a strong Gartley sell pattern. Thus, all we know is what charts tell us. And right now, they are indicating we should be a sellers of municipal bonds and U.S. Treasuries.

Final Thoughts

By now, it should be apparent that markets are driven by an often unpredictable combination of investor behavior and economic fundamentals. During this most recent financial crisis (which some will argue is still continuing) the importance of debt has been highlighted again and again. I have previously stated my belief that we are in the midst of a long-term debt cycle. When we examine some of the underlying numbers, we can see just how close financial institutions, and even sovereign nations, are to falling into an irreversible spiral of unsustainable debt. According to estimates by renowned author and economist Richard Ebeling, the U.S. national debt doubled between 2001 and 2008 from $5.7 trillion to 10.7 trillion. In the two and a half years since, it has further ballooned to an incredible $14.3 trillion, or 98% of the country’s entire Gross Domestic Product. That amount is nearly ten times the market value of all private sector manufacturing per year. Such immense numbers are not only the result of poor fiscal policy, but they also contribute to the ineffective policies that focus on debt financing rather than debt reduction and growth. The result so far has been low interest rates that have fed commodity bubbles and devaluation of the dollar, among other things. I highlight this because as economic conditions continue to deteriorate (it is likely that things will get worse before they get better), the ability to navigate markets with conventional methods will also decrease. In such a wild environment, charts and patterns may be our best and only reliable tool.

Lastly, these fundamentals do apply only to the U.S. economy. Contrary to popular belief that some developing economies (e.g. China and India) are effectively decoupled from the West, it is almost certain that this contagion will spread globally. Enclosed is a chart of the Baltic Dry index, which reflects the real cost of shipping goods. Many economists believe this is a non-speculative index that reflects general economic activity and a leading indicator for interest rates. The chart shows how this index has dropped considerably from its highs of last year when it was still above 10,000. From its all time high in 2008, it is now down 85%. Data such as this show that the economy is clearly dysfunctional which, together with unsustainable levels of debt, will most likely hit the financial markets at some time.