Financial Markets Forecast and Analysis July 31/04

The Dow Industrials have completed minute degree wave 1 down of a 5 wave stair-step down sequence that will become minor degree wave 1 down of primary degree wave 3 down (that could last until 2006) in Elliott Wave parlance. The move completed Monday, intraday, at 9913.92, a little sooner and shallower than our Short-term Technical Indicator Index expected this week. Since then we have seen a micro degree wave "a" move up of an a-b-c minute degree wave 2 up that should last about another week or two, three at the outside, and take prices to a max of 10,364, the 78.6 percent retrace of minute degree wave 1 down, and the point where prices would reach the upper boundary of the declining intermediate trend-channel (magenta) since February 2004. Then a sharp decline wave 3.

The rally from Tuesday has been on declining volume, adding to the evidence that it is corrective, not the start of a dramatic impulsive move higher. The Relative Strength Indicator has moved back into neutral territory rather quickly, and it shouldn't take a great deal more upside price action to reach overbought territory, which is the purpose of this rally - to set the table for the next major leg down in the Bear decline. The MACD turned up before reaching panic selling levels, also adding to the preponderance of evidence that a sustained Bull move up is not in the cards at this time. Those kind of rallies come after heavy sell-offs where supply throws in the towel. Hasn't happened.



Like the major index averages, Dow component Hewlett Packard Co. (HPQ) - shown above courtesy of www.stockcharts.com - looks ready to decline sharply once a small countertrend rally finishes over the next week or two. This stock has formed a Bearish Head & Shoulders pattern with a minimum downside price target of 13, portending a thirty-five percent decline over the intermediate- term. The rising MACD tells of the current rally. Once the RSI reaches overbought, the MACD should turn down as should prices. The next decline should be impulsive.

Coca Cola (KO) - another Dow Industrials component - may be crashing. It is down 19 percent since March 2004, and plunged sixteen percent this week. It is deeply oversold, so a bounce in this stock should help the DJIA over the short-run, but there may be more downside to come.

Alcoa Inc. (AA), also a DJIA component, is sporting a Bearish Head & Shoulders pattern that should break to the downside once the current corrective rally finishes up over the next two weeks as expected.

The Economy:

Sales of Existing Homes set a record in June according to the National Association of Realtors while Sales of New Homes fell 0.8 percent in June according to the Commerce Department.

According to the Chicago National Association of Purchasing Management, Manufacturing grew sharply in July to a 64.7 reading from 56.4 in June. According to Redbook Research, Weekly Chain Store Sales have decreased 0.3 percent in July versus June.

GDP was reported to have risen only 3.0 percent in the second quarter 2004 compared to 4.5 percent for the first quarter. Durable Goods Orders disappointed, dropping 0.4 percent in June if you exclude defense, after a revised 0.9 percent drop in May, according to the Commerce Department.

Crude Oil set an all-time record high Friday, July 30th, closing at 43.80. It rose $6.66 during the month of July.

According to the Internal Revenue Service, adjusted for inflation, Gross Income for Americans fell a whopping 9.2 percent for the two years ending in 2002. This approximate 10 percent decline is likely due to job losses and underemployment.

Jobless Claims came in at an unacceptable 345,000 for the week ended July 24th, and of course the Labor Department revised the prior week's reported initial claims to 341,000. According to www.cnnmoney.com, Continued Claims rose substantially from 2.79 million to 2.96 million. I wonder how many of these good folks voted for Dubya last time in a tight race? Will they be voting for him again? Should we be preparing for a Kerry Presidency? Time to think about this.

The Conference Board's latest Consumer Confidence reading was reported to be 106.1 in July, up sharply from 102.8 in June. Yet 26.0 percent answered that jobs are "hard to get." Wonder if this considers gasoline going to $2.50 a gallon? Crude's performance tells us it probably is.

Money Supply, the Dollar, & Gold:

M-3 is essentially flat since May 17th, up a mere $9.8 billion over that 9 week period, less than 1 percent annualized growth. Our research shows that whenever M-3 is flat or down for a period of two months or more, equities decline within one to three months thereafter.

The U.S. Dollar is ready to turn down as price action formed a key reversal Hanging Man candlestick pattern Friday, at the point of formidable resistance, the long-term declining trend-channel. The Dollar has formed a Bearish Head & Shoulders Top and a decisive break below 87 will confirm the pattern, with a minimum downside price target of 82. The RSI sits where three recent tops occurred and upside momentum looks like it has peaked. Prices should fall from current levels if for no other reason than they sit at the top of the long-term trend-channel, the place where declines are born.

It is do or die time for Gold the metal, as it is forming a Bearish Head & Shoulders Top and prices have sunk to the lower boundary of its long-term rising trend-channel. There isn't much downside room for Gold before technicals turn decisively Bearish. Should Gold drop below 375, the minimum downside target is 320. Let's all hope this doesn't happen, for if it does, it likely means massive deflation has or is about to occur. The first place this deflation would materialize would likely be in financial assets to soon be followed by real estate assets, then incomes, then goods and services. By the time it hits goods and services, we are likely in a Depression. Before that were to happen, expect the Federal Reserve to open the liquidity spigots wide. The Dollar would be sacrificed before deflation were allowed to take control. Our chart of the Dollar may be discounting this scenario. Once the Fed pumps the money faucet, Gold should recover. So there may be a terrific buying opportunity coming in Gold and precious metals. If you missed out before, you may be about to get another chance.



The above chart compares the HUI Gold Bugs with the Dow Industrials over the past two years. We see that the HUI has tracked the major equity average contemporaneously, except that since December 2003, it may actually be leading the DJIA by a couple of months. The sweet spot of the HUI's decline - a Crash - occurred as an Elliott Wave 3 down between March and May 2004. The DJIA's Wave 3 down isn't scheduled for another couple of weeks, but could resemble the HUI's price action. Gold the metal has followed a similar directional course and likely could follow stock prices lower. What we're seeing here are markets discounting asset deflation. This week the HUI appears to be in a similar countertrend rally as the DJIA but the pattern in HUI is a bit clearer, with a fourth wave triangle continuation pattern telling us prices have further to fall - likely after the HUI becomes overbought in a week or so.

Bonds & Interest Rates:

The rally in 10 Year Treasury Notes has further to run as it retraces a Fibonacci percent of the move down from March through May 2004. The minimum retrace we expect is 38.2 percent to 111.69. More likely is a rally to 112.88 (50.0%) or 114.08 is even possible (61.8%). The rally is temporary, is not the start of a Bull run, and we fully expect prices to be overbought once hitting one of these three Fib ratio levels.

The longer term pattern is decidedly Bearish as has been presented in these pages over the past weeks. The long-term chart shows a massive two year Head & Shoulders Topping pattern that will be confirmed with a price decline below 107. The minimum downside target for this pattern is the low 90's in the 10 Year U.S. Treasury Note. This is an intermediate to long-term forecast, but the decline should begin in earnest once the current rally finishes, probably over the next two to three weeks.

The asset deflation we see in Bonds could come in response to massive liquidity being injected into the system by the Fed in response to an equity market event. We shall see.

Bottom Line:

A Bear Market mini-rally has commenced that will serve the purpose of shaking out the shorts and creating overbought market conditions. Intermediate-term Bearish Topping patterns are all over the place and most major financial market index charts are discounting deflation. Complacency reigns as the SPX/VIX ratio is at 72.15 on 7/30/04 - a Crash warning level, Bullish advisors far exceed Bears, and ho-hum, Crude Oil has just set an all-time high the day we learned Consumer Confidence is busting up north. The coming worldwide collapse in financial markets looks like it is going to catch the majority by surprise. But, then again, doesn't a crisis always? Caution is warranted.

"The nations have sunk down in the pit which they have made;
In the net which they hid, their own foot has been caught.
The Lord has made Himself known;
He has executed judgment,
In the work of his own hands, the wicked is snared.
The wicked will return to Sheol,
Even all the nations who forget God."
Psalm 9: 15-17

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Note: VIX down, Dollar up, Crude Oil at Highest Level EVER!

Robert D. McHugh, Jr. Ph.D.
Main Line Investors, Inc.

Robert McHugh Ph.D. is President and CEO of Main Line Investors, Inc., a registered investment advisor in the Commonwealth of Pennsylvania, and can be reached at http://www.technicalindicatorindex.com/. The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. Editor shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.

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