WITH FOUR-YEAR CYCLE BOTTOM DUE IN SECOND HALF OF YEAR, IT MIGHT NOT BE TOO SOON TO START REALLOCATING SOME FUNDS OUT OF BONDS AND INTO STOCKS -- SO IS THE FACT THAT A HEAD AND SHOULDERS BOTTOM MAY BE FORMING IN THE S&P 500
IS A HEAD AND SHOULDERS BOTTOM FORMING IN STOCK?... Today's message is going to represent a shift in emphasis in favor of stocks. As you know, I've been writing since the spring about the huge move into bonds and out of stocks owing to fears of economic slowdown and deflation. I've also written in the past (June 17 to be exact), however, that a four-year cycle bottom is due sometime during the second half of this year. Although that four-year bottom usually kicks in during October, the last one (2006) took place during July and August (so it can happen earlier). It's also well known that September and October can be especially dangerous months. Having said that, one of the main reasons why I'm now leaning toward the view that this year's four-year bottom may occur sooner is the presence of so many potential "head and shoulder" patterns that are visible on stock charts. The S&P 500 is an excellent example of one. First a review of what a "head and shoulders" bottom looks like. It consists of three prominent lows (see circles) with the middle low (the head) slightly lower that the two surrounding lows (shoulders). Another feature of the H&S is that the right shoulder (the August low) often finds support at the same level as the left shoulder (May/June low). Another feature is a "neckline" drawn over the two previous highs (formed during June and August). Chart 1 is almost a textbook example of what that bottoming formation looks like. To actually complete a H&S bottom, however, prices need to close above the neckline. That's along ways off. However, it's not soon to consider the possibility that the market may be heading in that direction. Yesterday's explosive rally has already given a short-term buy signal. That can be seen in the point & figure boxes in Chart 2. By combining that possibility that a H&S shoulder is forming with the likelihood for a four-year cycle bottom during the second half of this year, I don't think it's too soon to start reallocating some funds out of bonds (or cash) and back into stocks.
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Chart 1
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Chart 2
HISTORY OF FOUR-YEAR CYCLE... My June 17 Market Message was headlined: "Combining Summer Rally and Four-Year Cycle Suggests Any July Bounce Will Be Followed by a Weaker Autumn". The point of that earlier article was to argue that the summer rally (which usually kicks in during July) was likely to give way to further weakness in the autumn when a major buying opportunity might present itself. The paragraph on the Four Year cycle described the consistent tendency for the stock market to bottom every four years going back to the late 1960s. I also explained that while most bottoms like 2002 (Chart 3) took place during October, "in rarer instances, four-year bottoms have occurred during July and August (as in 2006).... Either way, an important bottom is due during the second half of this year". Chart 4 shows the last four-year cycle turning up during August. The point of today's message is to suggest that an earlier four-year bottom may be forming this year.
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Chart 3
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Chart 4
POSSIBLE DOUBLE BOTTOMS... Arthur Hill wrote yesterday about the fact that consumer discretionary stocks were starting to attract new money. And economists keep telling us that consumer spending needs to pick up. Usually that shows up in the performance of retail stocks first. And that appears to be happening. Chart 5 shows the S&P Retail SPDR (XRT) climbing above its 50-day average today and giving a short-term buy signal. Its relative strength ratio (below chart) has been firming throughout August. The fact that the XRT held above its July low also has the look of a potential "double bottom" formation. That positive pattern can be seen more clearly on the chart of the Russell 2000 Small Cap Index (Chart 6). It's too soon to declare these actual market bottoms. For that to happen, prices need to clear their July highs. It isn't too soon, however, to start considering the possibility that bottoms are starting to form and to act accordingly. Please understand that I'm not recommending abandoning all defensive positions like bonds. I'm simply suggesting that it may be time to start "gradually" reallocating some of those funds back into stocks.
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Chart 5
