The sure-fire investment rule for our times

With the US stock market indexes at recent all-time highs (except for the Nasdaq), and with most other global markets falling way short of their all-time highs, that is a wide divergence that I believe all investors should take on board.

Stocks have been the main beneficiaries of central bank money printing and rock bottom interest rates, from the Federal Reserve to the Bank of England, European Central Bank (to some extent), and of course the champ of all asset bubble-blowers, the Bank of Japan.

China has had its own brand of financial ‘accommodation’ that has led to mega-cities with no-one living in them and huge shopping malls with no stores open. The term ‘mal-investment’ that the Austrian school economist, Ludwig von Mises, popularised must have been coined for such ventures.

The rule for our times

Under this central bank regime, the one sure-fire investment rule has been simply this: buy the dips. It really doesn’t matter what – just buy the dips.

The central theme behind this simple-minded rule is this: central banks will just not allow stock to fall. If they start a slide, the authorities will prescribe (or threaten) more QE medicine and the patient will recover. Job done. Risk has been eliminated and you can short all rallies in the Vix (fear index) till the cows come home.

And this has worked like a charm for six years. Now six years is an infinite time for algo-traders who race each other to shorten the picosecond (that is 10-12 second) delays in firing their orders into the market (and pulling most of them) in the new black art of high frequency trading.

The point is this: after six years, these algo-traders and their masters, who dominate exchange trading, have been lulled into total complacency. The sentiment readings have confirmed that.

Euphoria and madness

Take a look at this chart of the S&P and the Investors Intelligence sentiment index:

S&P 500 spread betting chart

Chart courtesy 

At no time during 2014 was this sentiment index (bulls/bulls + bears) less than about 73% – even during the very large dip in September/October of about 10%. Yes sir, the Fed has that big bazooka cocked and ready to fire! Or so the thinking goes.

But many money managers do understand their dilemma. They have been forced to ride the rally (to keep their jobs), but know in their heart of hearts that it will all come crashing down one day when the little dog Toto pulls the screen to reveal the Wizard of Oz as a mortal being. That is when faith in the central banks will have reached its zenith and the market will suddenly realise that the over-injection of the quantitative easing (QE) medicine will be seen to be doing more harm than good.

But by then it will be too late – the mountains of debt will be too large to ignore. Then, everyone will be running for the exits at the same time to lock in gains. While leverage is good in healthy rising markets, it is disastrous when they reverse. Remember, it is better to be a few months too early than a few weeks too late.

One recent fact caught my eye: almost 100% of S&P 500 earnings during 2014 has gone towards dividends and share buy-backs. Is this a healthy situation?

When will the inflexion point arrive?

From a trading perspective, are we near that inflexion point yet? If we do get it right, the rewards are likely to be immense. Remember, bear markets move a lot quicker than the preceding bull phase and swing traders make profits more quickly in falling markets.

In my post of 19 December, I had this as my best guess for my near-term roadmap of the Dow – 1,2,3 or A, B, C:

S&P 500 spread betting chart

In my view, the two options had a 50/50 chance of working out. Either the market would turn down directly in w3, or it would make a new high in a B wave and then turn down hard in a C wave, which would be strong as is typical for these waves.

This is the hourly chart of the S&P 500 as of 31 December:

S&P 500 spread betting chart

In fact the S&P did make new high, but on the last trading day of the year and in the final hours of trading, the market broke in a cascade of selling.

That is helping confirm my original Elliott wave labels that I have been working – all the way from the 2009 low.

Here is the daily chart showing my superb tramlines and complete five up count:

S&P 500 spread betting chart

If the market did make its final high on 30 December (26 December in the Dow), the way is clear for a solid third wave down and towards my first target at the lower tramline in the 1,850 – 1,900 area (16,000 – 16,500 in the Dow).

The critical point about this chart is that the upper tramline is a three-and-a-half-year line of resistance. At no time has the market penetrated it while in its solid rally phase. The market has respected it every time it has approached the line.

Here is the updated S&P hourly chart:

S&P 500 spread betting chart

The market moved down to hit the Fibonacci 38% support on Friday and that completed a five down. This places the odds very high that the December top will not be challenged.

If Friday’s low is wave 5, the market should rally early in the week and then begin a more concerted down move to the Fibonacci 62% support level in the 2,020 area.

But if the market is weak early on, the fifth wave hasn’t completed and its low will be under Friday’s low.

Already, I have drawn tentative tramlines that sport several accurate touch points and a prior pivot point (PPP):

S&P 500 spread betting chart

The ideal short entry point was the break of the wave 1 low during wave 3.

Because of the critical juncture I believe stocks are in, I shall be following the stock indexes very closely this year. The story will be exciting!