A Detailed Introduction to Exceptional Bear

A detailed introduction to Exceptional Bear

The Year of the “Noah effect”

Benoît Mandelbrot, the father of fractals,passed away at age 85 last week. Mandelbrot was the ultimate interdisciplinary scientist, who applied his findings across a wide array of scientific fields including physics, biology, mathematical finance, chaos theory and markets. A fractal is essentially a structure where the whole is echoed in its parts, and in parts of its parts, while remaining the same no matter how much it is blown up or scaled down.Below are two examplesof fractals. In the snowflake, focus on the white areas to find the floor plan of a Gothic Cathedral repeated in five progressively smaller sizes.

Figure#1Fractals

Fractalsare inherent in Nature,as shown aboveand therefore in Stock Market patterns, which closely model Nature.As Mandelbrot pointed out “all charts look alike - without the legend you can’t tell if you’re looking at decade’s worth of data or an hour’s”. The corollary is:

ABear Market is no more than a multi-yearcorrection on a monthly chart, where the identical pattern might lastjust a day or two on a 10-minute chart.

The chart below is the basicfractal, which serves as the templatefor the entire Supercycle Bear Market.

Figure #2

Please take a moment to get your bearings, SupercycleWave(III) is the March 2000 top, (labels are placed upon completion each segment) and we are on the way down in SupercycleWave(IV), anA-B-C, with only the C wave to go.

Figure #3S&P Monthly

(in candlestick charts the wicks denote a retracement, or double pass; a hollow red candle near the low indicates a bearish reversal, meaning the bottom is likely in, while a solid black candle near the top means a bullish reversal, meaning the top is likely in.)

Figure #4 S&P Weekly

The weekly chart above is a magnification of the previous monthly chart, showing only waveC unfolding.Once the secondDiag IIis complete, there is aSupercycle Transition a complexa-b-(a),a-b-(b),to indicate the last wave returns to the higher degree.The same degree that resulted in the longest Bull Market in history from 1982 to 2000,when the market price exceeded ten times the total price appreciation up to that point, from the late 1700’s.

Figure #5Hourly DowOctober-November 2008

The identical Diag II structure is inverted above on thehourly chart,as“the correction of a larger correction”as a fractal of the larger Bear Market. The hourly chart above shows that Diag II in detail, with the sub-divisions 5-3-5-3-5.

The Diag >indicates a terminal move, as you see the a marked the top, followed by a reversal to b

The chart below shows the previous Supercycle Transition that bean the longest Bull Market in History. This time the Diag IIs come after the transition, rather than before it, but the indication is the same the beginning of a long move, the more and larger the Diag IIs structures, the more severe the subsequent move. If I am mistaken about the total collapse, the minimum downside the area between S&P 128 and S&P 59, meaning a return to 1983-1984 price levels, however the more likely is a return to 1940’s prices,the same as 1909, severe Deflation. See Figure #8.

Figure #6

It was Mandelbrot who disproved the Efficient Markets Hypothesis, Modern Portfolio Theory, the Black-Schools Options Pricing Model and the Capital Assets Pricing Model half a century ago. Most financial equations continue to be based on these defunct theories, since they use the “risk-free rate” as their cornerstone. Markets neither follow a “random walk” nor do outcomes fall under the “bell-curve”. What’s more, although markets reflect all known information much of the time, as shown in the chart on the right below, in actuality, extreme outliers are far more common than a random coin toss would infer. Mandelbrot distinguished between the “Joseph effects”(seven bountiful years, followed by seven lean years) and the “Noah effects”– cataclysms like the Great Flood or the Crash of 1929, and its likely repeat in 2011. While financial models measure the “Joseph effects”, it’s the“Noah effects”which make or breakinvestors, since these outliers are responsible for the bulk of long-term wealth-building – namely yours.

Figure #7

The 20th century saw 48 days in which the Dow swung more than 7% (equivalent a standard deviation greater than 3.5%).Normal statistical modeling predicts such swings would occur once every 300,000 years! While mathematical models tend to capture a lot of reality, only a fool believes they capture all of it. Most investors continue to ignore Mandelbrot’s insights by remaining fully invested “long” in stocks at his juncture, and believing bonds are safe long-term, with the excuse that they “can’t time the Market”, or that its “Time in the Market, rather thantiming the Market” that leads to long-term wealth-building. The Market Crash ahead will likely blow the previous extreme standard deviations out of the water and go down as the “Mother of Extreme Outliers”, the proverbial “Black Swan”. Tho9se that remained invested between 1929 and 1932, had not stocks of companies that went bankrupt, like the blue-chip NY Central Railroad, and made no withdrawals, required more than 20 years to “get even”. If they made any withdrawals in the midst of Depression, their losses became un-recoupable.

Unlike the first Great Depression, this Supercycle Bear Market has had to contend with record amounts of fiscal and monetary interventions to postpone and restrainNature’s forces from unfolding – causing a counter-force of immense proportions to amass. Each time the day of reckoning is post-poned, increases its eventual severity and enduring effects. It’s doubtful that monetary policy has ever had more than a band-aid effect. So desperate is Bernanke that he has resorted to manipulating “expectations”, in addition to the market, (nearly the entire rally from the March 2009 low was manipulated by the Fed buying Futures through the NY Fed’s primary bond dealers)since the market forecasts the economy better than any economist, by manipulating the market the Fed hopes he can pull off enough of a rally to “fool the market” and the economy back to recovery.

While the previous outdated market theories would infer remaining “long” at all times, as Mandelbrot proved, the risk of doing so at this juncture, is immeasurableunder the current mathematical paradigm. Most investors continue to believe the Fed is in control of the economy and can pull off a slow recovery. Of course this time is different,“we have a ‘Depression Era scholar’directing the Fed”.Bernanke’s consciousness is 130 – lower than even Hitler’s! The same “super blip” that will inflict misery and embarrassing serial downsizing on many, will give new meaning to the concept of an “outlier,windfall – the Noah effect”to an informed few.

Elliott Wave Simplified

Ralph Nelson Elliott discovered nearly 80 years ago that five waves up, labeled 1-5in the diagrambelow, mark man’s progress in every endeavor.Where wave 2 corrects wave 1 and wave 4 corrects wave 3.(essentially three steps forward, two steps back) Once 5 waves are complete they equal wave 1 of the next higher degree of trend. In Elliott terms,1909-1932wasSupercyclewave 2, and the Bear Market beginning in March 2000 isthe corresponding Supercyclewave 4 of a huge 5-wave Supercycleadvance. Like the period between 1929-1932,we can expect a 90% plunge in stock prices, and catastrophic losses for the vast majority of investors, and all pensions.Relevant degreesof trend from high to loware Supercycle, CyclePrimary.

What’s more, the market is a fractal,which like a recurring theme in music, the larger structure is echoed in its parts. Thus waves 1, 3 and 5 called impulse waves, or what we would normally think of as “bull moves”, are labeled with numbers, and each sub-divides into another 5 and another 5, just like the Russian eggs, where there is always smaller one inside, at all degrees of trend, from the multi-century to the 1-minute chart.

Corrective waves,2 and 4, sub-divide into three waves or variations thereof, and are labeled with letters.They tend to be far more complex, with more than 42 possible permutations and combinations.

In the chart below you see the Century chart and the corresponding valuations the q ratio measures the discount or premium to replacement value of a company’s assets, while the cyclically-smoothed 10-year P/E ratio, sometimes referred to as P/E 10. As you see once the valuations peak and start down, the minimum downside is a 60% discount to their assets, but that’s at Cycle degree, or in multiple plunges in a Supercycle Degree, but the trough in Supercycle degree, is the yellow line where company assets sell for 10% of their replacement value, while stocks that earned $10 per share in the preceding 12 months sell for $2 per share.

Figure #8

Elliott’s only 3 Rules are:

1)Wave 2 cannot exceed the origin of wave 1

2)Wave 3 is never the shortest, and usually the longest

3)Wave 4 cannot overlap wave 1

Diag >s(read Diagonal Triangles) and Diag IIDiag II ( read Diagonal 2s) break all three rules

Guidelines

1)Corrections usually retrace to the previous 4th wave of one lesser degree.

2)Diag > are terminal structures indicating dramatic reversal ahead, labeled black to indicate a moribund move.

3)Diag IIandDiag II to indicate bullish or bearish,arefound at the beginnings of long moves.When found in Impulsesegments in either direction, they indicate the beginning of a long trajectory.When found in corrections the largestof these also signals a long trajectory, and usually the trough of the entire correction once complete.

4)The larger the structure the greater the subsequent effect. For example, a Diag II visible on the monthly or weekly chart, will be many times stronger than one that’s visible only on the hourly chart.

5)When several Diagof the same kind are found in sequence, they compound each other geometrically,as if their areaswere multiplied, rather than added, to magnify the force and velocity of the subsequent move.

6)The maximum number of Diags of the same degree that can appear in sequence is 3.

7)Once complete, allDiagsretraceback to at least the first touch point of the originating Diag.

8)Alternationoccurs whenever possible, for example if wave 2 is a simple correction, wave 4 will be complex, if wave 2 is a sharp correction which makes a new high, wave 4 willmove mostly sideways and vice-versa. It also applies to fast/slow corrections as between 2008 and 2010. So that those expecting the identical outcome as last time always get thrown for a loop.

Why must the Market Plunge?

1)Despite the Fed,the market is a self-correcting mechanism;the primary reason for a Crash now is a backlash to the Fed’s continued meddling. In order for recovery to begin, the Fed’s entire credit creation,artificially low interest rates and money supply expansion must be completely withdrawn first. A Crash effectively accomplishes all three in a flash.

2)On a basis of its average 10-year earnings multiple, and in relation to corporate assets the stock market is at least 50% overvalued and 99% of the S&P is trading above its 50-day moving average.But rather than dropping back to merely fair value, the market always overshoots from highly overvalued to highly under-valued.

3)According to Russell Napier’s Anatomy of the Bear, at market troughs stocks sell ata 60% discount to replacement value and a P/E ratio below 6. At the March 2009 low, stocks were still selling at 13 times earnings - more than double that. Meaning a drop far below the March 2009 low is assured - S&P 300 islikely the minimum, from Friday’s close of 1345equals a 78% plunge.

4)Carmen Reinhart, co-author of monumental work, This Time is Different,in a paper delivered at the Jackson Hole Banker’s Symposium in August, provided a glimpse of the future. Distilled from her research studies of 15 crises over three-quarters of a century, including the Great Depression.Referring to 2008’s market plunge, she concludes: “post-crisis, credit contracts by an amount equal to the pre-crisis surge”. But with the Fed continuing to pump out liquidity, the only way credit can efficiently contract is through a Market Crash, where trillions of dollars vanish into thin airvirtually overnight, severely constricting the money supply and reversing previous credit expansion.According to Reinhart, who reiterates the principles of the Austrian School,“Quick (Keynesian) fixes, grasped by political leaders impair,rather than improve the situation, by their unfortunate interventions, and turn the crisis into a persistent malady of our own making.” The dust has not begun to settle. Instead the shock from this crisis will likely be deep and persistent.

5)The dollar is about to strengthen, almost as much as it has dropped from the post-Greek crisis high. Given the current record volume in dollar shorts, the only thing that could cause such a surge is a knee-jerk “flight to dollar safety” that accompanies a Market Crashwith its sharp contraction of the Money Supply.

6)Technically speaking, two colossalDiag II’s, which compound each other,signal the beginning of a long move down to complete the C wave.The minimum likely downside of ~S&P 300, retraces the Diag II which marked the pre-crash 1987 high. As Diag >s indicate dramatic reversal ahead, back to at least where the lowest Diag began.

Figure #9S&P Daily

Yet in the daily chart below you can see that a b wave will likely reach a slightly higher irregular top.A bit more magnification in the Hourly S&P shows a Diag > in process which should now retrace to at least 1320 and most likely to 1312.UPRO, our position for timing services, shows nearly the identical pattern as the S&P above. We sold a partial position at 81.25 on Friday, and will buy back in the area of 77-78.

I have a high degree of certainty that the end of the completion of theSupercycle transition will likely take the S&P down in a “flash crash”.In Elliott an(a)-(b)transition is analogous to crown molding which makes the transition from vertical to horizontal, except the transition is from up to down.Whilecrashes normally occur in wave 3, we are already in the equivalent of wave 5, the second most likely spot for a Crash.The transition back to Supercyclemeans a log degree or 10x bigger than everything that has come since the 2000Bull Market top.It should be very clear, but if “long” investors wait for any further confirmation, there will likely be no exit, as in Sartre’s parody on Hell.

Like big paws on a puppy indicate a big dog later on, so a huge transition means a severe collapse in the market. An (a)-(b)transition,far larger than any I have ever witnessed,is highly consistent with a CRASH, especially coming on the heels of a Double Diag II extending from 2007 to 2010, see figure #4 above.

At least a 75% plunge is all but certain. Given that market corrections “alternate” between fast and slow, rather than the gut-wrenching slow decline we had in 2008, which was mistakenly called a crash in the press, a true Crash is like 1987’s, which was over in 3 days, or like May 2010’s “flash crash” on a much grander scale. While itshuman nature to discount this forecast as outlandish, when you recall that a 50% plunge has already occurredtwice this decade, such a projection should seem very reasonable.

Crashes are sudden realizations of Reality

Crashes are sudden realizations of reality - realizations such as “the entire‘green shoots’rally from March 2009 has been a Bernanke-manipulated fraud”. If the green shoots had been real, we would have had lush foliage by now, meaning job increases of 200,000-300,000 per month. Instead we have chronic unemployment, mass deleveraging, depressed bank lending, mounting foreclosures, and plunging Real Estate. As we continue in denial to look for “less bad” economic results, rather than improvements, we are setting ourselves up for the Mother of all Crashes.

VIX about to Spike up

The VIX,sometimes called thefear index,which measures volatility, is inversely related to the S&P. When the S&P plunges, it Spikes.Lately we’ve seen a tremendous drop in volatility, like the calm before the storm. In the chart below you will note that the same Supercycle transition as in the S&P, but in the opposite direction obviously. Diag IIsindicate the beginning of a long move up. What is highly significant is we are beginning a Supercycle wave (5), which will most likely spike up at least1.612 times and possibly 2.618xthe length of Supercycle wave (1) to either 145 or 235.These are Fibonacci multiples,named after Leonardo Fibonacci, a 12th century genius, from Pisa, who introduced Arabic numbers to Europe, and re-discovered “golden section”,phi, thefractal used to build the Great pyramid of Giza.Phi mirrors nature’s proportions in everything from the DNA molecule to the human body’s proportions.

What’s more,this chart indicates the “Noah effect” is right upon us!It should be all over no later than the end of December.Waves (1), (2) (3) trace out the same 5 wave stylized progression in figure #8.

Figure #10