The Coming Correction for Stocks

The Buddhist concept of Nirvana is described as a state of being that is free from mind contaminants, such as lust, anger, or craving and I may add greed and fear. Nirvana is thus a state of inner peace, contentment, and the highest happiness. This is not the transitory happiness of everyday life, but rather an enduring, transcendental happiness integral to the calmness attained through enlightenment.

Though no market can ever reach such an enlightened state, this market has come closer than any market I can recall in my 35-year market memory. Whether interest rates or oil prices rise or fall it is taken to be good karma for stocks. The same goes for the bloody and costly disaster of the Iraq misadventure. Indebted consumers and governments spending beyond their means appear to be other warped reasons for contentment.

I could add the sad housing market, the shrinking manufacturing industry, and other developments one would expect to disturb the blissful state of the market. At times like these I remind myself of market comments by Lord Keynes that “nothing is more suicidal than a rational investment policy in an irrational world,” and that “the market can stay irrational longer than you can stay solvent.”

The last time the market demonstrated how insightful these statements, made more than 60 years ago, remain was during the high-tech bull market of the late 1990s and 2000. It is just too bad that Lord Keynes, an economist and investor extraordinaire, never offered hints as to how and when rationality finally prevails, as it inevitably did in 2000-2002.

I am not implying that a comparable bear market has to follow this over-extended, over-aged, and over-priced bull market. No two bull markets or manias are alike in the way they form, advance, and end. There are big differences between the high-tech driven madness of the late 1990s and the broadly based gains of recent years.

Back in the late 1990s, the NYSE Normalized Advance/Decline Line hit an all-time high (April 1998). Then, as the majority of “old economy stocks” failed to participate in the high-tech blow- off, the A/D Line drifted down. It eventually bottomed out in early 2000, just as the S&P 500 and other tech-weighted indices were heading into a two-year bear market.

By May 2001, the weekly A/D Line made new all-time highs and has remained in an uptrend ever since. It has either led, or matched all new highs in the primary NYSE price indices. This technical strength has also been confirmed by the NYSE Hi/Low indicators and the NYSE Upside/Downside Volume Line.

It’s my view that the gains in the NYSE, TSX, and NASDAQ Composites of 20% plus in 6 to 7 months’ time make the market grossly overextended. A good example is the 8-week RSI of NYSE Composite that recently hit levels that tend to precede sizable setbacks. The last time the RSI rose over 80% was the week ending May 6, 2006, just prior to the start of the 10.9% correction in the NYSE Composite.

While I will not bore you with the specifics of the many elements that make up technical indicators I’ve charted weekly for years, I will tell you this: My indicators are flashing a 10% plus correction for stocks in the coming months.