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Please begin with an informative title:

The world’s major stock markets are showing signs of exhaustion, indicating that it’s time for some type of correction. A shock to the markets from U.S. debt default could mean the difference between a gentle decline and a memorable crash.

Intro

You must enter an Intro for your Diary Entry between 300 and 1150 characters long (that's approximately 50-175 words without any html or formatting markup).

Who in the world...?

I admit it’s an odd character portrait – someone with socialist leanings who makes a living (a modest one) following stock and commodity markets. One of the reasons I enjoy doing it is that it gives me an arena where I can work with fairly large numbers of data points and condense them into diagrams and projections that my readers elsewhere find easy to understand. Also, it’s extraordinarily challenging, and therefore fun. I’m always learning more, and I have good tutors to learn from.

Most of the time, for most people, the stock markets are just “background news” – something that merits a certain kind of rote reporting that is in no way compelling or enlightening. Every few years though, markets go through a correction, and at those times they become the center of attention. We’re probably approaching one of those times.

How do you know this?

I don’t know this. Nobody knows with certainty what any market is going to do in the future. If it were possible to know that, then there wouldn’t be a market, because every market requires buyers and sellers who have different opinions about which direction it will go.

However, markets give off signals, and some of those signals have a high correlation with what the market does next. The signals can be discovered in market statistics, although they are sometimes easier to see on the charts. They can predict continuation, or a turn, or sometimes other things. Right now, there are a rather large number of signals saying it’s time for a turn or a consolidation. Most of them fall within the category of “exhaustion signals,” meaning the remarkable upward move we saw during the past two years is nearing exhaustion.

The exhaustion signal that’s easiest to show and explain is also one of the most reliable ones – divergence between price and momentum. In a rising market, this type of divergence means price is still reaching higher highs, while a measurement of price momentum is showing lower highs. In a falling market, divergence means the opposite, lower price lows with higher momentum lows.

The momentum of price movement is just a calculation of where price is today in relation to where it was at a certain time in the past. There are dozens of methods for calculating momentum. None of them are really all that different from each other. The particular momentum indicator shown at the bottom of my charts is called the “adaptive commodity channel index.”

Show me.

Probably the clearest example of market exhaustion is in the Russell 2000 stock index – an index that represents a weighted average of stocks for 2,000 medium-sized companies headquartered in the United States. Of the many signals that one can find with various kinds of analysis, I have highlighted just three on the weekly chart below. The things that stand out are:

1) Price is meeting resistance in the form of the top edge of a price fork channel.

2) There is significant divergence between price and momentum. We see a higher high in price, while at the same time we see a lower high on the momentum indicator. The chart also shows what happened after similar divergences in recent years. (The effects of the present divergence might be bigger though.)

3) To the extent that markets obey periodicity, this market is entering the down-phase of a 155-week cycle that is anchored at the post-crash price low of 2009. This comes from a cycle-detection algorithm. (The way I like to think of cycles is not that they are deterministic, but rather they represent a shift in the prevailing winds. Right now, the winds are starting to “blow downward,” favoring downward moves in the market.)

Russell 2000 stock index, October 2013
Put a fork in it -- the Russell showing signs of exhaustion.
Show me more.

Exhaustion signals are showing up in all the major U.S. stock markets, as well as the major ones in Europe. They also show up in global indices (for example, the Global Dow).

U.S. stock indices, October 2013
These are not pictures of healthy markets.
Something that’s not shown on these charts, but that is equally meaningful, is that several of these markets are near long-term price targets. Those targets can represent areas where the markets pause before continuing to climb, or they can represent areas where the markets turn. For example, the Nasdaq 100 index is just a few points shy of the 61.8% retrace of the year 2000 all-time high. That’s an important level.

What does this mean for the economy?

That depends on the extent to which “mom and pop” are invested in this market. If their retirement portfolio takes a hit like it did in 2008-09, then it could have a big effect. My sense is that the average person has relatively less invested in the market now than he/she did in 2008, in part because the average person has less wealth. (Funny, that.)

Even so, sometimes it’s easy to forget that the stock market is not the economy. For the last two years, the market has been barreling upward, while gains in employment, wages, and standards of living have not increased nearly as quickly. The stock market reflects a certain kind of speculation, and in its current form it is almost by definition a pyramid scheme. It rises because people buy in, expecting it to rise. At some point, the population of new entrants must dwindle, and it becomes apparent to the speculators that there won’t be much more buying. And then... well you can imagine what outcome a smart speculator bets on then.

So my guess is that a decline of some magnitude (not necessarily a crash) would have a milder effect on the economy than what we experienced in 2008-09. However, if a panic turns what should be a correction into a crash, then the effect obviously would be greater. And with sentiments about Congress being what they are, the political consequences would be enormous.

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