I visited a terminally ill friend in hospital yesterday. It was not a pleasant experience as it was quite apparent that the writing was on the wall. But fading away from life does not mean a continuous deterioration – he still perks up from time to time as glimmers of hope lift his mood. After all, to hope is to be pro life.

This made me think of the complex world of investments – a world where hope unfortunately has no role. Richard Russell, 83-year old author of the Dow Theory Letters, said: “In the stock market hope gets in the way of reality, hope gets in the way of common sense. If the stock market turns bearish and you’re staying put with your whole position, and you’re hoping that what you see is not really happening, then welcome to poverty city.”

Not since buying my first stocks in 1968 have I experienced the stock market outlook to be as murky as we are experiencing today. The fears are well documented and, in short, include lingering concerns about the financial system, a US economy on the doorstep of recession, and mounting inflation worries.

For the first time since starting to write my regular weekly “Words from the Wise” blog post three months ago not a single positive item regarding the US economy/markets made its way into last week’s article. It was not surprising that Nouriel Roubini remarked that it was time to move away from the soft landing versus hard landing discussion and start concentrating on how deep the coming recession would be.

In order to gain some perspective on the outlook for equities it serves a useful purpose to study a long-term graph of the S&P 500 Index (or any other major US stock market index). This chart is based on monthly data which tends to be more helpful than daily or weekly series when trying to identify the stock market’s primary trend.

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Source: StockCharts.com

There are a number of interesting observations that one can make from this graph:

The MACD indicator (bottom section of graph) has just given a sell signal as evidenced by the blue histogram bars falling below the zero line. These signals do not occur often – the last one, a buy signal, was given in May 2003 and the sell signal before that happened in September 1999.

The more sensitive RSI (internal relative strength) oscillator (top section of graph) has fallen below 70, thereby giving its first sell signal since 1998. (A buy signal was registered four years later in 2002.)

The 20- and 40-month moving averages (middle section of graph) are still intact, but these are lagging indicators and the turning down and crossing over of the two lines typically only serve as final confirmation of turning points in the index.

But what about the argument that multiple Fed rate cuts are supposed to be bullish for stocks, i.e. the maxim “Don’t fight the Fed” (as described by Martin Zweig in his book Winning On Wall Street)? John Hussman points out that in those events where multiple Fed cuts helped the market, stocks had usually firstly experienced a bear market decline of 20% to 40% prior to recovering, and the average P/E on the S&P 500 Index was typically below 14 (compared with a multiple of 19.1 at the moment).

US profit margins, inflated by super-cheap credit in early 2007 (i.e. the lowest spreads ever seen), are clearly unsustainable. As a matter of fact, profits for the Standard & Poor’s 500 companies fell almost 25% on a per-share basis in the third quarter, the biggest year-over-year decline in almost five years. David Wyss, S&P’s chief economist, expects these companies’ earnings to fall as much as 30% in the fourth quarter as companies take more writedowns for bad investments. “The earnings recession has already arrived,” adds David Rosenberg, North America economist for Merrill Lynch.

Goldman Sachs noted that the average fall in the S&P 500 Index over the last nine recessions was 13% from peak to trough. These include 1969 (-18%), 1981 (-23%) and 2001 (-52%). The Index has so far declined by 7.6% since its high of October 9, 2007.

It is no wonder that the message conveyed by the Bullish Percent Indexes, i.e. the percentage of stocks in uptrends, is not exactly comforting with a large proportion of the major indexes in fact in downtrends as indicated below.

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Source: StockCharts.com

It is impossible to know to what extent stock markets may bounce from time to time, especially with the expiration of options and futures coming up on Friday. (The Dow Jones Industrial Index has rallied 20 times in the past 22 years during the week of the December expiration.) In addition to the long-term graphs looking rather gloomy, the daily chart of the Dow Jones World Stock Index (used as a proxy for global stock markets) has also just triggered a sell signal (see negative MACD histogram bars). (I remain skeptical of world markets decoupling from the US in any meaningful way.)

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Source: StockCharts.com

Somebody once remarked that “risk is often lowest when it is most visible”. Why do I have a niggling suspicion that a considerable dose of bad news has yet to surface and therefore not yet been discounted by stock prices?

These are unusually treacherous times and any rally should, in general, be used to lighten holdings. And avoid hope, as so eloquently put by Richard Russell above – rather embrace the cold reality of a situation that has possibly not yet seen its darkest hour.

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Hat tip: Barry Ritholtz, Big Picture, December 16, 2007.

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