Arbeter: Time to Head for the Hills?

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From Standard & Poor's Equity Research

If we look at this ratio on a 5-day basis, it reached 176% on Oct. 29, also the highest during the present bull market, and a clear indication, in our view, that the speculative juices are flowing.

Another way to measure speculation, at least these days, is to monitor the emerging markets. We think the price action of these markets makes it very obvious that emotions are running hot and that some air has to be let out of the bubble. The Hang Seng Index has taken out the psychological 30,000 level; unfortunately, we think the index is in a clear upside blowoff phase. We therefore advise caution. On a weekly chart, besides being extremely overbought, the price structure since 2003 looks very similar to the price structure of the U.S. stock market from 1982 to 1987. While it is tough to call a major decline, as they don't happen very often, we think the Hang Seng is susceptible to major damage, as the first piece of major support is over 8000 points below current prices, or about 26% to the downside.

As of the Oct. 29 close at 31,638.22, the Hang Seng index had risen 11,251 points since Aug. 17, or 55.2%. What we see as a parallel is that the U.S. stock market had a major blowoff in 1987, the fifth year of the bull market that propelled the S&P 500 39% in 8 months. The Hang Seng is in the fourth year of its bull market, but the charts look very similar. Both bull markets started off very strong, with the S&P 500 rising 67% in nine months off the '82 low, and the Hang Seng rising 68% in 10 months off the 2003 low. During the middle phase of the bull markets for each of these indexes, both grinded higher for a couple years, until they started going asymptotic. There is another similarity: the '82-'87 bull market advanced 229%, and, as of Monday's close, the Hang Seng had increased 279% from the '03 low.

The Hang Seng remains extremely overbought, and this suggests to us that we are closer to the top of an intermediate-term advance than to the bottom of the next correction. When looking at the spread between the 1-week and 50-week simple averages, the percentage difference as of Monday was almost 44%. This is the widest that these two averages have been apart since early 1994. The 14-week RSI is almost at 85, the highest since late 1993.

The iShares FTSE/Xinhua China 25 Index (FXI), at its recent high, had risen 82% since its Aug. 16 closing low. The index is very overbought and like the Hang Seng, we think it is much closer to an intermediate-term peak than the next corrective low. We believe the index is in the midst of a speculative blowoff and would advise taking profits.

It is possible that the FXI is tracing out a bearish double top. The problem is that there is very little chart support near current prices. There is minor support in the 187 area, but real strong support does not exist until the 140 to 155 zone. A move back to this zone of support would represent a considerable correction from current prices. The third Fibo extension, one that is very rarely reached, seems to have provided a ceiling for the index. This is based on a 423.6% extension of the most recent correction and lies at 218.

The 14-day RSI has traced out a negative divergence, and has also put in a lower low. The 14-week RSI is up near an all-time high of 85, and may be working on a very small but potentially damaging negative divergence. Many times, because of the speed of the FXI to the upside, weekly divergences do not have time to develop.

Another way to illustrate how overbought the FXI is, and to show that we are in potentially dangerous territory, is to take the difference between the 1-week and 50-week moving average. It is currently near 70%, or the highest difference in the history of the index. We believe this is quite rare for any index, and certainly is a warning that a top is probably near. Remember, these indexes can go down at least as fast as they went up.