Formation of Long-term Top in Stocks Remains Likely

| July 28, 2012

The S&P 500 index closed sharply higher for a second straight session on Friday, spurred by the recurring hope that Europe is on the verge of “solving” its sovereign debt crisis. This hope is, of course, misguided, because it is impossible to solve a solvency problem with additional liquidity. However, hope springs eternal and the rumblings from Europe induced panic buying in the US stock market, continuing the pattern of violent price swings that has characterized market behavior during the oversold reaction from early June. The close at a new short-term high has reconfirmed the uptrend and shifted the lower boundary of the advance to the 1,340 level. Additionally, the short-term breakout has negated the rising wedge breakdown that occurred last week.

However, the intermediate-term and long-term outlooks are still bearish as the development of a cyclical top remains likely. The initial breakdown of a cyclical bull market is usually followed by a violent, speculative advance of this character and the uptrend from June will almost certainly be followed by an equally violent decline.

Although the imminent development of a recession in the US remains likely, it is unlikely that the Federal Reserve will engage in any form of QE3 until the coincident data trends experience much more deterioration. The Fed has a long history of being well behind the curve and their current growth projections suggest that they are a long way from implementing additional liquidity operations, especially given the historic magnitude of the operations that have already been undertaken during the last four years. In spite of the optimism that continues to be exhibited by the mainstream view, stock market risk remains at a historic extreme, warranting equally extreme caution.

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