Clear And Present Danger.

Richard Russell, an 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.”

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 (above). 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.

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 (Relative Strength Index, which measures 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.

After the multiple Fed cuts, 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-on-year decline in almost five years.

“The earnings recession has already arrived,” adds David Rosenberg, North America economist for Merrill Lynch.