Is a U.S. Bond Crash Coming?

The following was originally posted on CyclePro Outlook August 28, 2003:

The bond market reached an all-time peak several years before the stock market peaked. Similar to our 1990's, stock prices appreciated so quickly that investors moved out of safer bonds into high-flying, speculative stocks. Once the stock market crashed in 1929, U.S. Bonds took over the role as the investment of choice in a flight to quality. This continued until late-1930. The chart shows what happened when the depression-era financial crisis gripped major banks and forced massive failures. Bonds very quickly lost favor and were dumped enmasse.

An interesting bit of investor history trivia, perhaps. But when reviewing the current U.S. Bond chart, please note the eerie and seemingly coincidental similarities:

Please note the unsuccessful recovery rally following the stock market peaks. Both eras show a clear 3-wave structure of which the A and C waves are nearly the same length. This was followed by a secondary peak and then a subsequent, and sharp, nasty sell-off. Another recovery occurred, but at an even lower level. And then, the crash unfolded.

Our current bond environment is still trying to shakeout and recover from last months abrupt sell-off. So to follow the same 1930's path, the current U.S. Bond chart should rally for several months, but to a lower peak level, and then begin to weaken again. Compare the two charts and draw your own conclusions for what may happen next.

Is a U.S. Bond Crash Coming?

Now that 7 months have lapsed, it may be time to update this scenario with current charts:

It appears that the bond crash scenario may still be in effect. The rally that we were looking for has occurred. The weekly chart shows the detail of the rally waves. I have interpreted these as a 5-wave corrective pattern, labeled as a-b-c-d-e. As in classic Elliott Principal fashion, after the "e" wave the chart moved sharply in the opposite direction (down).

If the bond market continues to play out as in our original discussion from last year, then bonds should continue to fall, with rising interest rates (inverse relationship to bond prices), and a break below the lower red line should at least raise the likelihood of a substantial crash scenario to another notch. Using the analogy of the security warning alerts, this should raise the warning from a yellow to orange status.

Since the Fed has already said that higher rates will eventually come - although no mention of when - we know that a break of the lower red line is inevitable... it is all a simple matter of "when".

The weekly chart shows a light green rising support line along the 2000 and 2002 lows. Also, a near-vertical light green line down from the March, 2004 peak. This line is the same downward slope angle as the move down from June-August, 2003. The intersection of these two lines points to a bond price of 97 in the last week of May, 2004. Looking at the calendar, this is less than 3 weeks away. But, hold on... let's first look at a closer comparison with 1929-1932.

Focusing out a little longer term, the following two charts show how a 1929-1933 style bond crash might look using current chart data:

A comparison of these two charts shows that the 1929 pattern is still quite intact. All we will need to fit the pattern exactly is for Greenspan to step in and start buying bonds through the Fed to thwart further interest rate increases via bonds. This should artificially stimulate a bond rally -- as the pattern clearly demonstrates -- into November 2004. Hmmm, I wonder what other major political or economic event might also be occurring in November?

So much seems to be hanging on until the U.S. elections that it is kind of like holding ones breath until near exhaustion, and then letting the air out all at once. I don't know about you, but I think this situation demands a close watch through the end of the year. If a bond crash is coming then a breakout below the August, 2003 lows could occur sometime very early in 2005 and that will be when the status elevates to red alert!

Once the 1929 scenario peaked on the red "e" wave in my chart, the crash lasted 11-12 months. The 1929 scenario peaked at 99'16 in 1/28, the next 91'23 low was 10/29 then a: 9/30, b: 12/30, c: 3/31, d: 6/31, e: 7/31 and the bottom of the crash was 6/32 at a price of 65'23. This represents a drop of 33'25 points, or -34%.

Notice that the current scenario is playing out in an expanded timeframe. Although none of the individual waves are in an exact duration, there are some interesting similarities. The 1929 top to first low to "a" was 81 months, the current similar pattern was 142 months -- an expansion in time of about 1.75. Then the combined 4 waves a-b-c-d in 1929 took 25 months, the CyclePro proposal for completing waves "d" and "e" to November, 2004 will be 43 months -an expansion in time of about 1.72. Following the same time expansion for the bond crash wave low for June 1932 would suggest a current bond low in May 2006. There is a margin of error since the only bond data I have from 1929-1933 is monthly, so allow for a month or two either way.

I see things as a long string of dominoes being put into place by Bush/Greenspan with very shaky hands... one small slip and the whole reaction cascades through to its completion.

If there is any validity to this outlook, then it suggests that a lot of different markets may experience severe reactions that end in a hot crescendo about 2 years from now. Either way, it demands monitoring.

Inflation-Adjusted DJIA: To update some information from my previous commentary, I received an e-mail from Travis R. as follows:

Dear Sir,
Back in 1974 the Bank Credit Analyst published a chart that showed both the DJI raw data and the DJI inflation adjusted in log scale. I see that you have updated the inflation adjusted version. Would it be possible for you to produce an updated combined version. It may be very illuminating.

Best regards,
Travis R.

Thank you for the suggestion, Travis. I used to have this chart but lost it in a PC crash and never got around to re-creating it. The following is the 200 year chart with the actual and inflation-adjusted DJIA overlayed.

There are several key points to note on the non-adjusted (pink) chart:

  • The 1906 peak is not visible on the actual DJIA.
  • The 1966 peak and 1970's volatility shows the ravages of inflation well.
  • Channeling is not suitable on the actual DJIA.
  • Robert Prechter's DJIA 400 is just above 1929 peak instead of the inflation-adjusted peak in 1835.

The inflation-adjustment during the time from 1966-1982 represents something very important. While the buying power of the Dollar was severely degraded through inflation, the DJIA maintained a higher trading plateau range. All of the 1970's bear market bottoms stayed well above the 1929 peak on the non-adjusted DJIA chart, while in the inflation-adjusted chart the final 1982 low came down to the same level as the 1906 peak.

As for Prechter's outlook, I think inflation adjusted is more appropriate since when we get there, his 400 will be in terms of the value of the Dollar at that point in time. Everything else in history will then be adjusted relative to the cummulative effect of inflation up to when we get to 400 (like pushing a wet noodle). Elliott Wave does not automatically build in inflation adjustments, instead it assumes a consistent valuation with which to measure wave extensions, overlaps, etc. Thus, the really long term charts need to be -- in my opinion, MUST BE -- adjusted.

The 1929 adjusted peak is just under 3000 on my chart. So if Prechter intended to use 1929's peak as his likely low point, then DJIA 3000 is probably a better guess. If so, then he and I are really making almost identical projections. I think he is making a big mistake by overlooking an inflation-adjusted view of it.

But that is only my opinion. We'll know for sure in another 40 years.

Crude Oil: Crude prices finally hit $40 which I mentioned last year was an "unavoidable certainty". It's nice when the markets comply with my forecasts. Unfortunately, we all have to live through the effects of such high energy prices. A lot will depend upon how long it takes for inflation to hammer the purchasing power of the Dollar down, but I am still holding to my earlier projection that sometime within the next 6-10 years we will see crude oil approach $100 per barrel.

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