The final, speculative phase of the cyclical bull market in stocks that began in early 2009 continues to unfold in typical fashion. The uptrend has “gone parabolic,” accelerating into an unsustainable advance that will almost certainly be followed by a correction of equally violent character.

The development of every bubble requires that the conventional mindset believe firmly in some type of profoundly faulty premise. In 2000, the premise that accompanied the dot-com boom was that the economy had achieved some type of mythical “plateau” and, as a result, major economic disruptions were a thing of the past. In 2007, the premise was that the real estate market had become a “no lose” proposition. Today, the faulty premise is that the Federal Reserve can continue to drive risk assets such as stocks higher without any meaningful long-term cost to structural economic development. The mainstream view has come to believe that Federal Reserve stimulus is some type of magical pixie dust that can drive the stock market higher indefinitely without any significant consequences. Unfortunately, nothing could be further from the truth. As with all bubbles, the current speculative advance will end very badly for the market. The following graph from the Hussman Funds website displays our current predicament resulting from the historic amount of Federal Reserve stimulus that has been injected during the past several years.

There is always a significant cost to implementing an extreme solution to a perceived problem, and the more extreme the solution, the more extreme the cost. As noted on the graph, the normalization of Treasury bill yields to 2 percent from current levels could be achieved in roughly three different ways. The only economically painless solution to this huge problem would be approximately 14 years of 5 percent GDP growth. Given the structural economic weakness that continues to exist due to, among other things, excessive debt levels, the likelihood of the painless solution is infinitesimally small. Therefore, we are left with two realistic scenarios. Either the country experiences massive inflation or the Federal Reserve embarks upon the largest monetary tightening in US history. Both of the plausible possibilities would cause severe economic disruptions, so there is no easy way out of this mess, contrary to what conventional thought continues to believe. Granted, limiting our possibilities to three distinct courses of action oversimplifies the situation, but this thought experiment accurately reflects the magnitude of the challenge we are facing. For now, mainstream analysts sing a happy song of unending stock market gains, but the music will invariably stop at some point, it is simply a matter of time. As always, the judicious study of market data will tell us when the forthcoming long-term top is likely in place.

Last week, our cycle analysis identified the potential development of the latest short-term cycle low (STCL) in the stock market. On Friday, a cycle low signal was generated, confirming that a new short-term cycle is in progress.

With respect to technical analysis, the uptrend from November remains extremely overextended and a break below key support levels would signal the likely start of a potentially violent overbought correction.

This is an important short-term cycle and market behavior during the next several sessions could have a meaningful impact on the long-term health of the bull market from 2009.

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Last week, we observed that several subcomponents of our Cyclical Trend Score (CTS) had declined to their lowest levels during the last two years, suggesting that the formation of a long-term top in the stock market is becoming more likely. For example, our sentiment and price oscillator scores have moved below the -80 level for the first time since 2011, indicating that the cyclical bull market from 2009 has become vulnerable to a severe correction.

Although market internals such as breadth and volume have yet to generate comparable signals, they have begun to exhibit early signs of weakness. For example, the recent pullback in the S&P 500 index was accompanied by a severe decline in breadth summation.

At a current duration of 51 months, the cyclical bull market from 2009 is long overdue for termination. Fueled primarily by a historic amount of stimulus from the Federal Reserve, the stock market rally has accelerated into a prototypical speculative blow-off phase, suggesting that the next cyclical top will almost certainly develop when the current intermediate-term advance from 2012 terminates.

The CTS has started moving lower in negative territory, although it remains well above sell territory at the -65 level. Therefore, a cyclical trend sell signal is not imminent.

However, when the CTS does move into signal territory, it tends to do so very quickly, so it will be important to monitor the current decline closely during the next few weeks. A move into sell territory would be the first step in the potential generation of a cyclical trend sell signal, but we are still a long way from any definitive developments. Cyclical tops usually take from several weeks to several months to form and the market will provide plenty of advance warning when the forthcoming long-term reversal is in progress. As always, the judicious study of market data will tell us when the cyclical top is likely in place.

At a current duration of 51 months, the cyclical bull market from 2009 is long overdue for termination. Fueled primarily by a historic amount of stimulus from the Federal Reserve, the stock market rally has accelerated into a prototypical speculative blow-off phase, suggesting that the next cyclical top will almost certainly develop when the advance terminates.

Driven by euphoria, highly speculative rallies of this character will often continue to advance even after the market has become extremely overbought across all time frames, and predicting the timing of the inevitable reversal with a high degree of statistical confidence is nearly impossible. However, several subcomponents of our Cyclical Trend Score (CTS) are flashing warning signs that suggest a long-term top is approaching. Our sentiment score has moved below the -80 level for the first time since May 2011, indicating that the market is vulnerable to a severe correction.

Additionally, our price oscillator score, which monitors overbought and oversold conditions from a cyclical perspective, has moved below the -80 level for the first time since June 2011, indicating that the cyclical bull market from 2009 has become extremely overbought.

Although internal measures such as market breadth and volume have yet to break down, the degradation in multiple other measures suggests that the inevitable reversal could occur at any time. The cycle high signal that was generated last week remains in effect, indicating that a half cycle high (HCH) likely formed during the week ending May 24. Only a quick move above the stop level at 1,667 this week would invalidate the signal and suggest that the initial rally phase of the intermediate-term cycle from April is still in progress.

At this very late stage in the cyclical bull market from 2009, every intermediate-term cycle high is also a potential long-term top, so it will remain important to monitor price behavior closely during the next few months.

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Gold closed sharply higher today, reacting further off of recent lows of the downtrend from October. We have been monitoring the development of a positive divergence on the daily chart since early last week and the strong advance today has created a slightly bullish condition overall that tentatively favors a return to congestion resistance in the 1,475 area.

Our Gold Currency Index (GCI), which tracks the intrinsic value of gold as an international currency, has developed an even stronger positive divergence, resulting in a moderately bullish condition overall on the daily chart that favors a return to its comparable previous high near 37.60.

Last week, we noted the potential development of the latest intermediate-term cycle low (ITCL) on the weekly chart of gold. The advance this week has caused both cycle analysis price oscillators to experience bullish crossovers and a bullish engulf pattern has formed on the weekly chart. In the absence of a sharp decline tomorrow that returns to the close on May 24 near 1,386, an intermediate-term cycle low signal will be generated this week, indicating that the latest ITCL likely formed during the week ending May 24.

The Gold Miners index is also exhibiting bottoming behavior. A weekly close above 813 tomorrow would generate an even stronger cycle low signal on its weekly chart, suggesting the likely formation of an intermediate-term bottom in the gold sector.

The long-term downtrend from 2011 remains in progress and it is too early to know with any useful degree of statistical confidence if the correction is in the process of terminating. However, the character of the rebound off of the latest ITCL will provide the next assessment of gold market health, so it will be important to monitor price behavior tomorrow for the potential development of this important intermediate-term signal.

During the past several years, the Federal Reserve has engaged in a historic market intervention through its quantitative easing (QE) programs. Early on in the process, Federal Reserve Chairman Ben Bernanke indicated that the intent of the intervention was to inflate the stock market and thereby spur a “virtuous cycle” through which the economy would be reinvigorated. Predictably, the economy has failed to respond meaningfully to QE as it continues to be constrained by excessive debt. However, the stock market has responded to artificially low interest rates and the cyclical bull market from 2009 has accelerated into a highly speculative advance that exhibits the characteristics of a prototypical bubble.

As an academic, Chairman Bernanke has exhibited the tendency to expect markets to behave rationally throughout his career. For example, many years ago, he argued that excessive debt would almost certainly not become a problem in the US because allowing debt to reach excessive levels would be irrational. Yet, here we are. Similarly, he probably did not expect the recent QE programs to create a speculative bubble in the stock market, but that is precisely what has occurred. As with all such highly speculative advances, the inevitable correction will be equally violent in character. It is only a question of when.

Additionally, it is important to reflect upon the extremely difficult task that will face the Federal Reserve when the time comes to reverse the QE process. How will this historic amount of monetary stimulus be withdrawn from the system without engendering significant economic disruptions? In a recent weekly commentary, fund manager John Hussman reviewed the unpleasant consequences of Federal Reserve policy that will need to be addressed after QE ends.

Over the past three years, the U.S. economy has repeatedly approached levels that have historically marked the border between expansion and recession. There is little question that massive quantitative easing by the Federal Reserve has successfully nudged the economy away from this border for a few months at a time. But as I’ve noted before, the belief that monetary easing solved the 2008-2009 financial crisis is an artifact of timing. The Fed was easing monetary policy throughout 2008, and while it is tempting to view the recovery as a delayed effect, the more proximate factors were a) the change in FASB accounting rules to dispense with mark-to-market accounting, which relieved banks of insolvency concerns even if they were technically insolvent, and b) the move to government conservatorship and Treasury backstop of Fannie Mae and Freddie Mac, which reduced concerns about default risk among mortgage securities.

The Pavlovian response of investors to monetary easing – as if it has anything more than a transitory and indirect effect on the economy – fails to distinguish between liquidity and solvency; between economic activity and market speculation; and between investment value and artificially depressed risk premiums. The economy is not gaining anything durable from these policies, and the conditions for the next bear market are already established. Meanwhile, the chart below updates the extreme that monetary policy has already reached (data points since 1929).

The 3-month Treasury yield now stands at a single basis point. Unwinding this abomination to restore even 2% Treasury bill rates implies a return to less than 10 cents of monetary base per dollar of nominal GDP. To do this without a balance sheet reduction would require 12 years of 6% nominal growth (which is fairly incompatible with sub-2% yields), a more extended limbo of stagnant economic growth like Japan, or significant inflation pressures – most likely in the back half of this decade. The alternative is to conduct the largest monetary tightening in the history of the world.

In September 2011, our cycle analysis predicted the formation of a long-term top in the gold market. Following the development of a consolidation formation from late 2011 until early 2013, prices moved below congestion support in the 1,550 area. As expected, the breakdown was followed by a severe decline of 12 percent during the last six weeks.

Our Gold Currency Index (GCI), which tracks the intrinsic value of gold as an international currency, has moved sharply lower in a similar manner, reconfirming the long-term correction that began in 2011.

With respect to cycle analysis, the sharp decline this week has reconfirmed the bearish translation that has persisted since late 2012. However, violent declines such as the move that began in April often result in cycle compression and it is likely that the next intermediate-term cycle low (ITCL) will form earlier than usual. The initial best estimate for the next ITCL window was from June 28 to July 26, but it is now likely that the forthcoming low will form sometime between May 31 and June 28.

The long-term correction from 2011 has retraced 29 percent of the secular bull market advance that began in 2001. This is typical behavior for a cyclical downtrend within a secular uptrend.

However, the Gold Miners Index has declined 58 percent from its comparable high in 2011, returning to levels that were first attained by the secular uptrend in late 2003.

From a big picture perspective, the obvious question is: has a new secular downtrend begun in the gold market? Given the historic expansion in the monetary base engineered by the Federal Reserve, along with the resulting structural imbalances, it is highly likely that the secular bull market remains in progress. The size of the monetary base has nearly quadrupled during the last five years and there is no known process through which this excess liquidity can be removed from the system without causing significant economic disruptions.

While contained at the moment, price inflation will almost certainly become a very big problem later this decade, probably beginning sometime during the next 2 years. Therefore, the fundamental foundation for the secular bull market in gold remains intact and we are likely several years away from the terminal phase of the rally. Cyclical corrections such as this one are healthy developments as they serve to purge speculative excesses from the market, thereby preparing it for the next phase of the advance. Additionally, they provide long-term investors with opportunities to add to their positions. As always, those accumulation opportunities are best identified through the use of optimal entry points as defined by the judicious application of chart analysis and we will report those opportunities as they develop.

Our computer models analyze a large basket of fundamental, technical, internal and sentiment data in order to calculate our Secular Trend Score (STS) and our Cyclical Trend Score (CTS). The historical data used by our models extend back to the market crash in 1929 and have enabled our STS to correctly identify every secular inflection point and our CTS to correctly identify more than 90% of all cyclical inflection points during the last 84 years. Additionally, when analyzed together, these data identify extremes in the risk/reward profile of the stock market from an investment perspective. Since early February, stock market investment risk has remained in the highest 1 percentile of all historical observations, joining a select group of five time periods that include the long-term tops in 1929, 1973, 2000 and 2007.

As always, this particular measurement of investment risk is not a top call or an indication that a severe market decline is imminent. Overbought rallies such as this one can remain overbought for a long time as speculative momentum carries prices to higher and higher extremes. What the current investment risk/reward profile tells us is that a severe market decline will almost certainly occur after the current cyclical bull market terminates. At a current duration of 50 months, the bull market is long overdue for termination and the next cyclical top could form at any time. Additionally, the rally has taken the form of a prototypical speculative advance as modeled by a log periodic bubble. This mathematical formula replicates market behavior extremely well during unsustainable advances and the following chart from a recent weekly commentary at the Hussman Funds website displays the high degree to which the current stock market rally is exhibiting the classic characteristics of a bubble in its final stage.

The most recent uptrend from November has moved higher at an unsustainable rate, gaining nearly 22 percent during the past six months and becoming extremely overbought on a short-term basis.

Any breakdown could signal the development of the latest cyclical top, so it will be important to monitor price behavior closely during the next several weeks. Now remains a time for extreme caution and we remain fully defensive from an investment perspective.

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As we note often, context plays a vital role in the development of reliable market forecasts. Short-term price behavior only has meaning when analyzed in the proper context afforded by the long-term view, so all investing and trading strategies should begin with a thorough understanding of the current secular environment. There have been five secular trends in the stock market since the crash in 1929, three downtrends and two uptrends.

The current secular bear market began in 2000 following a speculative run-up during the second half of the 1990s. As usual, market behavior clearly signaled that a secular inflection point was approaching and our Secular Trend Score (STS), which analyzes a large basket of fundamental, internal, technical and sentiment data, issued a long-term sell signal in December 1999. At the time, our computer models predicted that stocks would enter a secular bear market that would last from 10 to 20 years. Following the topping process in 2000, a prototypical secular downtrend began that continues today.

Severe secular bear markets such as this one are nearly always accompanied by extremely weak economic activity and the first decade of this century was characterized by the lowest real GDP growth since the Great Depression.

Stock market secular trends typically last from 10 to 20 years, depending upon the nature of underlying structural economic trends. Since we are currently in the final stage of a debt expansion cycle that began 60 years ago, it is highly likely that the current secular bear market is still several years away from its terminal phase.

The STS supports the hypothesis that this secular downtrend is far from over as the score has yet to return to positive territory following the sell signal in 1999. Secular inflection points develop slowly, usually over the course of 6 to 12 months, so the STS will provide plenty of advance warning when the next true investment opportunity develops in the stock market.

Secular trends are themselves composed of cyclical subcomponents, and the current cyclical uptrend began in March 2009. When they occur during secular bear markets, cyclical rallies have an average duration of 33 months. At a current duration of 50 months, the bull market from 2009 is long overdue for termination and it will likely be followed by a violent overbought correction.

The final phase of the previous cyclical bull market from 2002 was easy to identify as it developed in 2007. The measured move higher from 2004 until 2006 was followed by speculative blow-off rally that terminated the advance in prototypical fashion. The historic amount of Federal Reserve stimulus introduced during the last four years, targeted directly at risk assets such as stocks, has created massive market distortions, causing the current cyclical bull to be characterized by violent moves in both directions. However, the last advance off of the low in 2011 is rising at an unsustainable rate, suggesting that the rally has entered its final phase.

Another way to model an unsustainable advance is via a log periodic bubble. This mathematical formula replicates market behavior extremely well during highly speculative uptrends and the following chart from a recent weekly commentary at the Hussman Funds website displays the high degree to which the current stock market rally is exhibiting the classic characteristics of a bubble. Therefore, the next cyclical top is almost certainly imminent and it could form at any time.

Additionally, it is important to remember that stock market investment risk continues to hold near the highest level ever recorded. Anything can happen over short-term time periods, but the key to having consistent success over the long run as an investor and a trader is to stay aligned with the most likely scenarios and protect yourself from the unlikely ones. There will come a time when the risk/reward profile of stocks is once again favorable and the judicious study of market data will signal when that next long opportunity develops, just as it did in March 2009. However, now is a time for extreme caution and we remain fully defensive from an investment perspective.

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As expected, the recent two-session crash in the gold market has been followed by a violent oversold reaction. Following the 13 percent decline in mid-April, gold has rebounded more than eight percent during the last eight sessions.

With respect to short-term cycle analysis, the strong advance today has caused a change to our preferred scenario and it is now likely that the beta phase rally is in progress. Additionally, the move well above the last alpha high (AH) during the beta phase rally signals the likely transition to a bullish translation.

As we noted two weeks ago, technical and cycle analyses produce reliable outlooks when price movements are well behaved, but abrupt crashes like the recent decline severely limit the usefulness of these techniques. Therefore, short-term forecasting will remain difficult until the market stabilizes and we will need to wait for renewed clarity to emerge from subsequent price behavior.

From an intermediate-term perspective, the breakdown of the consolidation formation that had been developing since 2011 was followed by a quick return to the next meaningful support level in the 1,400 area. The strong rebound this week suggests that the 1,400 level will hold during this initial test, but it is likely that the violent price behavior of the past three weeks will continue in May.

A weekly close above 1,481 tomorrow would generate a cycle low signal on the weekly chart, indicating that the half cycle low (HCL) of the intermediate-term cycle from March likely formed last week.

Extreme moves often result in cycle compression, so the formation of a very brief cycle from March would not be unusual following the recent crash. However, the recent breakdown of the long-term consolidation formation was a significant bearish signal and it is too soon to know if a meaningful intermediate-term low occurred last week. Therefore, it will be important to monitor price behavior closely heading into the forthcoming ITCL for the next assessment of gold market health.

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