A detailed introduction to Exceptional Bear

The Year of the “Noah effect”

Benoît Mandelbrot, the father of fractals, passed away at age 85 last week. Mandelbrot

was the ultimate interdisciplinary scientist, who applied his findings across a wide array

of scientific fields including physics, biology, mathematical finance, chaos theory and

markets. A fractal is essentially a structure where the whole is echoed in its parts, and

in parts of its parts, while remaining the same no matter how much it is blown up or

scaled down. Below are two examples of fractals. In the snowflake, focus on the white

areas to find the floor plan of a Gothic Cathedral repeated in five progressively smaller

sizes.

Figure #1 Fractals

Fractals are inherent in Nature, as shown above and therefore in Stock Market patterns,

which closely model Nature. As Mandelbrot pointed out “all charts look alike - without the

legend you can’t tell if you’re looking at decade’s worth of data or an hour’s”. The corollary is:

A Bear Market is no more than a multi-year correction on a monthly chart, where the

identical pattern might last just a day or two on a 10-minute chart.

The chart below is the basic fractal, which serves as the template for the entire

Supercycle Bear Market.

Figure #2

Please take a moment to get your bearings, Supercycle Wave (III) is the March 2000

top, (labels are placed upon completion each segment) and we are on the way down in

Supercycle Wave (IV), an A-B-C, with only the C wave to go.

Figure #3 S&P Monthly

(in candlestick charts the wicks denote a retracement, or double pass; a hollow red

candle near the low indicates a bearish reversal, meaning the bottom is likely in, while a

solid black candle near the top means a bullish reversal, meaning the top is likely in.)

Figure #4 S&P Weekly

The weekly chart above is a magnification of the previous monthly chart, showing only

wave C unfolding. Once the second Diag II is complete, there is a Supercycle

Transition a complex a-b-(a), a-b-(b), to indicate the last wave returns to the higher

degree. The same degree that resulted in the longest Bull Market in history from 1982 to

2000, when the market price exceeded ten times the total price appreciation up to that

point, from the late 1700’s.

Figure #5 Hourly Dow October-November 2008

The identical Diag II structure is inverted above on the hourly chart, as “the correction of

a larger correction” as a fractal of the larger Bear Market. The hourly chart above

shows that Diag II in detail, with the sub-divisions 5-3-5-3-5.

The Diag > indicates a terminal move, as you see the a marked the top, followed by a

reversal to b

The chart below shows the previous Supercycle Transition that bean the longest Bull

Market in History. This time the Diag IIs come after the transition, rather than before it,

but the indication is the same the beginning of a long move, the more and larger the

Diag IIs structures, the more severe the subsequent move. If I am mistaken about the

total collapse, the minimum downside the area between S&P 128 and S&P 59, meaning

a return to 1983-1984 price levels , however the more likely is a return to 1940’s prices,

the same as 1909, severe Deflation. See Figure #8.

Figure #6

It was Mandelbrot who disproved the Efficient Markets Hypothesis, Modern Portfolio

Theory, the Black-Schools Options Pricing Model and the Capital Assets Pricing Model

half a century ago. Most financial equations continue to be based on these defunct

theories, since they use the “risk-free rate” as their cornerstone. Markets neither follow a

“random walk” nor do outcomes fall under the “bell-curve”. What’s more, although

markets reflect all known information much of the time, as shown in the chart on the

right below, in actuality, extreme outliers are far more common than a random coin toss

would infer. Mandelbrot distinguished between the “Joseph effects” (seven bountiful

years, followed by seven lean years) and the “Noah effects” – cataclysms like the

Great Flood or the Crash of 1929, and its likely repeat in 2011. While financial models

measure the “Joseph effects”, it’s the “Noah effects” which make or break investors ,

since these outliers are responsible for the bulk of long-term wealth-building – namely

yours .

Figure #7

The 20th century saw 48 days in which the Dow swung more than 7% (equivalent a

standard deviation greater than 3.5%). Normal statistical modeling predicts such swings

would occur once every 300,000 years! While mathematical models tend to capture a lot

of reality, only a fool believes they capture all of it. Most investors continue to ignore

Mandelbrot’s insights by remaining fully invested “long” in stocks at his juncture, and

believing bonds are safe long-term, with the excuse that they “can’t time the Market”, or

that its “Time in the Market, rather than timing the Market” that leads to long-term wealth-

building. The Market Crash ahead will likely blow the previous extreme standard

deviations out of the water and go down as the “Mother of Extreme Outliers”, the

proverbial “Black Swan”. Tho9se that remained invested between 1929 and 1932, had

not stocks of companies that went bankrupt, like the blue-chip NY Central Railroad, and

made no withdrawals, required more than 20 years to “get even”. If they made any

withdrawals in the midst of Depression, their losses became un-recoupable.

Unlike the first Great Depression, this Supercycle Bear Market has had to contend with

record amounts of fiscal and monetary interventions to postpone and restrain Nature’s

forces from unfolding – causing a counter-force of immense proportions to amass. Each

time the day of reckoning is post-poned, increases its eventual severity and enduring

effects. It’s doubtful that monetary policy has ever had more than a band-aid effect. So

desperate is Bernanke that he has resorted to manipulating “expectations”, in addition

to the market, (nearly the entire rally from the March 2009 low was manipulated by the

Fed buying Futures through the NY Fed’s primary bond dealers) since the market

forecasts the economy better than any economist, by manipulating the market the Fed

hopes he can pull off enough of a rally to “fool the market” and the economy back to

recovery.

While the previous outdated market theories would infer remaining “long” at all times, as

Mandelbrot proved, the risk of doing so at this juncture, is immeasurable under the

current mathematical paradigm. Most investors continue to believe the Fed is in control

of the economy and can pull off a slow recovery. Of course this time is different, “we

have a ‘Depression Era scholar’ directing the Fed”. Bernanke’s consciousness is 130 –

lower than even Hitler’s! The same “super blip” that will inflict misery and embarrassing

serial downsizing on many, will give new meaning to the concept of an “outlier, windfall

– the Noah effect” to an informed few.

Elliott Wave Simplified

Ralph Nelson Elliott discovered nearly 80 years ago that five waves up, labeled 1-5 in

the diagram below, mark man’s progress in every endeavor. Where wave 2 corrects

wave 1 and wave 4 corrects wave 3. (essentially three steps forward, two steps back)

Once 5 waves are complete they equal wave 1 of the next higher degree of trend. In

Elliott terms, 1909-1932 was Supercycle wave 2, and the Bear Market beginning in March

2000 is the corresponding Supercycle wave 4 of a huge 5-wave Supercycle advance. Like

the period between 1929-1932, we can expect a 90% plunge in stock prices, and

catastrophic losses for the vast majority of investors, and all pensions. Relevant

degrees of trend from high to low are Supercycle, Cycle & Primary.

What’s more, the market is a fractal, which like a recurring theme in music, the larger

structure is echoed in its parts. Thus waves 1, 3 and 5 called impulse waves, or what we

would normally think of as “bull moves”, are labeled with numbers, and each sub-divides

into another 5 and another 5, just like the Russian eggs, where there is always smaller

one inside, at all degrees of trend, from the multi-century to the 1-minute chart.

Corrective waves, 2 and 4, sub-divide into three waves or variations thereof, and are

labeled with letters. They tend to be far more complex, with more than 42 possible

permutations and combinations.

In the chart below you see the Century chart and the corresponding valuations the q

ratio measures the discount or premium to replacement value of a company’s assets,

while the cyclically-smoothed 10-year P/E ratio, sometimes referred to as P/E 10. As

you see once the valuations peak and start down, the minimum downside is a 60%

discount to their assets, but that’s at Cycle degree, or in multiple plunges in a

Supercycle Degree, but the trough in Supercycle degree, is the yellow line where

company assets sell for 10% of their replacement value, while stocks that earned $10

per share in the preceding 12 months sell for $2 per share.

Figure #8

Elliott’s only 3 Rules are:

1) Wave 2 cannot exceed the origin of wave 1

2) Wave 3 is never the shortest, and usually the longest

3) Wave 4 cannot overlap wave 1

Diag >s (read Diagonal Triangles) and Diag II & Diag II ( read Diagonal 2s) break all

three rules

Guidelines1) Corrections usually retrace to the previous 4th wave of one lesser degree.

2) Diag > are terminal structures indicating dramatic reversal ahead, labeled

black to indicate a moribund move.

3) Diag II and Diag II to indicate bullish or bearish, are found at the beginnings

of long moves. When found in Impulse segments in either direction, they

indicate the beginning of a long trajectory. When found in corrections the

largest of these also signals a long trajectory, and usually the trough of the

entire correction once complete.

4) The larger the structure the greater the subsequent effect. For example, a

Diag II visible on the monthly or weekly chart, will be many times stronger

than one that’s visible only on the hourly chart.

5) When several Diag of the same kind are found in sequence, they compound

each other geometrically, as if their areas were multiplied, rather than added,

to magnify the force and velocity of the subsequent move.

6) The maximum number of Diags of the same degree that can appear in

sequence is 3.

7) Once complete, all Diags retrace back to at least the first touch point of the

originating Diag.

8) Alternation occurs whenever possible, for example if wave 2 is a simple

correction, wave 4 will be complex, if wave 2 is a sharp correction which

makes a new high, wave 4 will move mostly sideways and vice-versa. It also

applies to fast/slow corrections as between 2008 and 2010. So that those

expecting the identical outcome as last time always get thrown for a loop.

Why must the Market Plunge? 1) Despite the Fed, the market is a self-correcting mechanism; the primary reason

for a Crash now is a backlash to the Fed’s continued meddling. In order for recovery to begin, the Fed’s entire credit creation, artificially low interest rates and money supply expansion must be completely withdrawn first. A Crash effectively accomplishes all three in a flash.

2) On a basis of its average 10-year earnings multiple, and in relation to corporate assets the stock market is at least 50% overvalued and 99% of the S&P is trading above its 50-day moving average. But rather than dropping back to merely fair value, the market always overshoots from highly overvalued to highly under-valued.

3) According to Russell Napier’s Anatomy of the Bear, at market troughs stocks sell at a 60% discount to replacement value and a P/E ratio below 6. At the March 2009 low, stocks were still selling at 13 times earnings - more than double that.

Meaning a drop far below the March 2009 low is assured - S&P 300 is likely the minimum, from Friday’s close of 1345 equals a 78% plunge.

4) Carmen Reinhart, co-author of monumental work, This Time is Different, in a paper delivered at the Jackson Hole Banker’s Symposium in August, provided a glimpse of the future. Distilled from her research studies of 15 crises over three-quarters of a century, including the Great Depression. Referring to 2008’s market plunge, she concludes: “post-crisis, credit contracts by an amount equal to the pre- crisis surge”. But with the Fed continuing to pump out liquidity, the only way credit can efficiently contract is through a Market Crash, where trillions of dollars vanish into thin air virtually overnight, severely constricting the money supply and reversing previous credit expansion. According to Reinhart, who reiterates the principles of the Austrian School, “Quick (Keynesian) fixes, grasped by political leaders impair, rather than improve the situation, by their unfortunate interventions, and turn the crisis into a persistent malady of our own making.” The dust has not begun to settle. Instead the shock from this crisis will likely be deep and persistent.

5) The dollar is about to strengthen, almost as much as it has dropped from the post-Greek crisis high. Given the current record volume in dollar shorts, the only thing that could cause such a surge is a knee-jerk “flight to dollar safety” that accompanies a Market Crash with its sharp contraction of the Money Supply.

6) Technically speaking, two colossal Diag II’s, which compound each other , signal the beginning of a long move down to complete the C wave. The minimum likely downside of ~S&P 300, retraces the Diag II which marked the pre-crash 1987 high. As Diag >s indicate dramatic reversal ahead, back to at least where the lowest Diag began.

Figure #9 S&P Daily

Yet in the daily chart below you can see that a b wave will likely reach a slightly higher

irregular top. A bit more magnification in the Hourly S&P shows a Diag > in process

which should now retrace to at least 1320 and most likely to 1312. UPRO, our position

for timing services, shows nearly the identical pattern as the S&P above. We sold a

partial position at 81.25 on Friday, and will buy back in the area of 77-78.

I have a high degree of certainty that the end of the completion of the Supercycle

transition will likely take the S&P down in a “flash crash”. In Elliott an (a)-(b) transition

is analogous to crown molding which makes the transition from vertical to horizontal,

except the transition is from up to down. While crashes normally occur in wave 3, we

are already in the equivalent of wave 5, the second most likely spot for a Crash. The

transition back to Supercycle means a log degree or 10x bigger than everything that has

come since the 2000 Bull Market top. It should be very clear, but if “long” investors wait

for any further confirmation, there will likely be no exit, as in Sartre’s parody on Hell.

Like big paws on a puppy indicate a big dog later on, so a huge transition means a

severe collapse in the market. An (a)-(b) transition, far larger than any I have ever

witnessed, is highly consistent with a CRASH, especially coming on the heels of a

Double Diag II extending from 2007 to 2010, see figure #4 above.

At least a 75% plunge is all but certain. Given that market corrections “alternate”

between fast and slow, rather than the gut-wrenching slow decline we had in 2008,

which was mistakenly called a crash in the press, a true Crash is like 1987’s, which was

over in 3 days, or like May 2010’s “flash crash” on a much grander scale. While its

human nature to discount this forecast as outlandish, when you recall that a 50% plunge

has already occurred twic e this decade, such a projection should seem very

reasonable.

Crashes are sudden realizations of Reality

Crashes are sudden realizations of reality - realizations such as “the entire ‘green shoots’

rally from March 2009 has been a Bernanke-manipulated fraud”. If the green shoots had

been real, we would have had lush foliage by now, meaning job increases of 200,000-

300,000 per month. Instead we have chronic unemployment, mass deleveraging,

depressed bank lending, mounting foreclosures, and plunging Real Estate. As we

continue in denial to look for “less bad” economic results, rather than improvements, we

are setting ourselves up for the Mother of all Crashes.

VIX about to Spike upThe VIX, sometimes called the fear index, which measures volatility, is inversely related

to the S&P. When the S&P plunges, it Spikes. Lately we’ve seen a tremendous drop in

volatility, like the calm before the storm. In the chart below you will note that the same

Supercycle transition as in the S&P, but in the opposite direction obviously. Diag IIs

indicate the beginning of a long move up. What is highly significant is we are beginning

a Supercycle wave (5), which will most likely spike up at least 1.612 times and possibly

2.618x the length of Supercycle wave (1) to either 145 or 235. These are Fibonacci

multiples, named after Leonardo Fibonacci, a 12th century genius, from Pisa, who

introduced Arabic numbers to Europe, and re-discovered “golden section”, phi, the

fractal used to build the Great pyramid of Giza. Phi mirrors nature’s proportions in

everything from the DNA molecule to the human body’s proportions.

What’s more, this chart indicates the “Noah effect” is right upon us! It should be all over

no later than the end of December. Waves (1), (2) & (3) trace out the same 5 wave

stylized progression in figure #8.

Figure #10

Figure #11

Finally the dollar has begun and intermediate-term rally, it’s in wave (ii) correction short-

term, while wave (iii) to follow should just reach 79 to retrace the beginning of the Diag > as marked by the green dashed line.

Not the worst “Recession” – but rather Great Depression IIRather than “the worst recession since the Great Depression”, as we keep hearing from

the press and the likes of Ben Bernanke and President Obama, this is the Second Great

Depression, which like the first, won’t be officially recognized until after the Crash.

Sovereign Risk in US Treasury BondsSoon Bond vigilantes will impose market discipline on Treasuries to compensate for

heightened default risk, the result of run-away fiscal deficits approaching 90% of GNP,

pitted against plunging tax revenues, meaning Treasuries are guaranteed certificates of

confiscation as rising interest rates translate into catastrophic losses on presumably

“safe government bonds”. This is déjà vu - a replay of the AAA-Rated Collateralized

Mortgage Obligations whose bubble was likewise instigated by the Fed, and ended up

being worth 20-30 cents on the dollar once mass defaults became evident. However, as

stocks begin to cave in, initially bonds will surge in knee-jerk “flight to safety”, before

it dawns on bond investors that default is all but inevitable. Perhaps a month after

stocks crash, bonds will follow. The dashed blue line in the RSI (relative strength)

shows bonds are as oversold as they were at the previous April low. From here we rally

back to the green dashed line (to fill the gap in the chart) before crashing as well. The

Diag II in wave i indicates the beginning of a long way down, but first it must be retraced

almost completely in wave 2 to the dashed green line, as shown. In the next move

bonds should drop back to the lower red dashed line before beginning the big move up.

The minimum upside in Treasury bonds is 107, afterwards a plunge below 87, while in

the ETF the min upside is 52 as shown, although first a drop to the dashed red line

should occur.

Figure #12

Insider selling, Emerging Markets, Banks

Insiders - the smart money, have sold their stock in record numbers 30, 40 and 50 to 1

over the last 12 months - they are rarely wrong. Emerging Markets have not decoupled,

they have merely gone temporarily “out of phase”, and will plunge hard, right along with

the developed economies – to which they owe their export-derived growth. Overly

optimistic fiscal authorities are over-estimating tax revenues, while federal, state and

municipal governments are on the brink of defaulting on their bonds. Rather than

temporarily illiquid, our banks are permanently insolvent. Instead of another wave of

monetary stimulus stretching out the road to recovery, anticipation of the next stimulus

wave is already spurring on the Crash.

Expert Market Timing employing leveraged, inverse ETFs In 2008, Exceptional Bear’s performance exceeded 360% for 2x leveraged Trader

accounts (360% beats the all-time, best-ever performance by a money manager, John Paulson,

who’s accounts appreciated 300% with far more leverage in 2008, and implied risk) In non-

leveraged Pension accounts our performance was over 240%. Since the net market

plunge was under 39%, to arrive at 240% we hit nearly every single market turn on the

nose) The next 12 months should easily surpass that benchmark. How did we do it?

Expert Market Timing. Since markets plunge many times faster than they rise, you can

earn more in one year of a Crash, than you’ve made cumulatively in the last ten, far

more.

Doesn’t it seem like the Fed is insulting our intelligence by targeting higher inflation,

while leading us to believe that it will buy Treasuries to lower nominal bond yields?

Like TIPS even a slight uptick in inflation turns bonds with already ultra-low yields,

into certificates of guaranteed confiscation This is the logic of a mad man.

"Make no mistake, the next 12 months will be profitable beyond your wildest dreams.

On the other hand if you remain long, you can expect catastrophic losses, from which

there will be no recovery”

At the trough, you will be able to buy stocks and bonds at ten cents on the dollar, when

no one else has any money, just before another Bear Market Rally kicks off, with most

assets appreciating very quickly back to peak prices in 5-7 years.

Your willingness to act now, or do nothing, will determine your standard of living and

that of your family for the rest of your lives– most people will have to severely tighten

their belts, many will experience unimaginable financial hardship, but a few will

prosper beyond your wildest imagination. Which will you be?

Markets are governed by Nature’s Laws - not the FedInflation is totally inconsistent with 8-9% unemployment. By its very nature,

unemployment pushes down the prices of everything, which in turn perpetuates a

deflationary spiral. That’s why we’re in cyclical a Deflationary Depression. Let’s face it,

another round of the Fed’s monetary experiments, is unlikely to dig the US economy out

of its current hole, any more than an appreciating renminbi, and is as irresponsible as

the Chinese currency manipulation. With record-low interest rates already in effect, the

economy is certainly not being held back by interest rates. Ultra-loose monetary policy,

coupled with extremely high fiscal deficits is precisely the wrong response to the Bear

Market. The length of a bull market in years corresponds with the median human

lifespan, which was ~72 years in 2000, at that point a Depression began to rid the

market of past excesses, so it can renaissance as a new Bull Market. Like the seasons

and the tides, Bear Markets and Depressions are governed by the intractable Laws of

Nature, which must be endured. Attempts to keep the boom going by artificial means

are delusional and exorbitant delays to the day of reckoning, bearing monumental,

long-term social, psychological and economic costs.

The Time is NowWe focus on just the three highest return probability ETFs, and their inverses, which of

course is very different from three stocks, since each covers an entire industry or in the

case of Emerging Markets, all of the investible Emerging Markets.

You can find my Market Letters published on the internet with one month delay, under

Exceptional Bear, you can Google it.

Foreclosures and BanksThere is increasing evidence that there will be mass foreclosures in the year ahead as

mortgages successively go underwater and former owners walk away. In many states

homeowners do not owe the banks anything more than the keys to their home if they

default on the mortgage. Since many who bought at the peak paid no money down,

there’s little holding them back with these homes now 30% underwater. Negative equity

will accrue to the banks and the government agencies Freddie Mac and Fannie Mae.

It’s happening now and these are not unemployed, many are gainfully employed, and

taking the opportunity to get free rent while saving some money or pay off their debts,

while they await eviction. There are potentially millions of homeowners with negative

equity who will be walking away from their homes after a market crash. When this

backlog of homes that’s now building up with the foreclosure moratorium is lifted and

the homes finally sold it will be at drastically lower prices. Once people lose faith in the

value of their home recovering, they will simply throw in the towel and move to a much

cheaper rental. Of course this means another collapse of the real estate market

together with commercial real estate likely as bad a shape, given the necessary

refinancing due in 2012. This will mean monumental losses in real estate and for the

banks who own the mortgages. There’s no better forecaster than a good Elliott count.

Eduardo Mirahyes

Market Analyst