2006, THE YEAR OF THE FAILED BREAKOUT (October 23, 2006): One very unusual feature of 2006 is that it has seen so many failed breakouts across asset classes. Most of these have been failed upside breakouts. A failed breakout is defined as any security surging to a new multi-year high, then collapsing to a level below where it was when the rally originally began.

Obvious failed upside breakouts have occurred for virtually all commodity share groups. Gold mining shares began the year with a sharp upward move, hitting significant new highs by the end of January. On May 11, HUI moved above 400 for the first time in history. By June 13, all of these gains and then some were surrendered. Gold mining shares since June have traced a weak triple bottom, a notoriously weak chart pattern, with the ultimate low likely still substantially below current levels (perhaps near 248; see analysis below).

Oil shares have performed almost identically to gold mining shares, by setting new multi-year highs, then giving up all of their 2006 gains. Coal producers, on the other hand, after having been the single strongest equity group through the second week of May, have since been the weakest-performing group. A few weeks ago, they declined to levels not seen since the summer of 2005. Partly this is because they had become so overvalued; partly it was in sympathy with other commodity shares; partly it is from fear that if the Democrats gain increased control of Congress, they will enact legislation that imposes stricter environmental restrictions on coal producers.

It should be mentioned that there will almost certainly be increased Democratic participation in both the House and Senate, even if they do not actually obtain a majority in one or both chambers. Not only would this likely be negative for coal producers, but for miners in general. The topic of global warming has received a lot more media attention in 2006 than in any previous year, and if the Democrats obtain increased influence over the legislative agenda, they are likely to make a serious attempt to remedy what they perceive as the overly lax environmental policies of the current Republican administration. Opinion polls seem to favor the Democrats in this quest. Old-line industrial and "smokestack" industries of all kinds are therefore likely to experience a sharp increase in emissions standards and in other forms of more restrictive pollution control regulations.

Returning to the topic of failed breakouts, many currencies attempted to set new multi-year highs earlier this year, but could not do so, as the U.S. dollar held above key support levels from three years ago. U.S. Treasuries attempted to break below four-year lows, but held to the upside, and have been making progressively higher lows--meaning lower yields--since May 12. Notice that May 12 is exactly one day after May 11, when gold mining shares mostly peaked, and exactly two days after May 10, when oil and coal shares mostly peaked. Thus, the financial markets remain closely interlinked.

Since the financial markets tend to repeat recent behavior, it is therefore likely that the recent attempt by many worldwide equity indices to set new multi-year highs will similarly lead to a sharp pullback and a surrender of all of the year's gains. While some headline indices such as the Dow Jones Industrial Average and the Standard & Poor's 500 Index have rebounded to their highest levels in several years, amid much media fanfare, nearly all smallcap indices have been unable to achieve new peaks. Both the Nasdaq and QQQQ were not able to set new annual highs in recent trading; the QQQQ did not seriously approach its January 11, 2006 recovery peak of 43.31, reaching an intraday high of 42.62 on October 16. In addition, important leading indicators such as the number of new daily highs on all exchanges has been substantially less than it had been in the past winter and spring.

Finally, my favorite leading indicator for U.S. equities has always been the performance of semiconductor indices and their funds, such as SOX and SMH. For nearly four decades, semiconductors have been reliably leading the way both higher and lower for U.S. equities in general. Here is a one-year chart of SMH, an exchange-traded fund of semiconductor producers. The black, nearly horizontal line represents a simple 200-day moving average (with a special thanks to http://freerealtime.com/):

A picture is indeed worth a thousand words. Notice that SMH recently broke above its 200-day moving average, but has since strongly repelled it to the downside. Therefore, equities in general are likely to soon experience a substantial downward correction that could continue for several months.