If you have followed the Fed for any length of time, you know they give every syllable careful consideration when making any kind of public statement. You don’t need to have a Ph.D. in Fed watching to understand yesterday’s release of James Bullard’s paper concerning quantitative easing is a carefully calculated move to signal to the markets the real possibility exists the Fed will begin buying Treasury Bonds in the not too distant future. We read Mr. Bullard’s Seven Faces of “The Peril” last night and put together a “read between the lines” interpretation of what it could mean to individual investors and the value of assets in the coming weeks and months. Regardless of whether or not you agree with or feel this type of policy will be effective in the longer-term, there is no question the Fed can significantly alter behavior and impact asset prices in the short-to-intermediate term. This means an announcement of quantitative easing in the coming weeks could significantly impact where stocks, bonds, and commodities settle on 12.31.2010. Our detailed comments on quantitative easing and Mr. Bullard’s paper can be found in: Reading Between The Lines: Bullard’s Paper.
Archive for July, 2010
GDP numbers, which show a slowing rate of positive growth, have hit futures fairly hard this morning. The daily chart of the S&P 500 is showing some signs of weakness, but the longer-term outlook remains positive from a risk-reward perspective. The CCM Bull Market Sustainability Index (BMSI) came in at 1,718 as of Thursday’s close. As shown below, the risk-reward profile of similar markets in the past have been favorable, especially over the three-month time horizon. A historical risk-reward ratio of 5.22 is excellent.
We expect the markets to be volatile, and they need to be monitored closely. However, the outlook into year-end remains favorable given the data we have in hand currently. Heading into Friday’s trade, the weekly chart of the S&P 500 still had indicators moving in the right direction.
Weekly and monthly charts are much more relevant to investors. Daily charts, while helpful, tend to cater to the short-term time horizons of traders. The question we ask ourselves on a day like today is, “Do the odds still favor higher asset prices on 12/31/2010?” If the answer is “yes”, then we should err on the side of looking to the longer-term rather than getting spooked by shorter-term volatility. We have been, and remain concerned about the big picture of both the economy and the fundamentals. However, those concerns have not reached a point where the longer-term outlook has come into serious question.
We also whole-heartedly believe the Fed stands ready to make major policy changes should the S&P 500 trade between 945 and 1,010 again. Last night, we reviewed, in detail, St. Louis Federal Reserve President James Bullard’s paper, which was released yesterday. We will be posting some comments concerning the very significant policy shirts that may be coming our way should the asset markets fall precipitously in the coming days and weeks. All portfolio decisions must incorporate possible Fed action, since it could significantly alter asset prices in the short-to-intermediate term. Bullard’s contingency plan paper discusses “bazooka-like” moves that could be announced relatively soon.
From a 3:00 pm ET Bloomberg story:
Federal Reserve Bank of St. Louis President James Bullard said the central bank should resume purchases of Treasury securities if the economy slows and prices fall rather than maintain a pledge to keep rates near zero. “The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released today about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”
We just printed the 23-page paper from Bullard. We will review it overnight and make some comments tomorrow if anything looks noteworthy. A week ago, in Bernanke, the Fed, Deflation, and the Dollar, we stated the following:
The Fed is a wild card in making portfolio decisions in the coming weeks and months. Let’s use an example to illustrate. Let’s assume, hypothetically, the S&P 500 falls to somewhere between 945 and 1,000. As we approach these levels, the threat of deflation starts to become very real. The average investor, driven understandably by fear, sells their entire portfolio moving to 100% cash. The next day, the Fed announces they are no longer going to pay interest on bank reserves held at the Fed (to encourage lending). Stocks rally, but the incoming economic news continues to disappoint. Ten days later, the Fed announces a new asset purchase program to pump more money into the economy. Commodities rally strongly; stocks rally; gold and silver rally; the U.S. dollar tanks. Driven by the Fed’s actions (right, wrong, or indifferent), the S&P 500 finishes the year between 1,200 and 1,325. Investors who sold out between 945 and 1,000 on the S&P can’t sleep at night. Some investors, who knew the Fed would not remain on the sidelines as the threat of deflation rose, held their positions and breathed a sigh of relief as they began to wrap holiday gifts in December of 2010.
We have seen a few articles stating gold’s recent lower low is foreshadowing deflation and lower asset prices. We understand the concerns about the slide in the precious metal. However, the current correction still looks like other corrections that have taken place in the last few months. As shown in the chart below, a lower low in GLD, the gold ETF, did not mean the end of the rally in February of this year. After the lower low in Q1, both gold and stocks went on to make new highs.
Gold’s chart is showing some signs of a weakening corrective trend as well (see bottom of chart above). The 200-day moving average sits close by coming in at 1,145 for the metal itself, and 112.17 for the ETF. With real deflationary forces present in the economy, we’re keeping a close eye on all asset classes. For now, gold’s move appears to be a correction within the context of an ongoing uptrend.
We are all familiar with the common expression, markets do not like surprises. As it relates to the current state of the labor markets, the number of Americans filing first-time claims for unemployment insurance came in at 457,000 last week, which has again brought out comments from the media like “a figure that signals the labor market will be slow to improve even as the economy grows”. Is slow employment growth a surprise to anyone? Expectations from almost all quarters call for slow improvement in the labor markets and persistently high unemployment. In fact, John C. Williams of the San Francisco Fed said yesterday:
Indeed, given the outlook for only modest growth through the end of the year, I expect unemployment to end 2010 at about its current level of 9½ percent. Once growth picks up to a more robust pace, the unemployment rate should gradually decline, but only to about 8½ percent by the end of next year. I expect it will take several years before it returns to more normal levels.
Not to discount the importance of job creation and the real hardships endured by thousands of American families, but financial markets have performed well in prior cycles despite “jobless recoveries”. In the last recovery (early 2000’s), job creation did not return for almost two years after the economy bottomed. However, asset markets performed quite well from October of 2002 to October of 2007, with the S&P 500 gaining 105% from the bear market lows to the bull market highs.
In the early 1990s, job creation was tepid as we emerged from a recession in March of 1991. From March of 1991 through year-end 1993, the S&P 500 gained 26% during a “jobless recovery”. It is true markets do not like surprises, but weak job creation is a surprise to no one. In a similar vein, we noted recently in “Falling Consumer Confidence: Not a Death Knell for Stocks”, it is important that we try to differentiate between economic concerns and economic concerns that historically have derailed bull markets.
Creating satisfying and rewarding jobs is extremely important to the happiness and well-being of Americans, but persistently high unemployment does not necessarily spell doom for the financial markets. Fortunately, rising asset prices can assist in rebuilding balance sheets at all levels of the global economy. Healthier balance sheets at the household, corporate, and government level can eventually lead to higher levels of confidence and job creation.
Concerns about the economy, markets, and job creation are all warranted, and the big picture needs to be monitored closely. However, it is important we understand how past economic concerns have impacted asset prices.
John C. Williams, Director of Research for the Federal Reserve Bank of San Francisco, made a presentation to community leaders in Portland on July 28, 2010. As we go through some of his remarks, keep in mind Mr. Williams is the “numbers guy” for the Fed on the West Coast. He probably understands the current data as well as anyone.
Recent economic data have been disappointing and there’s no denying that the economy has hit a bit of a rough patch. Still, I believe that the recovery that has been in train for about a year is still on course, albeit at a more subdued pace. We economists keep a list of words we use to describe economic growth. It’s very carefully calibrated from “torrid” at one end to “freefall” at the other. The silver lining is that we’re still better than “meager” and “anemic.” And, thankfully, we are still several notches above “double dip recession.”
The key terms above are “several notches”. He didn’t say “hanging by a thread”. He didn’t say “one notch above”, he choose to say “several notches above a double dip recession”. If you examine the current data in hand, the odds of a double-dip remain relatively low, with 30% being the high side of most forecasts. Recent consumer confidence numbers and the past few months of action in the financial markets don’t seem to match the economic data. We agree with Mr. Williams’ remarks below in that we are experiencing a lack of confidence or something more akin to a lack of trust.
Households, businesses, and investors have endured painful economic and financial trauma over the past few years. It will take considerable time for confidence and trust to heal. We know from past experience here and around the world that recoveries from financial crises take a lot longer than recoveries from “usual” recessions. Indeed, businesspeople and consumers today are extraordinarily cautious and averse to all kinds of perceived risks, whether from the economy, financial markets, or government policies. This caution is manifesting itself in a reluctance to invest or hire unless absolutely necessary.
The mood of the market and consumer continues to be somewhat skeptical at best. Ultimately, the decisions of human beings, and not mathematical models, drive the economy. Therefore, lack of confidence and lack of trust is something we need to continue to monitor.
Although discouraging, the recent softness in the economic data looks much more like a bump in the road of what we already thought would be a gradual recovery, rather than a swerve into the ditch. Importantly, monetary policy remains highly supportive of recovery. Interest rates are extraordinarily low. And we’ve seen a marked improvement in the willingness of investors to take on reasonable risks, as measured by interest rate spreads between corporate securities and safe Treasury securities, as well as other metrics. At the same time, even though the bank loan market hasn’t fully recovered, banks are somewhat more willing to extend credit.
Our view remains bullish into year-end based on the following:
- The economic recovery appears to be on a sustainable path.
- Technical deteriroation is not out of line with past bull markets.
- Interest rates are very supportive of asset prices and economic growth.
- Sentiment data, a contrary indicator, does not align well with past bear markets.
With a global economy still saddled with high levels of debt, the argument for deflation has some very valid points. In his remarks below, Mr. Williams refers to the risk of deflation as “small”. This is similar to the “several notches” comment above; his choice of words is important.
There is a small risk of deflation, especially if it takes longer for the economy to recover than I expect. But I view a sustained period of deflation as unlikely for a couple of reasons. First, price trends aren’t nearly as sensitive to the state of the economy as they used to be. For example, core inflation, which strips out volatile food and energy prices, was running at about an annual rate of 2.6 percent at the onset of the recession, higher than the rate of about 2 percent that most members of the Fed’s policymaking committee have said is appropriate. That inflation rate has dipped to 1.3 percent today, two-and-a-half years into arguably the worst recession since the Great Depression. In other words, despite such an awful downturn, we’re now only about as far below the desired rate as we were above it before the recession started.
Given the data in hand and with asset markets at present levels, we also believe the odds of deflation remain relatively low. However, if asset prices begin to tumble again, the risks to balance sheets will increase, along with the risk of deflation. We firmly believe the Fed will take additional, and possibly significant, action should the S&P 500 again trade between 945 and 1,010, since further balance sheet deterioration is not acceptable in their eyes. The Fed, and possible policy announcements, will make managing portfolios difficult should we revisit the July lows. Below 1,010 on the S&P 500, the odds of the Fed making a game-changing announcement would increase with every tick down in asset prices (see Fed Signals Money Printing As Possible Next Step for more). Regardless of how effective any move by the Fed would be in the longer-term, there is no question they can significantly influence asset prices, especially commodities and stocks, in the short-to-intermediate-term.
With the S&P 500 gaining over 10% since making an intraday low of 1,010 on July 1, 2010, investors may feel it is a good idea to wait for a “pullback” before investing any cash. Recently, the Dow, NASDAQ, and S&P 500 all moved back above their respective 200-day moving averages (see Hedge Funds Care, So Should You). Many investors have been waiting to see what would happen at the 200-day before investing any new cash. The internal voice of investors may be saying, “Now that the 200-day has been cleared, I need to be patient and wait for a pullback”. That approach may or may not turn out to be a good idea, but the history of stock market action after the S&P 500 retakes its 200-day moving average may make you reconsider your “pullback strategy”. A visual inspection of the historical charts shown below can help you better understand the range of possible outcomes when stocks regain their 200-day moving average.
The purpose of this research is not to forecast or predict what stocks may do in the coming weeks, but rather to review historical cases where the S&P 500 Index (”stocks”) continued to surprise on the upside after crossing the 200-day moving average. The pullback approach aligns with the basic instincts of an investor after a big move off an intermediate low. We can find historical periods where the “pullback scenario” would have worked well. However, we were also able to find numerous cases where waiting for a pullback would have proved frustrating (see table below).
Below, we examine each of the historical cases cited above, including charts showing the market’s moves relative to the 200-day moving average. The first example is taken from 1998. Fundamental concerns of the day included the Russian financial crisis, aftermath of the Asian financial crisis, and falling commodity prices. Following a multi-month correction, stocks moved above their 200-day moving average in October of 1998. Once the 200-day was cleared, stocks continued to move higher with little in the way of buying opportunities. After calls for a new bear market, stocks gained almost 32% in the nine months after the S&P 500 retook its 200-day moving average.
2004 saw similar fundamental concerns to what we have in 2010; questions about the sustainability of an economic recovery, including slowing data relative to job creation, durable goods, and retail sales. After retaking the 200-day in October of 2004, stocks sprinted 8.7% higher in roughly two months with almost no opportunity to buy on a pullback.
Lingering effects of the savings and loan crisis in 1991 contributed to economic problems in the United States, Canada, the United Kingdom, and Australia. The Gulf War led to a spike in oil prices in 1990, which hurt both consumers and businesses. The period was marked by slow GDP growth, large budget deficits, and high unemployment. Stocks were able to see better days ahead and found a bottom in October of 1990. The S&P 500 crossed its 200-day moving average in late January 1991. Those who waited for a pullback were disappointed as stocks gained almost 18% with little in the way of corrective action after retaking the 200-day moving average.
In 1984 Dr. Deming’s “Five Deadly Diseases of American Industry” described a corporate culture that had lost its way, causing a decline in global competitiveness. Unemployment was 8% in January of 1984 and would finish the year at 7.0%.
Fears of a recession were high entering 1996 after a stagnant 1995 fourth quarter in terms of economic growth. GDP growth was tame in the first quarter of 1996 coming in at 2.0%. Stocks hit an intermediate peak in May and did not find a bottom until July of 1996. After an 11.04% correction in the S&P 500, the 200-day moving average was recaptured in late July with the Index valued at 635. That level was never revisited as stocks gained almost 29% in the following seven months.
Computers were blamed for much of the stock market volatility in 1986. Declining oil prices helped tame inflation and the Fed was able to lower interest rates. Reduced capital spending by businesses and a decline in exports contributed to slowing, but positive, economic growth. Unemployment stood at 7% for most of the year. Stocks experienced a sharp correction in September of 1986. After finding a bottom, the 200-day was crossed in a bullish manner on October 1, 1986. Stocks remained above the 200-day over the next six months, except for two days, while posting a gain of 29.18%.
The 1981-1982 case shown below is probably the least similar to present day 2010 since the cross of the 200-day followed a true bear market instead of a correction. However, the sharp move higher after finally breaching the 200-day in July of 1982 does show how market sentiment can change rapidly in a positive manner.
We want to reiterate this analysis is not meant to serve as a forecast of how stocks will perform in the coming weeks. Our purpose is to better understand the real possibility stocks could continue to surprise on the upside should the S&P 500 be able to hold above its 200-day moving average. We also understand and respect the problems of 2010 are quite different from the problems of the historical periods cited above. However, there are also similarities concerning fear of slowing economic growth, recessions, computer dominated stock trading, stubborn unemployment, and a general concern about the competitive standing of the United States in the global arena. In each case, the stock market was resilient and moved higher after completing a corrective process.
Asset markets are ultimately controlled by the actions of human beings. In the financial markets, humans tend to base decisions on either the fear of losses or the fear of missing potential gains. While the fundamental problems of the day vary in scope and severity, the human emotion of fear remains a relative constant from economic cycle to economic cycle. Consequently, it can be helpful to understand the full spectrum of history as we formulate investment strategies in the coming weeks and months.
An HTML version of this document can be found here.
CCM Clients: We are working on a study of market behavior following the retaking of the 200-day moving average after a significant correction. The results should be ready either later today or tomorrow.
The S&P 500 Index joined the Dow and NASDAQ by closing above its 200-day moving average today. More on recent moves related to the 200-day moving averages can be found in Hedge Funds Care, So Should You. [ Technorati site verification code QDMHFN93NV4R ].
Markets set asset prices. Markets determine how much your brokerage account, IRA, and 401(k) are worth. Hedge funds and large institutions drive markets. Therefore, it is prudent to know what large institutions and hedge funds care about and what they see in the current market. Right, wrong, or indifferent, hedge funds and large institutions monitor closely and care about 200-day moving averages.
In oversimplified terms, the big market players like to be in markets that are above their 200-day and out of markets that are below their 200-day. Despite all the calls for the market to head south, both the NASDAQ and Dow closed above their 200-day moving averages on Friday.
Markets can reverse and be volatile near the 200-day; so one day does not mean all that much. However, the longer these markets can hold their 200-days, and the further they can move away from them in the short-term, the more meaningful it becomes relative to the potential future value of your investments. Shorts will also be much more inclined to cover positions in markets that have recaptured their 200-day moving average, which can fuel a short-covering rally.
One of the best ways to monitor the health of any rally is to look at the number of stocks participating, which is referred to as market breadth. Wide participation is a sign of a healthier rally; one which has higher odds of continuing for more than a few days. How does market breadth look as of Friday’s close? pretty good. The Summation Index (shown below) is an intermediate-to-longer-term measure of market breadth. The Summation Index has made a higher low and recently closed above its 35-day moving average for the first time in eighty-eight calendar days. Both occurrences lean bullish for the intermediate-term.
CCM uses a proprietary market model, known as the Bull Market Sustainability Index (BMSI), to help us better understand the market’s current risk-reward profile. The current profile looks attractive, especially over the next six months. This ties in well with our comments made on July 2, 2010, Stocks May Surprise By Year-End.
The health of the markets have improved quite a bit in recent weeks, but things still need to be monitored closely, especially as markets congregate near their 200-day moving averages. We would still classify the markets as neutral-to-bullish. Some other short-term bullish developments are outlined in Stock Market Outlook Improving Short-Term.