Archive for January, 2008

Why the Fed Can’t Save the Market

January 27, 2008

While it is probably not a primary objective of the Federal Reserve to boost stock prices, the investment community seems to hold the view that current Fed activities can influence equity prices in the near future much more than it is reasonable to expect.

Historically, falling Fed rates have preceeded, on average, rising stock prices.  The time periods of rising prices are experienced for many months (and even years) after the first rate cut.  However, there are times when the delay from the first rate cut to rising stock prices is very long.  The most recent example is the current bull market which just ended.  It started in the fourth quarter of 2002, well over a year after the Fed started cutting rates.

The latest three day bounce in the stock market is not likely to last.  This week the Fed meets and the futures markets have priced in the expectation of an additional 50 basis point (0.50%) discount rate cut.  What will actually happen is up in the air, in my opinion.  The Fed is really on the spot.  I have a most likely market response scenario for each potential Fed action:

1.  The Fed raises rates this week.  I believe this is an impossiblity.

2.  The Fed takes no action this week.  The market will sell off sharply with much handwringing over an unresponsive Fed being “behind the curve”.

3.  The Fed lowers by 25 basis points.  The market will sell off, but probably not as sharply as in 2.  There will be the same handwringing as in 2.

4.  The Fed lowers by 50 basis points.  This is what is expected by bond traders.  In my opinion, the probability is 50/50 (pardon the pun) or less.  If this happens the market may have a short rally (possibly only minutes) and then start drifting lower again.  The investor psychology will be dominated by a fear that maybe things are even worse than they thought because the Fed has cut the discount rate by 1.25% in a week’s time.

5.  The Fed lowers by 75 basis points.  This is quite unlikely, in my opinion.  If it were to happen, the response would be similar to 4. for the same reasons.

6.  The Fed lowers by more than 75 basis points.  I believe this is impossible.

My view is that whatever the Fed does this week will produce little benefit for stocks.  We still have the weight of unwinding all the complex financial derivatives that were developed over the past five years.  We still have the uncertainty of what the balance sheets really are for the major banks.  We still have a slowing GDP growth rate – some think it may already be negative.  We still have consumers squeezed by record credit card debt, rising variable rate mortgage contracts, falling home values and concerns about keeping their jobs.  With consumer spending accounting for 2/3 of our GDP, our economy is struggling.  Stocks will not put in a bottom until there is hope that all these negative factors will turn up within 3-6 months.  We are not there yet and may not be until late this year.

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Market Update

January 6, 2008

We are at a critical juncture in the state of the market.  A classical “Head and Shoulders” pattern has been traced by the three major market indices since 3/13/2007.  All that remains to complete what could be a market top signal for the S&P 500 is a close below 1406.70, the close on 8/15/2007.  A retest of that low on 11/26/2007 produced a close at 1407.22.  The close yesterday (1/4/2008) was 1411.63!

If the S&P 500 has a closing price below 1406.70 in the next several days, we have a bear market signal.  How do we know if a bear market is actually going to occur?  My benchmark to confirm a bear market is a close for the S&P 500 below 1370.60, which was the intraday low reached during trading on 8/16/2007.

If the current situation is simply another (successful) retest of the 8/15 low, the coming week will see a market rally of a few percent.  I do not feel a successful retest can be proclaimed unless the S&P 500 ends the coming week above 1450.  A smaller advance must be viewed with suspicion and judgement reserved.

In August, the recovery from the lows of 8/15 and 8/16 saw the S&P close at 1411.27 on 8/16 and 1445.94 on 8/17.  By Tuesday 8/21 the market closed above 1450.  The high in October (the “Head” of the chart) was a close of 1565.15 on 10/9 and an intraday high during trading on 10/11 of 1576.09.

At the end of November, the S&P 500 reached an intraday low of 1406.10 and closed at 1407.22.  Two days later it closed well above 1450.

The software for this Blog does not allow me to import my Excel chart showing the plot of the “Head and Shoulders” pattern.  If you would like me to e-mail it to you, please contact me at jlounsbury59@hotmail.com .

This discussion has been on purely technical observations, not economic analysis.  What makes me especially watchful at this time is the confluence of a “perfect storm” on the economic side.  We have a credit crisis, world-wide, still of unkown proportions.  The US consumer, responsible for 2/3 of our economy, is extremely over-extended by falling home equity, record mortgage and credit card debt, high fuel prices (which may well rise further in the coming weeks) and rising unemployment.  One important indicator is help-wanted advertising, which has fallen to lows not seen for more than thirty years.  The possiblity of a recession has increased markedly in the past few months.  Stocks generally do poorly going into a recession.  The bright side is that they start doing very well once we actually are in recession.

How to deal with this?  Be careful in making any new investments while this scenario is playing out.  Trim positions that have had large run-ups in 2007.  If you use stop loss orders to limit risk, tighten (raise) the stops.  If you want to try some short term trading, look at ETFs that short various indices or sectors.  Examples are SDS (200% short the S&P 500), QID (200% short the NASDAQ Composite), SRS (200% short the US Housing Index), SKF (200% short financials) and FXP (200% short the Shanghai Index).  Note: Loss control is critical in using these highly leveraged, very volatile ETFs.