Time To Digest

Those who heeded my Thursday last blog posting warning not to take the bait have been rewarded with +167 basis points thus far and are likely to benefit further in the coming days and weeks as the near term indicators tracked – momentum and MACD – are now even more solidly entrenched in pullback mode as the accompanying chart clearly illustrates.

Poised to close below last Tuesday’s closing price of 1175, the S&P 500 would join its major global markets brethren (EAFE (EFA) and emerging markets (EEM)) with downside price confirmation of the negative momentum and MACD trends warned of last Thursday. With the short term indicator (slow stochastics) well above its oversold territory (below 20), a pullback target to the average of 5 to 10% is more than achievable and would drop the S&P 500 to the most interesting price of 1133, or just above its head and shoulders neckline and 200 day simple moving average right around the 1125 price level before then signaling an end to the pullback.

Why Not More (Or Less) Of A Decline?

Since the market action that preceded this pullback lacked any external divergences and considering the fact that 100% of the 30 indices tracked are in bullish Mega Trends, the market only had the less serious internal divergences to work off. Accordingly, the magnitude of the current decline should be muted.

As for the decline stopping right here, that is not likely as the internal divergences are so solidly tilted to the downside plus the fact that the other major indices are also performing in like fashion. Such action rarely stops dead in its tracks and reverses itself without first producing signs of trend change.

Why Do Divergences Work?

It is important to remember that this divergence stuff I keep emphasizing works because of the nature/structure of the market. With so many market players operating in the short term space dominated by the need to match performance and with a philosophy of momentum investing, trends that get established tend to stay that way until they are exhausted thereby producing divergences. It is for we investors and traders who can correctly exploit this momentum lemming-like behavior by either joining or going against (contrarian) the crowd that can reap the absolute and relative performance rewards.

When Will It Stop?

The key bullish signs to watch for are the same ones that warned of the market decline we are now experiencing: divergences both internal and external. Specifically, the point at which momentum and MACD do not confirm lower lows will be time to consider increasing the equity exposure. Whether external divergences develop will factor into the decision process at that time.

Like a Thanksgiving meal, it is always good to digest some of what you ate before gorging yourself again on the simplistic “don’t fight the Fed” tune.

Note: My appearance yesterday on foxbusiness.com with Tracy Byrnes is available on my media blog Beyond The Sound Bite.

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Don't Take The Bait

US Stocks are poised to produce a nice upside opening today. Investors might therefore be tempted to conclude that the staple of this bull rally - buy the dips - is back in action and short term profits are in the offing. However, as the accompanying chart shows, when certain market conditions exist any upside move tends to be little more than a bounce followed by a resumption of the pullback. Here are the facts:

Thus far this year, the chart shows that whenever the two primary near term indicators tracked - momentum and MACD - both turn negative - mid January, mid April, mid August, and now - the stock market experiences a bounce that turns out to be a failing rally with a lower low in stocks shortly thereafter. This is made all the more likely this time as an internal divergence (between price and momentum) has occurred twice this year - mid April and now. It is only when MACD then turns negative that price then declines in a sustained manner.

In the April to early July pullback, US large cap stocks dropped more than 10%. The current pullback, however, is unlikely to repeat that magnitude decline (due to the absence of any external divergences). More likely in the 5 to 10% range, with a mid point of 1133, which interestingly sits right above the reverse head and shoulders neckline and 200 day simple moving average of 1125.

Of course, nothing is flawless and works perfectly all the time. But the odds of a healthy market pullback are highest when the above conditions exist.

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The Fed, Sir Isaac Newton, and QE

In today's FT, Mohammed El-Erian discusses the PIGS’ (Portugal, Ireland, Greece, and Spain) resurgent credit spread problems*. Toward the end of his commentary, he references a phrase that all non economists should know as it helps in understanding the mind of the dismal scientists and the comments posted the other day re the US Fed’s thinking on the risks of a Japan style deflation taking hold in the US**. The phrase is "path dependency".

"The history of emerging economy crises also tells us that these worrisome dynamics are self-reinforcing, resulting in what economists call “path dependency”. Rather than snapping back to a better outcome, bad developments increase the probability that the next set will be even worse."

Newton To The Rescue

A path dependency that leads to a steady state equilibrium for inflation and interest rates (which is the central point of the chart posted on Wednesday**) is the great fear of the Fed. And in the mind of the Fed the only way out of that condition is to exert an external force on it, with that external force being QE. Or as Sir Isaac Newton advised: "Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it."

Push, Ben, push.

*"Irish crisis demands new EU response"
**scroll down to Wednesday's posting, "Why The Fed Believes QE2 Is Necessary"

QE2 Sets Sail

Here is the calendar for the first round of the Fed's $600B in purchases as QE2 sets sail. Anchors aweigh!

Here’s Why The Fed Believes QE2 Is Necessary

Monday’s NYSSA luncheon with St. Louis Fed President (and voting member of the FOMC) James Bullard was most illuminating (wish you were there). In addition to the somewhat heated give and take with attendees, Mr. Bullard provided a chart that captures the principal fear the Fed has re deflation. It is what is known as the steady state (equilibrium) of inflation and interest rates.

The accompanying chart is the one he presented (which was also provided in his recent commentary and presentation “Seven Faces of “The Peril’”). In it I have pointed (larger arrows) to the steady state for the US (boxes to the right), steady state for Japan (circles to the left), and in the middle the May 2010 current level for the US. You will note that the May 2010 point is the closest to the Japan outcomes.

The concern at the Fed is that the slide toward the steady state for inflation and interest rates (in a zero bound interest rate environment) renders interest rate driven monetary policy impotent (as it has in the case of Japan). Moreover, a steady state tends to become entrenched (that’s why it’s called a steady state). And economists will tell you that when it comes to deflation/inflation it is the entrenched, longer term levels (and not the shorter term, more volatile factors such as commodities) that matter most.

As the May 2010 point illustrates quite clearly, the US trend is not where the Fed wants it to be.

Here’s Why The Fed Believes QE2 Will Work

In a nutshell – because it worked the first time.

Time and again in the aforementioned heated discussions, Mr. Bullard consistently pointed to the financial markets rebound during QE1 and in anticipation of QE2 as evidence of the positive effects of QE. Moreover, since the economy has recovered and avoided further economic deterioration (Great Recession not Great Depression 2), QE was and will be (in his opinion) effective.

Conclusion

No doubt the debate over the Fed's QE policy will continue. But at least now you know some of thinking behind the actions.

Caveat: Mr. Bullard was speaking for himself and his opinions do not necessarily reflect those of the Fed.
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The Gambler

Who knew Ben Bernanke was actually Bret Maverick?

Using its dual mandate – price stability and full employment – as a rationale (excuse!?) for unilateral action, the Bernanke Fed has embarked on a grand experiment hoping that the wealth effect on financial assets will somehow stimulate the deleveraging US consumer to suddenly reverse course, revert to form, and shop ‘til he/she drops. The Bernanke Fed also hopes that the US consumers’ primary asset –his/her home – will somehow overcome the foreclosure fiasco and miraculously increase in value thereby adding spending fuel to the wealth effect fire.

Finally, the Fed is hoping that its actions will encourage the banks and corporations to disgorge themselves from the mountain of cash they have been hording and start lending and hiring again.

The cumulative effect of this grand adventure is to hopefully enable the US economy to reach an economic escape velocity and enter into the self-reinforcing, sustainable virtuous circle thereby enabling the Fed to enter into its exit strategy.

In today’s Washington Post, Mr. Bernanke provided his audacity of hope with arguments that had so many holes in them as to resemble Swiss cheese. Here’s a few morsels with his comments in italics and mine beneath:

Easier financial conditions will promote economic growth.
By how much? And when?

For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance.
What about the large supply of unsold homes? What about the impact of the foreclosure fiasco?

Lower corporate bond rates will encourage investment.
Possibly, but where will that investment occur – in high cost/low growth markets like the US or in low cost/high growth markets like emerging markets?

And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.
Unlikely without the support of the US consumers’ most important asset – the home. (see above noted point) Moreover, deleveraging to save for an uncertain future is a strong force for soon-to-retire baby boomers, who know that entitlement reform is in the offing.

Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Not if companies decide to invest elsewhere, as noted above. Also, small businesses, the driver of jobs growth, will wait to see demand before committing to new hires and higher wages.

The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector.
Correct, but unlikely given the looming political gridlock environment ahead.

But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability.
And this provides the justification to act unilaterally – without the aforementioned other parties involved as well as the cooperation and coordination of other central banks and countries around the world?

Steps taken this week should help us fulfill that obligation.
How's that hopey, changey stuff goin' for ya?

Investment Strategy Implications

The music is playing and the actors are dancing, driven in large part by the underperforming and desperate momentum lemmings from hedge fund land. Valuation levels are now moving well above average (>15 times) anchored in solid corporate profits, low interest rates, very ample liquidity, and belief that the cyclical forces at work will overwhelm the unresolved secular structural issues.

It is imperative that investors remember this one point – just because a company was founded in the US, is domiciled in the US, and derives some of its profits and growth from the US doesn’t mean it has to rely on the US for its future growth and profitability. And therein lies the rub with Bernanke’s argument: will QE2 (then QE3, then QE4) provide strong economic growth and prosperity for the US? Or will it produce yet another bubble in assets and other markets (notably emerging economies) leaving the US economy in worse shape than when it started?

Ultimately, the all important asset allocation question is: To what extent should an investor participate in this monetary Mephisto Waltz? The answer I've come to is listed to your left.

Bloomberg radio appearance

In case you missed the Tuesday, October 19 appearance on "Taking Stock with Pimm Fox", click here

Seeing Is Not Believing

Confused over this morning’s initial US stock market reaction to the poor employment data? Don’t be. Here’s why:

In the eyes of the cyclical bulls (who currently rule today’s market thinking, with the underperforming momentum lemming hedge funds in tow), the poor employment numbers are a twin win for the following two reasons:

1 – The Fed’s dual mandate includes the goal of full employment. Accordingly, QE2 is headed the economy’s way. This ensures another flood of money thrown at the problem, much (most?) of which will bleed its way into the financial assets.

2 – Today's employment data is the last report before next month's mid term election. Anything that damages the reviled party in power, the Democrats, enhances the chances of a Republican win next month. Gridlock will ensue, something the cyclical bulls believe is good for the economy and markets.

From a corporate profits perspective, third quarter results will be just fine – at to slightly above consensus expectations. This will provide the expectational foundation for future earnings results at consensus expectations at a minimum, which puts the 12 month forward operating earnings outlook for the S&P 500 at or above $84.

With an above average P/E of 17, the future fair value of the S&P 500 is 1428, or 1286 in today’s market.

Seeing Is Not Believing

Other than 3Q10 earnings results, I do not subscribe to any of the above views as presented but offer them as the rationale for this morning’s initial stock market action. That said, the technical analysis deterioration noted over the past weeks (see blog postings below) is unchanged. Unless reversed, a 3 to 5% stock market pullback is likely.

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Dreams of a Cyclical White Knight

And now for some more first order thinking.

At the heart of yesterday’s commentary is the issue of cyclical recoveries morphing into sustainable economic expansions. The argument by the bulls subscribing to this view is that this is precisely what will occur this time as it has every other time before. The virtuous cycle saves the day. This is about as straightforward as it gets. The argument against this thinking is equally straightforward.

When the global macro economic system is hit by an extraordinary event, the post crisis environment is anything but normal and the odds of a cyclical recovery resolving a structural crisis are very long. What is then needed is a structural solution to a structural problem. Examples of this thinking abound (not that the cyclical bulls are listening), with today’s commentary in the FT by Martin Wolf among the most cogent.

The topic of Martin’s commentary may be the emerging currency war with a particular focus on China. The essence of Martin’s commentary is, however, the more important point – structural problems require structural solutions, which in a global economy can only be solved via cooperation between the major global players. Yet, cooperation between the major global players requires leadership. Since the logical country in a position to exhibit that leadership, the US, has as its head a political manager and not a leader, the odds of someone taking the lead toward the necessary cooperative environment for structural change are very long indeed.

The Post Crisis Environment

Crises occur mainly due to structural (systemic) problems. The post crisis environment that ensues is one that rarely resolves itself via the cyclical solution. Yes, cyclical rebounds do improve things for a while but they do not get to the heart of the matter. The structural problems remain and will overwhelm the relatively meager energy of a cyclical bounce. It’s like trying to treat a patient with a life threatening disease with antibiotics. It just doesn’t work.

To use the stock market analogy in the current environment: cyclical bull markets within secular bear markets do not change the reality that the equities are in a secular bear market. Accordingly, cyclical recoveries within a structural (secular) change environment will not resolve the systemic issues at hand.

The bullish rejoinder to this is the muddle-through solution: Things are never so neat and tidy. Stuff happens, things are messy. But, fear not, we will find a way out of this mess. We always have and will do so again. This time is not different.

However, as I argued yesterday, such thinking concludes that this time IS different, for the norm in a post crisis environment is for extraordinary measures to be exerted, which includes fundamental changes in the rules of the game. Therefore, this time is not different as crises do occur and the subsequent environment requiring fundamental change is the norm.

Who will be right? The cyclical-recovery-saves-the-day crowd or the we-need-to-address-the-structural-problems club? Time will tell, which I suspect will be sooner than most think. One thing is for sure, however, someone is going to be real right and the other will be real wrong.

Investment Strategy Implications

My money is with the structural problem club. However, the cyclical dreamers are in control right now. Therefore, as an investor and investment strategist, I cannot act aggressively until the technical analysis signs that the market is ready to embrace the more worrisome view of my club. (Think, the recent vintage tech and real estate bubbles.)

Accordingly, before shifting from the currently cautiously bullish (60 to 90% in equities) posture to neutral (40 to 60% in equities) to outright bearish (<40%) clear technical analysis signs, most notably external and internal divergences, must be evident. At present, as noted last week only the internal divergences are. Therefore, cautiously bullish (the equivalent of driving with one foot on the brake) remains the advisable strategy.

As history teaches us all too well: delusional thinking rooted in old school dogmas can maintain its grip for a very long time.

This Time IS Different

The bulls (not the bears) would have you believe that this time is different.

The root of this view in anchored in the dogma that the cyclical recovery cures all ills as follows:

The cyclical recovery evolves as increased corporate spending on wages and new hires which, along with an increase in emerging economies’ consumer spending, result in a consumer led demand driven sustainable cyclical expansion. Corporate profits rise further enabling the virtuous circle to become engaged.

The sustainable cyclical expansion then helps to alleviate the structural risks to the global economy – e.g. current account imbalances – thereby enabling the financial sector to recover further and move the global economy off government life support.

The financial markets respond with a move more toward normality as rates rise, the dollar stabilizes, gold loses its luster, and equity valuation levels return to above average (>15 times). The combination of higher corporate profits and above average P/E levels drives stock prices back to record highs, which for the S&P 500 means 1548 (18 x $86).

An era of growth and prosperity returns thereby proving that this time is not different; that there will be no new normal (i.e. below average growth and profitability).

Sounds good, doesn’t it? Even plausible, provided one thing – conventional thinking in unconventional times requires a belief that this time IS different.

The Burden of Proof

The bulls would have everyone believe that the burden of proof that this time is different falls on those who say what was no longer works (the old normal) and that the future is a place of great uncertainty (the new normal) with the road ahead a most bumpy one. There’s one problem with this thinking – evolutionary processes to new normals are normal. A purging of the old always occurs and it always leads to a new normal, whatever that new normal may be.

Extrapolating the recent past into the future often becomes a substitute for first order thinking. Be it fighting the last war or blindly accepting corporate earnings guidance, embedded interests conspire to preserve the status quo, which facilitates a blindness to change. And it is change that is normal, not what-worked-before-will-work-again-indefinitely thinking, made all the more illogical given the highly dynamic complex global macro environment the world finds itself in.

In evolution, those that are about to become extinct are the last to notice. The same is true in the social sciences of economics and the markets, where old rules in changed times demand the view that this time is different.