The Market Direction: Fed Late to Party

Gil Morales and Chris Kacher
Posted: Jun 15, 2011 12:01 AM

Since the market low on March 9, 2009, which also roughly coincided with the start of quantitative easing (QE), the NASDAQ Composite has had four corrections that exceed -8% (dates shown are the NASDAQ low for that correction):

February 5, 2010 -9.7%

July 1, 2010 -18.6%

March 16, 2011 -8.3%

June 10, 2011 -8.4%

The July 2, 2010 correction was due to the end of QE1, thus exceeded -10%. The corrections of February 5, 2010 and March 16, 2011 ended before the market had a chance to pierce -10% correction levels.

Instead, the market found its footing when all looked ugly, and the QE-motivated bull market resumed.

Based on the recent price/volume action of the major indices and leading stocks, it could be argued that a bounce that occurs at these oversold levels could be met with more selling.

The market is forward looking and is currently casting ia negative vote that the mutant version of QE2 after June 30, 2011 will be much less effective at propping up the market.

The mutant version of QE2 will take the form of reinvested proceeds and capital gains from maturing securities over a period of perhaps 3 to 6 months. Then after this period has ended, there will then be an "organic" shrinkage of the Fed's balance sheet.

The Fed would ideally like to see the market find its footing during this 3 to 6 month phase of mutant QE2. It seems though as if the market is already losing its footing before this mutant form has a chance to start because the markets are typically looking ahead by 6 to 9 months.

This does not bode well for the Fed.

The Fed naturally does not want to see all of its "hard work" undone by a deep correction in the stock market, so it could try to step in with a full measure of quantitative easing (QE3) should market conditions warrant.

In the meantime, the market could correct at least as much as it did (-18.6%) from April 26-July 1, 2010 around the time QE1 ended.

The Market Direction Model at is calculating all of this as it adjusts its rules to account for the material change in quantitative easing.

Since the stock market tends to lead the economy, not the other way around, the Fed is hoping the economy will gain traction from the bull market that began March 2009.

However, pertinent economic figures including the latest figures on unemployment shows the Fed's attempt to jump start the economy has yet to produce a spark.

This begs the question as to whether QE3 would harm the economy more than help. So far QEs have not had the positive impact they should, and they also carry the long term negative impact of devaluation of the dollar, with the longer term potential of unmooring the dollar's status as the world's reserve currency.

Should this unmooring occur in the years ahead, this would come as no surprise as all reserve currencies eventually meet with a tragic end.

The Fed's IDEAL scenario: The stock market maintains traction after QE2 ends, the economy gains traction, inflation rises, and the Fed starts its rate hike cycle (Fed fund futures are pricing in a probably rate hike in early 2012).

The early part of rate hike cycles tend to be bullish as they are a sign the economy is doing better. Since rates have been kept artificially low for a prolonged period, the Fed would have large headroom to hike rates while the economy soft lands, gains traction, and moves forward well into 2012-2013.

The Fed's potential REALITY: The stock market continues to falter even before QE2 ends, the economy continues to show little sign of life, the dollar continues to devalue as inflation continues to rise, forcing the US into a stagflationary or hyperinflationary environment.

The Fed tends to be late to the game as it was late to lower rates in 2001, late to lower rates in 2007, and will probably be late to hike rates to contain inflation in 2012. Once unleashed, inflation tends to be hard to contain.

In the long run, continued global monetization of debt by the debtor nations should keep precious metals a sound long term investment.

In the short run, a possible slowdown in China and continued troubles in Europe may help prop the dollar as it is still the world's reserve currency and thus still represents a flight to safety. This could put pressure on precious metals in the short-term.

Currently, the the Market Direction model maintains its cash signal. The model will switch to a sell signal if it detects enough selling pressure weighed against the possibility of a sharp bounce due to oversold conditions.

Likewise, the model will switch to a buy signal if it detects enough legitimate buying pressure (as opposed to a technical short-lived bounce) that is indicative of a sustained rally.

Note, the model on rare occasions will delay the issuing of buy and sell signals such as it did after its highly profitable sell signal on April 28, 2010. This was a period after the flash crash, motivated by the end of QE1, when volatility levels spiked.

Indeed, the safety of the sidelines can, in volatile, trendless periods of uncertainty, be the best course of action.

This was last shown by the model's ability to stay out of the market for the most part from May to July 2010, then resume with a profitable sell signal on August 11, 2010 and a profitable buy signal on September 1, 2010.

And it is good to know that even if the model is in cash while the market moves lower, the model outperforms the general averages on a relative basis. Being in cash during the sharp corrections that took place in the 1990s and 2000s brought much peace of mind.

One does not need to be in the action of the market all the time.

Brief discussion of prior signals issued by the Market Direction Model (MDM):

The quantitative easing fakeout on May 31 pushed the model into a cash signal while we noticed other models went to a buy signal. MDM went to cash due to quantitative easing which has been prevalent. The market then promptly sold off the next day. The model stayed in cash instead of moving to a buy signal on May 31 because:

1) The market has been choppy and trendless for the most part of 2011 while QE remains in effect, thus sell signals have not resulted in big profits with May 2010 being the exception when QE1 ended. Indeed, major averages such as the NASDAQ Composite have not even corrected -10% (outside of May 2010) since QE began in March 2009.

2) The model went to a sell signal on May 5, which would have remained a sell without the QE fake-out on May 31. The market then immediately had a big down day on June 1. The model has a rule where it would switch to sell signal once the low of June 1 is broken which occurred on June 2. However, in this QE environment, there is an overriding rule which says if the market is down further than it's original sell signal on May 5, a new sell signal here carries that much more QE risk, thus it is best to remain in cash. That said, given the recent new data, the model's QE-based rules will account for a diminished capacity for QE to prop the market.

As you can see, there are subtleties to the rules which enable the model to navigate through a trendless QE-motivated environment which has created a most challenging environment for timing models this year. What is also nice is that the rules have kept the model in longer on buy and cash signals, and quicker to exit sell signals.

Patience is the hardest discipline to practice as even the most seasoned traders often want to be in the action. In baseball, wait for the right pitch. In poker, wait for the right hand. 

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