Market update 13 May 2011

Stock Market Update as of market close Thursday May 12, 2011

As long term followers of the blog are aware, I follow the markets daily but do not normally put out a blog post unless there is a need to do so. Given we are coming into the summer months (where the market is traditionally weak), and in response to a number of inquires from subscribers to various investment questions; I thought it necessary to put out this update.


Quantitative Easing

I have received a number of questions in regards to the Quantitative Easing programs in the U.S. and their imminent end.

First, here is a nice overview of QE1 vs. QE2 from Chris Martenson:

QE1

QE1 consisted of all sorts of liquidity efforts that went by various acronyms, but the main act was the accumulation of some $1.25 trillion in MBS and agency debt. Some might note that taking MBS paper off the hands of financial institutions, which then bought treasuries with the cash, is little different than the recently announced QE2 program because at the end of the day, money was printed and Treasuries were bought. In this regard, they’re right.

But let’s be clear about something: The first QE effort had the specific aim of repairing damaged bank balance sheets. That is, banks and other financial institutions had made some colossally poor and risky financial moves that didn’t work out for them. They needed some help, and the Fed was more than happy to oblige by handing them free money to patch up their losses.

Of course they didn’t do this outright by saying, “Here take this money”; they did it somewhat sneakily. But when the Fed hands you huge piles of money (for your dodgy debt) and then let’s you park that very same money in an interest-bearing account at the Fed, there’s really no difference between that and just handing banks free money. No difference at all. If the Fed ever offers you free money that you can then park in an interest-bearing account with the Fed, you should take them up on it, and you should do it as much as they will allow. Indeed, that’s exactly what happened. These parked funds are called “excess reserves”.

Now, it’s also true that the Fed doesn’t pay a lot of interest on this money, just 0.25%, but on $1 trillion that pencils out to some $2.5 billion a year, handed straight over to the banks. I call this program “stealth QE” because it’s nothing more than printing money and handing it over to the banks with a slight bit of complexity thrown in just to put the dogs off the scent. A couple of billion may not sound like much these days, but I raise it to illustrate the many and creative ways that QE1 was about getting the banks back to health, and not much else.

So QE1 (and the “stealth QE” program) was directly aimed at banks to help them repair their balance sheets and make them whole on their terrible decisions and losses. It turned out, though, that fixing the banks did absolutely nothing for Main Street. The rest of the economy remained mired in a rut, with banks either unable or unwilling to make additional loans. They kept their QE lotto winnings and parked them with the Fed.

QE2

QE2, then, is about getting thin-air money to the government, which, the Fed rightly assumes, will immediately spend that money and push it out into the economy. Here’s how the head of the Dallas Fed, Richard Fisher, put it in a recent talk he gave:

A Bridge to Fiscal Sanity?

The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt.

This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice.

There it is in black and white. You might want to read it a couple of times to let it sink in. The Fed is directly monetizing the next eight months of excess(ive) spending by the federal government and is doing it despite being perfectly aware of the extent to which history is littered with the economic carcasses of those who have traveled this path before.

Presumably we’re supposed to console ourselves with the idea that the Fed will be successful where others have failed, and sometimes failed miserably. Yes, we’re talking about the same Fed that fueled that last two destructive bubbles by keeping interest rates too low for too long, failed to see the housing bubble as late as 2007 for what it was, and which apparently entirely lacked the capability to foresee any of the current mess. That Fed.

In summary, the difference between QE1 and QE2 is that QE1 went primarily to the banks and QE2 is going directly to the government. While this may be something of a semantic difference, it shows that the Fed is changing its strategy again. We might ask: Why this shift and why now?

QE1 was basically a way of providing “earnings” to the banks to recapitalize their balance sheets. This was done by their holding large amounts of “ring-fenced” US dollars printed by the FED and collecting .25% interest on the proceeds. Those proceeds never went into the economy at large but were used as "earnings" by the banks to recapitalize their balance sheets for all the bad loans they held on their books.

QE2 was a different story as it had a direct effect upon the economy. It was essentially a shell game whereby the US Treasury would issue bonds (government borrowing). Those bonds were bought by the US Federal Reserve (the FED) who literally printed the money out of thin air to purchase those bonds. This increased “demand” for bonds would (in theory) causes their price to rise (and yield to fall) thereby forcing interest rates to move lower with the hope of stimulating the economy. A second goal of the policy was inflate asset prices with the intent of pushing investors out of interest bearing accounts (due to low interest rates) into purchasing “risk assets” such as stocks. This would boost the stock market and create a wealth effect due to personal portfolios increasing in value and would make the consumer more willing to spend.  An additional objective was to put a floor under the tumbling housing market.

It is interesting to note that QE2 has had mixed results. The yield on the 10 year US treasury when QE2 was announced (August 27, 2010) was 2.64%. Today it is 3.23% so on the interest rate side QE2 has been a failure as it has not pushed down interest rates (however, it is worth thinking about where interest rates may have been without QE2?). The increased rates have raised mortgage rates so it has done nothing to boost the housing sector.  On the other side, the S&P 500 Index closed the day before the announcement at 1047. Today it is at 1348; a 300 point gain in the SPX since the announcement. On the “wealth effect” side QE2 could be deemed a success when viewed by way of the stock market advance.

The question remains as to what will happen next. There is little appetite in the U.S. politically for further borrowing. Unless Bernanke/the FED can up with a new shell game that injects liquidity into the markets without increasing borrowing, it appears the money that is currently in the system will be all there is to sustain the current economy.

It is worth noting that QE2 will not disappear in June (contrary to common belief). The bonds the FED bought from the Treasury over the last 8 months ($600 billion) will continue to be repurchased upon maturity by the FED (i.e. a 10 year treasury bond maturing Dec/2011 would have the principle + interest “paid” by the Treasury to the FED but then the FED will turn around and reinvest that same money in a newly issued 10 year treasury bond). As such, an ending of QE2 does not reduce the amount of money in the system as QE2 will be perpetual in its function. It is only that the expansion of the program via continuous additional cash injections will end. As such, any panic associated with the ending of QE2 is unjustified at this stage until its full effects can be monitored upon the economy.

During the period when QE1 was unwound (April 23-Aug 27) the SPX fell from 1217 to 1064. This was associated with a reduction in liquidity in the markets. During that time, the best performing sectors were the defensives: Telecom, Utilities, Consumer Staples, and Health Care. The worst performers were the economically sensitive sectors: Financials, Tech, Energy and Consumer Discretionary. Additionally, commodities dropped, oil plunged, the VIX jumped, gold popped, and Treasuries rallied.

A scan I ran yesterday showed the best performing sectors over the past few weeks as:

1) Health Care, 2) Consumer Staples, 3) Utilities, 4) Long Term Treasuries.

Commodities are plunging and financials are the worst performing sector. The markets are rotating into defensive.

Deva vu? Maybe, but it does bear monitoring as it could be the 1st sign of a turn down in the markets.

Having said the above, overall the markets are still behaving themselves but I am cautious. Since my last update and Provident Fund purchase, the markets have advanced a further 3%. Most charts remain bullish except for the short term charts (see below for further).

For the past 10 days the S&P 500 index has been trading in a tight range between 1330-1370.  During this "churn" period my charts have indicated much more sell pressure than buy pressure.  This is usually a sign of large institutional fund liquidation of equities.

We are now in the “weak period” of the stock investment annual cycle (between May and September). The recent move of the defensive sectors into the lead has me worried we may be on the verge of a market correction. Nothing technical yet to confirm but I am watching closely.



Long Term

SPX Monthly

The long term chart remains bullish. Price continues above the 12 month simple moving average and has done so since the whipsaw action we saw on this chart back in May-Aug 2010.


Intermediate Term



SPX Weekly

The intermediate weekly chart remains bullish. The chart turned bullish the 1st week of September 2010 when price closed the week above the Bollinger Band midpoint (black dotted line) along with my other technical indicators turning positive (as shown on the chart).

Price appears to currently be constricted by the upper trend line (solid black) and the Bollinger Band midpoint. As such, there is considerable resistance to the upside but little support to the downside. Even so, the chart remains bullish as of today.




SPX Point and Figure (Traditional)

 The traditinal Point and Figure chart remains bullish and has a price objective of 1520



Short Term



SPX Daily

The daily chart remains bullish.  Strong support is shown on the daily chart with 2 support lines at 1338 and 1332. In addition, a short term trend line is rising up to the 1332 area.

The market has been stuck in the 1332-1370 trading range for over 2 weeks now. A break of the trend line along with 1332 support (and the 50 day moving average currently @ 1323 and rising) would be bearish. Not there yet but watching close.



SPX 60 Minute

The 60 minute chart shows a rising trend channel meeting current price.  Should this channel hold we should see a push to the upper blue trend line forming a bearish rising wedge.

Also shown is a possible inverted head and shoulder pattern.  This pattern is currently in play and projects a price target of 1420 should it play out "textbook".





SPX Point and Figure (1-Box)

 The short term 1-box PnF chart is bearish with a price projection of 1306.



Provident Fund ($US) Weekly:

The weekly Provident Fund chart (priced in USD) currently favors International Stocks followed by International Bonds followed by USD cash.

The short term daily chart (not shown) favors International Bonds followed by International Stocks followed by USD cash.


Provident Fund (Euro) Weekly:

The weekly Provident Fund chart (priced in Euro) currently favors International Stocks followed by followed by Euro cash followed by International Bonds.

The short term daily chart (not shown) favors International Bonds followed by International Stocks followed by Euro cash.


Provident Fund (Aussie) Weekly:

The weekly Provident Fund chart (priced in Australian Dollars) currently favors International Stocks followed by Australian dollar cash followed by International Bonds.

The short term daily chart (not shown) favors Australian dollar cash followed by International Bonds followed by International Stocks.


Provident Fund (Pound) Weekly:

The weekly Provident Fund chart (priced in British Pounds) currently favors International Stocks followed by International Bonds followed by British Pound cash.

The short term daily chart (not shown) favors International Bonds followed by International Stocks followed by British Pound cash.



Multi-year Monthly Long Term Chart

I try not to speculate on the future direction of markets and let the technical indicators tell me when to be in and when to be out. However, I’ve had several people ask me for my “long term” outlook over the next number of years.

As I posted previous, I believe we are currently in a dangerous SECULAR BEAR MARKET that began in 2000. Typically a secular bear market will last 15-20 years. However, within that secular bear market you will have CYCLICAL BULL MARKET advances. These typically will last 2-3 years (2003-2007 and March, 2009 to current) and go “counter-trend” to the overall trend.

I believe the current counter-trend cyclical bull market we are in may have some ways to go (perhaps another 10-15%). Typically these will unfold in 5 waves (3 up, 2 down). We are currently in wave 3. I expect a “wave 4” down any time now followed by a final “wave 5 up” that could take us as high as 1500-1600’ish on the SPX (though technically it could also go only as high as the top of wave 3 once it has been achieved forming a double top). I expect this final top would be achieved sometime in late 2011 to early 2012 (up to May 2012) associated with the 4th year of the Presidential Cycle.

Following that top, I truly believe we will be in for another down leg as severe (or worse) than the 2008-2009 decline. We could easily retest the bottom trend line on the chart by 2014-2015 before we finally get to a level of valuation in the market where all the “excesses” are purged from the economy and stock price valuations approach historical value levels.  We are a long way from "value" in stocks.

This is primarily the reason why an investor needs to be cautious in this environment. This is NOT a “buy-and-hold” market that your parents enjoyed. It is not a market where you can expect to blindly invest your money in stocks and get 10%+ rate of return. Some investors are fortunate to have a SECULAR BULL MARKET fall in line with their peak earnings and career advancement (as those currently age 70-100 did when they were working) and some are unlucky and have to deal with the secular bear market we are currently within occurring during their peak earnings and career advancement (those currently age 40-60). Those currently age 20-30 will enjoy a bull market once again once we get past this period but for the next few years it is still time to be extremely cautious.

During these times you need to be smart and sharp and not let euphoria get in the way of vigilance. You need to use tools that let you “play the game” in order to capitalize upon short term counter trend bull market advances but be prepared to revert back to cash when the time is right.  You need to understand during this bear market timeframe stock market returns will be below historic norms and scalping small percentage gains while preserving capital is key.

The question is how to play such a game.  I've been very successful over the years by removing as much emotion from my investment decisions as possible.  I use strict discipline according to technical indicators and try to block out any fear, greed, or excitement when conducting my investment decisions.  It is much more difficult to do than it sounds but ulitmately that is the "mindset" you need to make money in the markets.

That is the way I play.



Bottom Line:

-My short term technical indicators are currently bearish with the intermediate and long term indicators bullish.

-We are currently in the annual “weak period” stock market cycle period between May and September but remain within the 4 year bullish Presidential cycle.

Back in March I increased my Provident Fund exposure to 50% equities/50% cash. My intent was to go to a more fully invested equity position but current weakness has me maintaining my current holdings with a cautious stance.


Emirates Provident Fund:

As of Thursday, May 13 I remain in a strategic 50% equities/50% USD cash weighting as follows:**

-BlackRock US Dollar Cash Portfolio Fund: 50%

-Russell Global 90 Fund: 15%

-Fidelity International Fund: 10%

-BlackRock Managed Equity Fund: 25%

**Actual positions will change daily based upon price action and market volatility.


For information, the ECAM Asset Allocation Fund is currently 88% invested with a 12% cash reserve.  I will blog an update on it's current holdings at a later date for those who might be interested.


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