The Fed Still Has Your Back….Just Not Yet

First of all I’d like to say that I’m back and readers should expect some pretty heavy blogging from me in the week ahead as the markets appear to be entering into a tumultuous period. Last week, equities made a nasty head fake on Tuesday by appearing to have snapped the series of lower highs & lower lows by closing above 1345 on the S&P 500. Tuesday also happened to be the last day of May which made the closing prices much more important for fund managers who are measured by monthly performance. Many traders were hurt badly by what I have termed Tuesday’s “fakeout breakout”, while many others have been in cash and have been trading lightly or not at all over the past few weeks.

I was bullish throughout April and in fact called for a rally up to S&P 1370 followed by a pullback to test support at 1338. However, I must admit I didn’t anticipate the full extent of the recent weakness. The market has managed to fool the majority of market participants which is what it does best. The transition from the euphoria of new 3-year highs at S&P 1370 on May 2nd to Friday’s dreary close with the S&P hanging on to 1300 by a thread has been subtle and filled with head fakes; consider that nearly half of the 70 point decline from the May 2nd high occurred in one single trading session last week (Wednesday June 1st). Wednesday’s session began as a garden variety morning gap down which soon turned into an all out grinding sell-off straight through to the close. It is also fairly rare to see a large (2%+) down day without even the slightest attempt by the bulls to rally during the session. Followed by Thursday’s failure to bounce back and Friday’s “confirmation drubbing”, all of a sudden the market appears to have turned bearish.

Undoubtedly, there will be those who profess to have seen this turn coming and will point to the heavy distribution during the week of May 2nd, or the commodity carnage throughout early May. These were absolutely warning signs, however, one must remember that throughout this entire rally from late August 2010 there have been warning signs such as periods of distribution and commodity selling (November 2010, March 2011). Yet, each and every time the market picked itself back up and the dip was bought. Is this time really different?

Let’s consider some things that have changed since May 2nd:

  • Economic data has reversed markedly: the unemployment rate has ticked back above 9% and the trend in jobless claims and consumer confidence is clearly deteriorating.
  • The Eurozone sovereign debt crisis has made its semi-annual return to the headlines as Greece is once again in need of a large amount of financial assistance from the so called ‘troika’ (ECB/EU/IMF).
  • Previously I refused to consider this as a market concern in the slightest, however, it appears that recently the escalation of the debt ceiling debate has begun to weigh on markets. Moody’s issued a warning last week that it would have to downgrade the US sovereign debt rating if there were to be a short term default resulting from the debt ceiling debate currently taking place in Congress.
  • The market seems to have only recently begun coming to terms with Fed Chairman Bernanke’s explicitly stated comment during his recent post-FOMC announcement press conference that the risks of further quantitative easing outweighed the benefits.
  • Fed Vice Chair Yellen gave a speech in Tokyo on Thursday wherein she implied that the high yield bond and small cap equity segments of the market may have become a bit too frothy.

It is easy to see that the storm clouds have been gathering and the market has certainly responded. However, I believe this is likely to be another bump along the bumpy road to economic recovery and global economic rebalancing. The ‘QE3′ debate will likely continue to rage and the Fed is almost sure to address the QE3 question very soon. I expect Bernanke to play his cards close to the vest and not give away too much information, however, if the recent economic soft patch turns into something more serious you can surely expect the Fed to intervene with another round of stimulus. That being said, QE3 does not have to take the same form of the QE2. The Fed can change up their game plan and attempt an unconventional form of stimulus. The dilemma the Fed faced last summer when it chose to embark on QE2 is still present; structural unemployment and an abnormally high gap in levels of employment between skilled and unskilled workers. The so called ‘wealth effect’ that has been brought about by rising asset prices (namely equities) appears to have not been able to pick up the slack brought about by the large cutbacks in public sector spending.

To wit, the Fed is still there to fulfill its dual mandate and you can bet your bottom dollar that if the employment situation continues to deteriorate, the Fed will do what it has done before- stimulate.

Let’s go to the charts:

 

$SPY weekly- Bearish engulfing candle on the weekly (there are a lot of bearish engulfing candles from last week throughout the market)

 

 

$SPY daily- Wednesday’s large red candle cut through three key moving averages in one fell swoop. Friday’s close didn’t inspire much confidence for the week ahead either. Look for support at 1294, then 1274 and 1249. My instincts tell me we will see the 1250′s before we see the 1350′s.

 

 

$IWM- Bearish engulfing candle on the weekly chart, notice the large bearish engulfing candle from the week of May 2nd which was formed after the Russell 2000 made all-time highs at Monday’s open (May 2nd).

 

 

$IWO- The Russell 2000 Growth Index continues to correct lower ( nearly 8% compared to 5.1% for the S&P 500) and has formed a near picture perfect head & shoulders topping formation.

 

 

$IYT- Bearish engulfing candle on the weekly chart for the Dow Transports which had been holding up well before last week. I will be keeping a close eye on the transports in the week ahead as we are nearing a possible Dow theory sell signal.

 

 

$DX_F- The US dollar index continued lower along with equities last week breaking the usual inverse correlation between the two. Pay attention to the dollar in the coming weeks- a weakening dollar and declining equity prices are a particularly bearish combination (the wealth effect in reverse).

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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