The Rally Is at a Crossroads

Even after the current "powerful rally", the S&P 500 is still down over 12% YTD, something to keep in mind if you feel we are missing something. All we have missed year-to-date is a 12% loss. Bear markets always give people a reason to stick around. Wednesday, we commented "...rather than signaling the end of the bear market, the more probable outcome for the current rally in the S&P 500 is for it to fail somewhere between current levels and 806." This rally may have further to run, but Wednesday's high on the S&P 500 was 803.

Fed Throws Gasoline on the Inflation/Deflation Fire: In our view, the most important fundamental factor in investing today is managing the shift from principal protection (as asset prices fall) to purchasing power protection (as the Fed eventually will produce positive inflation). As the average American’s 401(k) statement has shown in recent months, a principal protection strategy is more important than a purchasing power protection strategy. As cited by Wednesday's WSJ article below, The Fed threw gasoline on the inflation/deflation debate with Wednesday’s announcement. At some point in the future, purchasing power protection will be more important than principal protection – we are not there yet, but we have to pay close attention.

From the Wall Street Journal (03/18/09) - notice the choice of words:

WASHINGTON -- The Federal Reserve ramped up its effort to revive the economy, declaring it would buy as much as $300 billion of long-term U.S. Treasury securities in the next few months and hundreds of billions of dollars more in mortgage-backed securities. The Fed had already cut its benchmark interest-rate target to near zero. Unable to go lower, the central bank now is essentially printing money to raise the supply of credit and thus push down the longer-term rates paid by families and companies on mortgages and other key loans.

Hyper-Money–Printing Mode: What Now? Americans should be concerned that we are now openly talking about our government printing money. When the Fed prints money and increases the number dollars in circulation, they are setting the table for an inflationary dinner, which will make every dollar in our pockets worth less. In the final analysis, the government is indirectly taxing all of us by eroding the purchasing power of the dollars we hold. We may not be hurt by the money printing right now, but it will be virtually impossible for the Fed to withdraw the liquidity from the system in a way to avoid inflation. Eventually investors are going to have to trade mattresses and coffee cans for gold, oil, and stocks.

The chart below is as of Wednesday's close ["today" refers to Wednesday].

Timing A Surprise: Months ago the Fed signaled they were considering the option of buying Treasuries. The market believed such a radical policy shift would only be used "if things get really, really bad.” Apparently, from the Fed’s perspective, things must already be “really, really bad”. If the Fed felt the economy was in the process of bottoming, they would not be taking this radical step now.

College Days: Like in calculus, where tending to infinity is a common term, we can learn about the Fed’s desired policy effects with an extreme example. If Chairman Bernanke and Secretary Geithner dropped $100 bills from helicopters for a few weeks, all Americans would have more money to spend. In this example, it is easy to see how a rapid increase in the money supply can drive up the prices of everything from milk to mortgage-backed securities. Despite the economic problems of the day, we have to be open to the possible "reflation" effect of a virtual helicopter drop. If the Fed’s policies are effective, they may be able to reflate the value of stocks, homes, oil, etc. Especially after Wednesday’s "crank up the printing presses" announcement, we have to be open to a surprising rise in assets prices. It may be starting now, or it may come much, much later.

The helicopter story (i.e. the infusion of printed money) is a real fundamental factor which cannot be ignored. However, the charts (or technicals) need to confirm or align with the helicopter story before it is prudent to jump back with both feet into risk assets. The following ETFs can be used as a reflation gauge – we can expect to see them begin to make meaningful new highs (not bear market rallies) when the Fed’s helicopters begin to have their desired effect:

• Gold (GLD)
• Gold Stocks (GDX)
• Treasury Inflation Protected Securities (an oxymoron? – TIP)
• Crude Oil (USO, USL)
• Physical Commodities (DBC)
• Emerging Market Stocks (EEM)

Pay Attention: Concerning the ETFs above, the markets will give us numerous clues when the real shift starts to take place from falling asset prices to rising asset prices. There is no need to guess, forecast, or predict.

Short covering big part of stock rally: When you sell short you must buy shares to cover or close out your short position. As the market rose off the recent November low, many shorts were covered, which increased buying demand for stocks. The vast majority of shorts have now been covered. Therefore, the stock market has lost some buying power.

Range traders – buy low – sell high: Range traders trade between market extremes of oversold and overbought. Range traders are not long-term investors. Range traders will be quick to take profits if the S&P 500 fails to clear 806. They will also be quick to sell if we reverse from current levels (locking gains from the "trade").

New shorts: Range-traders are happy to go short too. They sell high and buy back low. We are “high” now. New shorts are licking their chops looking for a sign of a reversal. New shorts will add to any selling pressure. The new shorts are waiting to see what happens below 806 on the S&P 500 before pulling the trigger. If we break 806 for a time, the new shorts will gladly go long instead.

Remaining shorts: There is a group of "long-term" shorts who have not covered yet because stocks clearly remain in a primary downtrend. If stocks can break 806, we may see one more round of short covering, which means it pays to be patient even if we trade above 806 for a few hours or few days.

Break of support says new lows still probable: It is dangerous to push aside the recent break of long-term support above 741 on the S&P 500. After a break of support, it is not unusual to move back above the lower end of support before reversing to make a new low. If the S&P 500 cannot hold above 806 for a few days, the odds continue to favor new lows for the stock market. Buyers of this rally should be very careful - some patience is prudent.

Markets tend to retest lows: Even if we have started a new bull market (not probable, but possible), we will not go up in a straight line (just as we have not gone down in a straight line). As we covered in a previous article, bear market bottoms tend to be retested, which means, at a minimum, a retest of the 667-741 range on the S&P 500 is likely. A retest may not come for weeks or even months, but we need to be aware the possibility exists. We failed on the retest of the November 2008 lows. It is doubtful this market will bottom before a successful retest.

Human beings can do anything: There are people behind all these charts. People are capable of doing anything at anytime, which means there is nothing sacred about a trendline or technical indicator. Technical analysis can help us with probable outcomes and trends. Trends can, do, and will change. Probable outcomes are not certain outcomes. We have numerous moving parts in the current market, many of them extremely rare (Fed printing massive amounts of money). The ongoing battle between economic weakness and the printing press is very difficult to wrap our arms around. Keeping an open mind and paying attention will serve us well. If a new bull market has started, countless signals will appear over the coming days and weeks.

About making money: There are ways to make money in bear markets and ways to make money in bull markets. Our objective is not to be right or to prove we are smarter than the market. Our purpose is to make a profit while at the same time protecting hard-earned principal. Ego, pride, and emotion rarely, if ever, play a role in making prudent investment decisions. The charts help us with probabilities in a manner similar to a good blackjack player. A good blackjack player plays and bets according to the odds. A good blackjack player does not expect to win every hand even when the odds are in their favor, nor should we expect the higher probability outcome to always occur in the financial markets. If we did, there would be no need for a stop-loss and money management discipline.

In our estimation, cutting losses is the single biggest difference between consistent pros and the typical investor. As money managers, we respect that investing is not a form of gambling, but the analogies related to probabilities and protecting capital are sound. Probabilities are probabilities – nothing more nothing less. However, over the long haul, if we play the probabilities, cut losses when we are wrong, and let winners ride when we are right, we will find it difficult to go too far off the path to desirable long-term outcomes.

Using Our Hands: In closing, it may be best to sit on our hands in the morning during the next few days. How the market finishes is much more important than how we start each day. Many will be making what could be short-lived, kneejerk reactions to the Fed. We prefer to see what the market tells us late in the day and over the next few days. Buying or selling in a fast market can backfire. The economy remains weak, which can get lost with all the external noise.

The charts and commentary above are for illustrative purposes only and are not recommendations to buy or sell any security. Inverse ETFs or short positions are not suitable for many investors.

Disclosure: Author and CCM clients have positions in SH, GLD, and GDX.

Comments

[Conan the B...:]

It doesn't really matter what the Fed does.

What matters is that the Present Leadership doesn't have a Leader.

Whatever Promises are made, Contracts signed, or Laws enacted...whatever...are all subject to irrational Change at a moments notice.

" whatever the President does isn't illegal" is a line from a movie about Pres. Nixon. (paraphrased)

This Congress seeks to enact Laws regardless of their Legality...whats the difference..

"We Won".

Mar 21 09:11 AM

[prudentinve...:]

Chris, thanks for an informative and logical discussion. Yes, I fully agree that inflation cannot be reined in once it starts, because we don't have another Volcker doing what's necessary, instead we have pop star central bankers doing what's popular, i.e. doling out candy.

The pundits who are saying we won't have inflation because what the fed is now printing merely replaces "lost wealth" are oblivious of the fact that we had an inflationalry asset bubble that naturally burst, not earned accumulated wealth that was accidentally "lost". My guess is that the fed will eventually succeed in creating inflation, but the current manipulative and interventionary policies will not lead to any real, sustainable growth, so the result will be stagflation.

Mar 21 09:20 AM

[Soham Das:]

Absolute gem of an analysis!
Technical Analysis works and when coupled with understanding of the macroeconomics can prove to be a force to reckon with.
Naturally, Chris has everything on his side.

Mar 21 09:50 AM

[Yossel:]

I knew you could do it; I just didn't know you could do it so well !

Mar 21 11:35 AM

[ain't no fo...:]

I'm struck by the first chart that so graphically demonstrates the destruction of the dollar from 2001 thru 2008... it just jumps off the page.

I believe this created real inflation that was covered up, as always, by government "management" of inflation reports such as the CPI during that time frame... specifically by the use of substitution, shrinkage and hedonics.

If that is so, and I believe it is, perhaps there is much "hidden" or "quiet" inflation getting wiped out of this economy that has not been previously recognized much less quantified. I'm not necessarily implying that this creates a silent buffer between where we are today and deflation, because we sure aren't trending UP the inflation scale.

But has this fact been lost on the Fed? I don't think so.

Mar 21 11:38 AM

[samwise:]

Gasoline on the fire. It has been impossible to value most if not all securities in the downdraft--and now the Fed has just told us all to buy dollar stocks and everything will be fine. In other words the policy response seems literally as the Swamp-Fox states one of "chaos" as it relates to trying to calm down the day to day movements in the market itself. It really is just amazing to see literally the visceral need for hopefullness on the financial "news" shows. The bias toward Pollyana is really at near ludicrous proportions. Hope is the enemy and our leaders are pumping it up as though the inevtible let down simply has no consequence either. I say gold is a fools trade in here--the pig getting slaughtered. Land strikes me as the place to begin any "investment" strategy just as Jim Rogers has done in Canada and Brazil. Make food and make a fortune. If the social unrest ("burn baby burn") really starts to get underway buy the railroad stocks.

Mar 21 12:22 PM

[User 357469:]

Beware of J. D. Swampfox. He is using multiple accounts to positively rate his own posts and downgrade posts from others. Note that he usually remains in the top 20 but as soon as someone gets a little ahead of him he will knock them back down or even out of the top 20. Note also that he has only roughly half the comments that others in the top 20 have yet has the same number of thumbs-up or more and that he will get at least 2 or 3 thumbs up within a minute or so of posting any comment which is rare especially when the comment is the only reply to an article.

Mar 21 12:26 PM

[Sober Realist:]

User 357469,
hmm. with a name like Swampfox, you could be right.

Mar 21 07:57 PM

[coldcut:]

You made sense.


On Mar 21 08:17 AM Truefire wrote:

> The Fed's actions (in my humble, uninformed view) of monetizing debt
> was to complete the boxing in of the Chinese. China has been on a
> worldwide asset buying binge trading off their Treasury holdings
> for assets at the top of this dollar rally.
>
> The Fed just diluted their buying power by causing a dollar selloff.
>
>
> So the Chinese buying has been stunted, for now.

Mar 21 11:39 PM

[Old Trader:]

An informative piece. Being primarily a fundamentalist, I've started "going to school" on TA. I'm not convinced that its "better", but the fact that so many use it tends to make it a self-fullfilling prophecy, and am using it to better time my entries and exits on positions I feel have value from a fundamental perspective.

Mar 22 01:49 AM

[Old Trader:]

Do you think the PTB are that clever? My take is that the administration is moving around like a one-armed paperhanger with the itch, trying to "contain" what's going on here, in the States.


On Mar 21 11:39 PM coldcut wrote:

> You made sense.

Mar 22 01:52 AM

[holmesnmanny:]

Who's worse, the guy that caused it, or the guy who's trying to fix it, but is running into problems because of how bad it got?


On Mar 21 09:11 AM paultaut wrote:

> It doesn't really matter what the Fed does.
>
> What matters is that the Present Leadership doesn't have a Leader.
>
>
> Whatever Promises are made, Contracts signed, or Laws enacted...whatever...are
> all subject to irrational Change at a moments notice.
>
> " whatever the President does isn't illegal" is a line from a movie
> about Pres. Nixon. (paraphrased)
>
> This Congress seeks to enact Laws regardless of their Legality...whats
> the difference..
>
> "We Won".
>

Mar 22 09:54 AM

[holmesnmanny:]

It's really all very simple what has gone on the last few years. Mortgage rules were relaxed to allow every Tom, Dick, and Harry to get a loan. As a result, the demand of houses went up, and supply went down, causing housing prices to artificially skyrocket. After most of the teaser rates adjusted starting in 2007 and foreclosures started up as a result, housing prices started adjusting to where they belong. Securities that were sold as a result started losing value as defaults continued, as did hedge funds of course.

Everything else is a result of all of that mess, combined with Bush wasting trillions on the illegal and completely unjustified Iraq war that was created to finance defense companied that went in to Iraq to clean up the oilfields and such that were destroyed for no reason, as well as to help raise oil prices around the world.

Mar 22 10:08 AM

[holmesnmanny:]

I think most high level finance companies and securities companies knew that everything was gonna adjust, but because of the amount of money being made, they just pretended it would never happen.

You can think of the loan and finance industry as for being like the Bernie Madoff scandal. People kept pouring money in, thinking they were making money, but in the end it was all artificial, however those that got out before the adjusting made out like bandits.

Mar 22 10:11 AM

[holmesnmanny:]

The only sound plan would be to tax the rich(who in reality are the only people that made out, or which you can essentially assume have made money off of these artificial years), and created a system that directs money to foreclosure people. Giving money to banks is essentially creating an unnecessary middle man. If you help the people themselves, even though they are indeed most to blame for taking loans they knew they couldn't afford in the long run, you help stabilize the bottom, which in turn will help out the banks since the money would be flowing back up to the banks.

Also, you would be helping to slow foreclosures which would slow down the housing price reductions(not stop it altogether unfortunately). Yes, there is a lot of others questions, such as just exactly who gets helped out, but you have to help some people out and figure out a way to do that.

But giving money to banks directly who benefitted the most is really just gonna put money in greedy hands.

Mar 22 10:21 AM

[Mad Hedge F...:]

Up or Down? I only get two choices. There have been 14 bear markets in the postwar period with an average 25% decline. This bear market is down 58%, and it still may have farther to go. No wonder everyone’s risk models are blowing up. This time it really is different. Over the last 100 years the average return on stocks has been 10% a year, with 40% of that coming from dividends. Today there are dozens of prime industrial companies offering dividends rates in the mid teens. Why investors are not loading the boat with General Electric (GE) stock yielding 12% at $9/share is beyond me. Take systemic risk out of the equation, and investors will leap at these.

Mar 22 03:17 PM

[Conan the B...:]

User 357 and Sober: Another incidence of gaming the SA system, JD likes to make comments on "breaking News" items which have only one comment...JD's.

Multiple thumbs up follow without a single other comment. However, I notice that these now have more Thumbs Down than Up. Could be that others have come to the same conclusion...

Mar 22 03:35 PM

[oroloco:]

Okay Jolly Rancher,

For those less astute or alert, like myself, just how did they get rid of mark-to-market so covertly? And who is "they?"

Mar 22 03:58 PM

[Conan the B...:]

Holmesnmanny: you are as right as rain, Companies knew what they were getting themselves into but they did it anyway.

A case in Point, Sirius and the Signing BONUS plus for Howard Sterns, $500 million. The Media jumped all over this act of idiocy. But SIRI did it anyway. One person, $500 million.

And what is SIRI worth in actuality, they are a work in progress like the Banking system. But in this particular piece of work, Insiders do not like it at $0.12 where around 400,000 shares were sold in the past month.

Lets tax the Rich, the Great Society Mantra of the spreading the wealth.

America, "Land of Opportunity"... come to America, get a job, an education. Opportunities abound But do not even consider becoming Wealthy.

The wealthy have no place in the New America.

Mar 22 04:08 PM

[squark62:]

old trader:

i picked up TA for that reason you, for better timing of trades on good stock pick. as time has past since then, the market has just pummeled the good stocks into the ground. so i've taken a little more conservative approach: broad based ETFs. and in the process i've learned that market does follow patterns that easily recognizable and so i'm better able to hedge. whether it's self fulfilling or not i don't know. but TA works more time than not. -cheers!


On Mar 22 01:49 AM old trader wrote:

> An informative piece. Being primarily a fundamentalist, I've started
> "going to school" on TA. I'm not convinced that its "better", but
> the fact that so many use it tends to make it a self-fullfilling
> prophecy, and am using it to better time my entries and exits on
> positions I feel have value from a fundamental perspective.

Mar 22 08:25 PM