Bear Sighting: Will The Fed Rescue The Markets?

by: Emmet Kodesh

Deteriorating economic fundamentals and inflated, disordered markets led on August 5 to the beginning of a significant market decline. Absent massive increases in QE or expectations of same we have begun the 3Q correction many analysts have predicted. Beginning in mid-February, in discussing an interview with John Williams I suggested we were skating on thinning ice. Recognizing the power of QE to boost markets, until June I urged "nibbling" at equities and under-weighting bonds. In the last ten weeks I have urged trimming equities and bonds, shortening duration of the latter and increasing cash positions.

A bear is now in view. When the S&P (NYSEARCA:SPY) fell through its May 21 high and continues down it is useful to examine its chart these past six-plus quarters. One must look at the peaks and corrections since the 3Q 2011 downgrade of US credit to find trend lines and the outlook for equities. For months I have presented much material on the intrinsic weakness of the housing recovery, stagnant income, a falling loan/deposit ratio and inflation that dwarfs official numbers and makes bonds a particularly a bad play (so too does the QE that creates the inflation). In closing I will consider possible outcomes of the latest gathering of financial powers at Jackson Hole later this week for their hints or statements will shape near-term market movements.

This S&P interactive chart shows the significant corrections of the past 19+ months. Adroit deployment of POMO (permanent open market operations of targeted bond and MBS buying) has meant that despite poor economic conditions there have been few major drops. Most years have at least one 10% or more correction. Over 56% of the 63 years since 1950 (previous link) have had 10-20% corrections.

Looking back to July 25, 2012 the S&P rose from 1337 to 1710 on August 2, 2013, fifty-three weeks later. August 5 nearly matched the Friday high at 1707 but then slippage began that on August 12 became a sustained decline. On August 15, last Thursday, the index lost its 4-week plateau near 1684 and is about to crash through the trend line that extends to June 24 from the November 15 low at 1353. That date marked a retracement of 7.5% from the September 14 peak at S&P 1465. The index climbed 27.9% in nine months before losing its edge. Riding on infusions of digital dollars and the Fed's growing involvement in Mortgage markets, it is due for a major correction that has not yet occurred. SPY closed at 1646 Monday August 19, down 3.75% in 11 trading days. To match the decline of 3Q 2012 would mean doubling the recent loss from 64 to 128 points. This would bring us to S&P 1582, slightly above the June 24 low at 1573. That level marked a 7.4% correction from the May 21 high at 1699.

The index is within ten points of dropping through the trend line that runs from Nov. 15 (1353) through Dec. 28, 2012 at 1402 to this June 24's trough at 1573. There is another longer-term lower channel to this cyclical bull just a few points below the Nov. - Dec. - June line: the one that extends from the June 4, 2012 low at 1278 through the June 24 low at 1573 eight weeks ago. If that line at about 1630 is breached we are looking at the lower channel from the June 4 - November 15, 2012 line that would bring the index down to 1435. This also is the area found by the down channel line stretching from the 11/25/11 to the 11/15/12 lows. That would be a correction of 16.01% from the August 2 close and is in the midst of the range of retracements expected by analysts including Jeffrey Saut of Raymond James, Dr. Marc Faber, Michael Pento and Tobias Levkovich of Citi (all cited in my recent pieces) among many others.

The October 27, 2011 drop from 1285 to the November 25, 2011 trough at 1159 was a 9.8% correction. The markets have not seen a release of steam like this for 15 months (2Q 2012) as Fed infusions of debt have continued. If it stops we may become re-acquainted with the 1500 area on the S&P. It is too late to avoid this by changing economic and tax policy, by fostering organic improvements in the economy: only Fed action can postpone a major correction in the near term.

The enormous unknowns are the decisions, suggestions or hints, including the usual contradictory hints about fiscal policies that will emerge from the latest gathering of financial heavy weights. The working vacation at Jackson Hole includes Christine Lagarde, Managing Director of the IMF, Vitor Constancio of the ECB (European Central Bank), Charles Bean of the Bank of England and Haruhiko Kuroda of the Bank of Japan. The manic yen-creation of the BoJ has brought seismic convulsions to the Nikkei and added confusion and unsustainable plays on the "Japan carry trade" into Western indices. Presumably, ways to coordinate the direction and relative strengths of the major currencies in the DXY (USD) index will be made or considered at the meet. World markets are close to becoming unmanageable even for the managers as action in the PM (precious metals) sector has been signaling.

While the equity indices have been dropping, the yield on the 10-year T-bill has kept rising: it reached 2.83% August 19. While far from covering real inflation, rising yields (up 75% since early May) are destroying the book value of bond investments, choking the mortgage and housing markets and straining all those who are servicing debt, not least Sovereigns. August 19 the REIT ETF (NYSEARCA:MORT) lost 4.37%. Emerging markets (NYSEARCA:VWO), down 1.81%, continue to get hammered.

It is likely that the Central Banks will work to keep the major indices from a massive drop if only to retain trust in a system and situation that has forfeited the former and made comfort impossible. If the debt creation and low interest rate regime continues, equities will regain their footing and bond prices will rise. It will be time to sell bonds at their low yields and deploy funds in the depressed commodity sector, short term fixed income, cash and companies geared to weather the times. Some of the strongest of these are British Petroleum (NYSE:BP), Schlumberger (NYSE:SLB), Deere (NYSE:DE), United Tech (NYSE:UTX), Disney (NYSE:DIS) and Time Warner (NYSE:TWX). If signals from Jackson Hole are mixed or tapering of debt or the possibility of sovereign defaults is hinted, equities and bond prices will drop. It will be time to exit both, especially bonds and wait for some solidification of interest rates from market forces and/or government policies before re-entering.

PM (precious metals) prices are likely to rise and physical metal gold ETPS like Asian Gold Trust (NYSEARCA:AGOL) or Sprott Physical gold (NYSEARCA:PHYS) or silver (NYSEARCA:PSLV) to benefit. However, in this sector one must consider that various governments have strategies to suppress metal - prices relative to currencies: India does it by gold import duties now at 10%. An exception to this scenario would be comments hinting the start of a transition to a new world reserve system with increased gold backing.

As so often the past few years of enormous liquidity and Sovereign debt, investors are waiting on policy hints or decisions from the governing echelons. Hints of more QE may stem the descent of asset prices toward levels that better reflect economic reality. The market trends are clear and defensive positions and readiness are indicated.

Disclosure: I am long PSLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have an S&P index ETF.