Fed's Crisis Policies Will Continue to Backstop Financial Assets

In last month’s report, we noted that the stock market was vulnerable to a correction following seven straight up months, and a 60% gain in the S&P 500 from the March lows. By mid-October, stocks had pushed even farther into overbought territory, testing a key resistance level at 1100 in the S&P 500. The 1100-1120 zone is important technically because (1) it represents a 50% retracement of the entire bear market from October 2007 to March 2009 and (2) it marks the spot where the major down trend-line originating from the October 2007 peak comes into play. Consequently, this resistance zone is a significant technical barrier that the market will have to overcome at some point to dispel any lingering doubt about whether this is a legitimate bull market or just a huge bear market rally.

Stocks managed to survive October with only moderate declines, but in the past two weeks have experienced the most significant correction since early July. The S&P 500 dropped 6.5% from its recent peak, but other indexes (e.g. small-caps and emerging markets) suffered 10% declines. The stock market was highly extended and ripe for a pullback, so this correction was to be expected, and thus far has not done any serious technical damage to the uptrend that has been in place since March. The weight of the evidence continues to suggest that we are experiencing an overdue correction in the context of an ongoing bull market that will extend into 2010.

Stock valuations are not intrinsically cheap, as they were in the early phase of the rally, but they are reasonably priced, especially in light of the low-yielding alternatives available to investors. Similarly, the stock market is not yet challenged by excessive bullishness, so the sentiment backdrop is conducive to higher prices. Indeed, stocks are climbing the proverbial “wall of worry.” Many are (justifiably) nervous and skeptical about the durability of the economic recovery and the staying power of bullish financial market conditions, which is constructive from a contrary opinion standpoint.

As noted above, the technical condition of the market has deteriorated somewhat but remains bullish. Our cautious optimism about the intermediate-term stock market outlook is also predicated on the idea that the Fed’s crisis environment monetary policies will continue to act as a strong backstop to financial assets for some time longer. The lack of recovery in U.S. employment conditions ensures that Fed policy will remain loose. Fed Chairman Bernanke has all but guaranteed a zero percent federal funds rate and continuing quantitative easing (debt monetization) until early 2010 at a minimum. The Fed looks at inflation solely through the prices of goods and services. Because of a glut of global capacity, slack in labor markets, and weak demand, consumer price inflation is unlikely to be an issue for the next several quarters. Consequently, the Fed will feel justified in keeping the monetary floodgates open, which in turn is having the most immediate inflationary effect on financial asset prices.

The Fed may be forced to begin normalizing interest rates if the dollar falls below its mid-2008 lows, but for now, it is trading 7% above such levels, so the Fed is under no immediate pressure to act to defend the dollar. Even if the Fed does make a token move on interest rates (i.e. a half percentage point hike to a 0.5% rate) the poor yield on cash will continue to drive investors to seek a better return. An awful lot of money is still on the sidelines earning no return (or very little return in many areas of the bond market) and it is gradually being deployed in the stock market. This factor has contributed to the rather shallow and brief nature of the corrections we have seen.

It seems reasonable to expect this process to continue at least through the balance of the year. Looking out over the next six months or so, our best guess is that the downside risk in the S&P 500 will be limited to 975 (about 7% below current levels) and the upside potential is 1200 (about 14% above current levels). This represents a reasonable risk/reward for investors who consider themselves too heavily exposed to cash, particularly since a stop-loss in the area of 975 could be employed. A close below 975 on the S&P 500, which would violate all of the support levels established since the July low (see chart below), would indicate a change of character in the stock market and have more bearish longer-term implications.

[click to enlarge]

Comments

[Mr. Big:]

You forgot to mention that the zero interest rate policy commitment by the Fed is fueling the enormous dollar carry trade that is pushing up asset prices.

Any indication by the Fed that they will support the dollar via interest rate policy may trigger the simultaneous unwind of these carry trades and a massive sell-off in the stock markets.

Tread carefully, dear investor.....

Nov 05 03:58 PM

[woollyB:]

I see irrational exuberance more than any wall of worry. I see Daily Sentiment Index (trade-futures.com) hitting bullish levels that exceed even the 2007 top.

I see P/E ratios at record highs. Even at the March lows they didn't approach the levels that have marked the end of every bear market for over a century.

I see surveys of economists who, as in 2000 and 2007, are unanimous in forecasting growth.

I see Fannie, Wells Fargo, et. al, rolling out Hail Mary plans to keep "homeowners" paying something, anything, rather than walking away and forcing the lenders to recognize losses.

You don't think there is excessive bullishness? Check the mirror.

Nov 05 04:03 PM

[ryanclarke:]

The dollar index is at 76 ... which is about where the index was at in November 2007. Although U.S. October 2009 gasoline and oil stocks are higher than October 2007, I suspect drawdowns in oil stockpiles, typical for this time of year ... will not be met with rising inventories of gasoline. For the same reason as in the spring of 2008, with gasoline inventories below acceptable levels for the summer driving season, the spring of 2009 will see the dollar index tumble to 72 because of demand for foreign gasoline. The Fed showed their hand yesterday ... they have no problem with inflation getting out of hand ... and relying on the military to pressure the Saudis, the Russians, and the dictator Chavez ... to tow the line and increase production. Will they?

Nov 05 05:38 PM

[Davewmart:]

It is more accurate to say that the weakness of the dollar has led to the illusion of bullishness in the stock market:
See today's article:
seekingalpha.com/artic...

This market has all the stability of Wylie Coyote, just after he has run off a cliff and before he realises that he is bound to fall.

Financial instability has been increased, not decreased, by the measures taken to support the unreformed banks.

Nov 05 05:53 PM

[TxTim:]

"Because of a glut of global capacity, slack in labor markets, and weak demand, consumer price inflation is unlikely to be an issue for the next several quarters. Consequently, the Fed will feel justified in keeping the monetary floodgates open, which in turn is having the most immediate inflationary effect on financial asset prices."

Oddly, I don't thing the author is incorrect here. It simply slaps me in the face that fractional ownership in US companies--Shares of Stock, are being priced like commodities chased by too many dollars, totally disconnected from fundamental valuation. Historically inflation has been unkind to stock values (CAPM, etc.) In the voice of a carnival promoter, "Step right up take your chances on the wheel of fortune..." "Buy a share here, buy a share there, you might be the lucky winner!" "You sir, how 'bout 1000 shares today..."

Nov 05 06:10 PM

[BetTheHouse:]

Really. Who is more irritating. The guy who posts on every thread "this market does nothing but go up" or the guy hawking shoes and hair straightener?

Nov 05 09:45 PM

[raising4dau...:]

Is any other better purpose for our military?


On Nov 05 05:38 PM ryanclarke wrote:

> The Fed showed their hand yesterday
> ... they have no problem with inflation getting out of hand ... and
> relying on the military to pressure the Saudis, the Russians, and
> the dictator Chavez ... to tow the line and increase production.
> Will they?

Nov 05 10:17 PM

[j_remington:]

the mkt will not rollover on a dime...follow the chart

Nov 06 08:53 AM