The greatest rescue effort in history bailed out the world’s largest financial institutions, pulled the global economy from the brink of recession or depression and fueled a two year surge in stock and commodity prices. When initial efforts proved insufficient, governments and central banks stepped up with additional rounds of stimulus. In this country, equities declined in the spring of 2010, by almost 20%. With the economy improving but still at recession levels, the Federal Reserve determined that even more stimulus was needed to prevent a complete failure of the initial rescue effort. That was the “all clear” signal to Wall Street, and investors determined that Fed Chairman Bernanke was unwilling to let market prices or the economy decline meaningfully.
From the August 2010, announcement of a second round of quantitative easing (money creation), stocks took off again on another 30% up leg into the beginning of May 2011. Fueled by new money, the economy continued to grow, although at the slowest rate of post-recession recovery since World War II.
From the early-May high, the U.S. stock market began to retreat, gradually but persistently. Equity prices have declined for five consecutive weeks for the first time since 2004. Economic statistics are slowing globally, even in the emerging economies. That has put nary a dent in the confidence of the Wall Street community. Economic expansions typically last longer than two years, so confidence remains high that the current advance will continue. The recent slowdown is seen merely as a soft patch to be followed by new stock market highs.
That view of another temporary pullback followed by at least one more stock market high is supported by Lowry Research Corporation, one of the oldest and most respected technically oriented data analysis firms. In business since the 1930s, Lowry’s specializes in the analysis of the market’s supply and demand forces. It maintains that in nearly 80 years the stock market has never made a major top without their measures of supply having first increased substantially. That has not yet occurred.
While I am a great believer in paying close attention to consistent long-term precedent, there are some extraordinary factors at play in the current market. This is not a “business as usual” environment. What cannot be accurately assessed until it disappears is the artificial effect of massive central bank interference in the markets and the economy. Will normal patterns unfold when government stimulus ends, much less is withdrawn? It is certainly possible that the greatest-ever creation of liquidity has distorted normal cause and effect relationships in the economy and the markets.
People want certainty. There is never certainty in markets. Today, however, even short-term probabilities are hard to discern. Will the Fed determine that a third round of quantitative easing would be the best approach if economic fundamentals continue to deteriorate? Should it make that determination, would there be so much political opposition that implementation would become unlikely? If the Fed did implement some form of QE III, would investors react as they did after QE I and QE II? Or would investors begin to focus on the inevitable impossibility of repaying the debt that has been created in the rescue efforts?
To add to the confusion, the message of the market itself is conflicted depending upon one’s time frame. As indicated earlier, Lowry’s figures point to a probable new high before any new bear market. Over the intermediate term, the weakness off the early-May high would point to a probable continuation of this pullback before any meaningful attempt at a new high. In the very shortest time frame, five weeks of persistent price decline have produced a significant short-term oversold condition. Most such conditions are worked off by at least a multi-day rally. There haven’t been six consecutive weeks of decline since 2002. On the other hand, the market’s tenor appeared to change last week. Whereas buyers have materialized consistently over the past two years when prices retreated, buyers were noticeably absent last week at points where they have been appearing. And Friday closed very soft after weak attempts to rally.
With countries on the verge of default, this clearly is not business as usual. The risk of debt unraveling is huge despite government rescue promises. We will continue to monitor the message of the market but recognize that crosscurrents are severe. Rewards are still possible if the government rescue succeeds, at least for a while longer. Penalties, however, are potentially even larger should confidence in the government rescue wane. Investors have to assess their own individual ability to withstand the risk of significant loss in determining their willingness to accept exposure to risk-bearing assets.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.