Global Markets in Review: Stocks Higher on a Stimulus and a Prayer

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Includes: AGG, CAF, DIA, EEM, EFA, EWY, EWZ, FXI, GLD, HYG, IEF, IWM, JJCTF, JJU, OIL, QQQ, SPY, UDN, UUP
by: Prieur du Plessis

Global stock markets shrugged off dire news on the U.S. employment front, arguing that the gloomy data would hasten U.S. lawmakers’ passage of a stimulus package. After falling for four straight weeks and recording the worst performance of the major U.S. indices for January on record, Wall Street reversed course on the back of a stimulus-induced rally.

The U.S. government seems on track to announce two new recovery plans next week:

  1. Senate Democrats reached an agreement with Republican moderates on Friday regarding a fiscal stimulus package. According to The New York Times, the deal, in essence, entails about $110 billion in cuts to the roughly $900 billion legislation.
  2. A rescue plan to inject billions of dollars into banks and entice investors to purchase toxic assets will be outlined on Monday by Treasury Secretary Timothy Geithner.

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As investors’ risk appetite returned, the MSCI World Index and the MSCI Emerging Markets Index chalked up decent gains of 3.8% (YTD -5.4%) and 5.3% (YTD -1.7%) respectively. Among exchange-traded funds (ETFs), sector leaders were China (see additional comments below), Brazil and South Korea - all recording double-digit gains, according to John Nyaradi (Wall Street Sector Selector).

All the major U.S. indices revved higher, as seen from the week’s movements: Dow Jones Industrial Index + 3.5% (YTD -5.6%), S&P 500 Index + 5.2% (YTD -3.8%), Nasdaq Composite Index +7.8% (YTD +0.9%) and Russell 2000 Index +6.1% (YTD -5.8%). Interestingly, the Nasdaq has been outperforming the Dow and S&P 500 since the beginning of December. Leadership by the technology sector is often good for the market as a whole.

Recent safe-haven trades such as U.S. Treasuries (-0.7% in the case of 30-year bonds), the U.S. dollar (-0.6%) and gold (-1.5%) took a back seat, as investors favored equities and commodities such as copper (+4.9%) and aluminum (+7.7%).

While pundits were speculating about when the Federal Reserve would enter the market as a buyer of U.S. government bonds, Treasuries sold off as a large issuance of sovereign debt looms. However, German bonds gained handsomely on the perception that the European Central Bank was behind the curve with interest rate cuts against the backdrop of poor economic data.

The performance of the major asset classes is summarized by the chart below, courtesy of StockCharts.com.

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Giving a glimmer of hope, is the Baltic Dry Index (BDI), which measures freight rates for iron ore and other bulk goods. It jumped by 40% last week due to increased Chinese demand for iron ore. The Index has gained 125% over the past two months after plunging by 94% since its May high. The chart below illustrates the close relationship between the BDI (red line) and Reuters/Jeffries CRB Index (green line). (Not shown are the BDI and U.S. Treasury yields trends, which, more or less, are also following the same path.)

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As reported in my “Credit Crisis Watch” review of a few days ago, the past few months saw progress on the credit front, with a number of spreads having peaked. The TED spread, LIBOR-OIS spread and GSE mortgage spreads have all narrowed markedly since the record highs. Corporate bonds have also seen a strong improvement, but high-yield spreads remain at distressed levels. The tide seems to be turning, but the thawing of the credit markets still has some way to go before liquidity starts to move freely and confidence returns to the world’s financial system again.

Speaking of confidence, Montek Ahluwalia, deputy chairman of India’s planning commission, made the following remark at the recent Davos Forum:

Confidence grows at the rate a coconut tree grows. It falls at the rate a coconut falls.

Now, let's return to the planned U.S. rescue packages, and specifically, Bill King’s comments:

The main problem plaguing the US economy is too much debt has been accumulated on gratuitous spending and the papering over of declining US living standards. Solons espouse a monstrous surge in debt to fund even more consumer spending. The toxin is not the cure. Inducements to save and invest in production are the remedy. But the welfare state and its ruling class are trying a last grandiose socialist [Keynesian] binge in the hope of salvaging their realm.

Next, a tag cloud of my week’s reading. This is a way of visualizing word frequencies at a glance. Key words such as “bank,” “economy” and “market” dominated the list, whereas “China” seems to be gaining more prominence.

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Stock markets have been in a “holding pattern,” or trading range, since the beginning of December. Key resistance and support levels for the major U.S. indices are shown in the table below. The immediate upside target is the 50-day moving average (the Nasdaq and Russell 2000 are already above this line), followed by the early January highs. On the downside, the December 1 and all-important November 20 lows must hold in order to prevent considerable technical damage.

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Here is Richard Russell’s (Dow Theory Letters) interpretation of the situation:

Frankly, I’m very impressed by the stubborn and continuing resistance of the DJ Industrial Average. I don’t think many analysts realize the extreme importance of the Industrial’s steady refusal to violate its November 20 low. The action of the Dow contains the answer to the trillion-dollar question - ‘Is the bear market in a halting process - or will the stock market signal a continuation of the primary bear market?’

So here we are - at a crossroads to history. The market will issue its verdict when, and only when, it is ready. But for now - if there’s anything traders love, it’s a market rising in the face of lousy news.

An optimistic outcome would be a continued refusal by the Industrials to close below 7,552. An obviously more bullish outcome would be the DJ Industrial Average and the DJ Transportation Average continuing to rally and ultimately (both Averages) bettering their early-January peaks.

Clearly, the most bearish outcome would be the Industrials finally breaking below the November 20 low and thereby confirming that we are still locked in a continuing primary bear market.

From across the pond in London, David Fuller (Fullermoney) said:

… there is a scenario which few other people are taking about. As part of our often-mentioned forecast for a ranging, reversion to the mean recovery rally first hypothesized in late October, there is a possibility that stock markets will do surprisingly well in the next few weeks. Strong rallies would eventually leave markets susceptible to partial pullbacks, including some right-hand base formation extension.

How could strong rallies possibly occur when everyone is talking about depression? The answers can be found in sentiment and liquidity. Today, most people are either incredibly bearish or despondent, but extreme forecasts are seldom accurate, as I have mentioned before. However, there is plenty of liquidity in many portfolios and governments have significantly increased money supply in recent months. A rising stock market would force a reappraisal by bears, leading to a reversal of short positions, while long-only investors put more of their cash back into the stock market.

My view is that stock markets, in general, are still caught between the actions of central banks furiously fending off a total economic meltdown on the one hand, and a grim economic and corporate picture on the other. While we figure out whether we are in a normal bounce or witnessing the start of something bigger, I am not averse to selective stock picking - picking out the choice morsels, so to speak.

As far as specific countries are concerned, I alluded to the Year of the Ox in my “Performance Round-up” of last week, and mentioned that this is regarded as a sign of prosperity that has been very rewarding in the history of China. And, what a start to the year it has been, with the Shanghai Composite Index gaining 9.6% during the past week.

The chart pattern (see graph below) arguably shows one of the best base formations of the major stock market indices, followed by Friday’s breakout. Although the Index is still down by 64.2% since its high of October 16, 2007, it has moved to the top slot among global stock market performances for the year to date with returns of +19.8% (local currency) and +19.4% (U.S. dollar terms).

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For more discussion about the direction of stock markets, also see my post “Video-o-rama: Stimulus ad nauseum."

Go to Page 2 - Global Markets in Review: Economy, Markets>>

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