Friday, July 12, 2013

Bernanke's Comments Reverses Recent Sell-Off

by Lance Roberts

At the beginning of June we began discussing the approach of an initial "sell" signal.  I stated at that time that the onset of such a signal would be a "warning" that you should begin paying much closer attention to what is happening inside of your portfolio.  The sell off that began in late May coincided with mounting expectations that the Federal Reserve would begin reducing their monetary interventions later this summer and cease the program entirely by 2014.

As I discussed in "The Dimishing Effects Of QE Programs" the economy remains far too weak for the Federal Reserve to begin reducing support for the financial markets anytime soon. I stated:

"...the real issue is that IF the recent negative trends in consumption, employment and inflationary pressures do not start to reverse it is highly likely that the Fed will not be able to extract the monetary supports anytime soon. The recent increases in interest rates, combined with still very weak wage growth, higher costs of living and still elevated unemployment is likely to keep the Fed engaged for the foreseeable future as any attempt to remove its 'invisible hand' is likely to result in unexpected instability in the financial markets and economy."

Consequently, the "trial 'tapering' balloon" lofted by the Federal Reserve after the last FOMC fell quickly to earth as stock prices sagged, which began to erode consumer confidence, and interest rates spiked sharply higher putting economic growth in danger.  Those realites pushed the Federal Reserve to backpeddle on their "tapering" stance as Ben Bernanke clearly stated that:

"I think you can only conclude that highly accommodative monetary policy for the foreseeable future is what's needed in the U.S. economy.  And I guess the final thing I would say in terms of risks of course is that we have seen some tightening of financial conditions, and that if, as I've said and as I said in my press conference and other places that if financial conditions were to tighten to the extent that they jeopardize the achievement of our inflation and employment objectives then we would have to push back against that."

There was a clear confirmation by the Fed to market participants that the Federal Reserve will not take away accomodation because they cannot afford to let the markets "tighten."   Rising interest rates and falling asset markets are one thing and put the economy at risk.  However, the lack of inflation is also a real concern.  As I discussed in "What Inflation Says About Bonds & The Fed:"

"It is highly unlikely the Fed will substantially reduce interventions in the short term.  More likely the Fed is likely to try and talk markets down by increasing expectations of future declines in bond purchases. Most importantly, however, the Fed will likely emphasize their 'accommodative policy stance' going forward. In a weak economic growth environment the Fed cannot begin a program of boosting overnight lending rates. As the chart below shows, every time the Fed has embarked on such a program to increase borrowing costs it has led to an economic recession or worse.


The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a 'soft patch' currently despite the mainstream analysts' rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get themselves out of the 'liquidity trap' they have gotten themselves into without cratering the economy, and the financial markets, in the process. As I said recently this is the same question that Japan is trying to figure out as well."

Confirming Sell Signal Avoided

For the stock market the reversal of the stance by the Federal Reserve gave Wall Street the "green light" to pile back into equities.  As I stated previously in the analysis of the initial "sell" signal I stated that:

These warning signals are just that – a 'warning' that you should start to pay very close attention to your portfolio.  When all of these signals align it is always in conjunction with a market correction.  Currently, the [indicators] are close to issuing a 'warning.' It will take a VERY strong rally to keep that from happening."

That is exactly what has occurred.  The rally that began three weeks ago, after breaking short term support, has been strong enough to keep the "confirming sell signal" from being triggered as shown in the chart below.


More importantly, the Fed's announcement that their "highly accomodative" policies will remain in place alleviated market participant fears, at least in the short term, which has subsequently vaulted stocks out of the negative downtrend in June.  This short term reversal also keeps the longer term uptrend intact maintaining equity allocations at target weightings for the time being.

The chart below, as discussed in last week's missive "Is The Correction Over:"

"For longer term investors it will be critical for the markets to reverse the longer term "initial sell signal" that was triggered [in June] without the "confirming sell signal" being initiated. In order for this to occur the market will need to rally above 1630 on the S&P 500 next week and rally towards old market highs. This is shown in the chart below.

The downtrends, as denoted by the green dashed lines, are notable as they tend to predict the direction of prices in the coming weeks ahead. However, with the Federal Reserve on tap to inject $45 billion in bonds in July it is unclear just how large the current correction might be."


That has now occurred with the markets now wrestling with all time highs.  As you can see in the chart above the recent correction was the smallest of the last four, however, when these previous downtrends were positively broken it led to further advances in the markets.

Still Overbought, Bullish & Extended

The bad news is that the market remains extended to the upside as the recent correction was not large enough to reverse the longer term overbought conditions of the market.  The first chart below shows a weekly long term view of the S&P 500 Index with a 50-week moving average and bands representing 3-standard deviations above and below the long term average.


As you can see the only times in history where the market has deviated this far above its long term moving average has been at the peak of every prior bull market cycle.   However, the risk of more signficant correction occurring from such extreme deviations is compounded when fueled by leverage and speculation.  The next chart shows the level of margin debt on stocks.


The problem, of course, is when a more significant correction begins it will be fueled by the unwinding of leverage.

It is very important to understand that there are two VERY DIFFERENT dynamics at work currently.  The economic and fundamental environment is clearly weakening.  However, asset prices are being pushed higher by continued injections of liquidity.  Ultimately, this dislocation between fantasy and reality will reconnect and will be very painful for most investors.  However, the timing of that event, due to the ongoing market manipulations is currently unknown.

Therefore, as we will discuss below, we have to take actions within portfolios in the short term to participate with the liquidity fueled markets.  This is certainly not a long term or "risk free" view but just an understanding that in the short term we cannot successfully "fight the Fed" and win.

While we continue to remain invested in the financial markets, as long as they are trending positively, we remain extremely concerned about the weakening economic and fundamental data both domestically and globally.  Liquidity programs DO NOT create organic economic activity but rather create an "Potemkin" facade that hides the underlying reality.  As I stated above, eventually, the reality will assert itself, and when it does, it has historically not been kind to investors. 

Portfolios Remain At Target Allocations

While the recent correction was not large enough to provide an ideal entry level for adding equity exposure; it also did not warrant any changes to our portfolio allocation model.

Part of the process that I recommended following the initiation of the "warning signal" was to sell positions that were technically, or fundamentally, broken.  I also suggested taking profits in positions that had reached extreme over bought conditions.  Those actions raised cash in portfolios that can now be selectively redeployed bringing equity exposure back up to target weights.  Furthermore, as I wrote recently in "Reiterating Bond 'Buy'," it is also an ideal time to bring bond weightings up to target allocations as well.

While this is NOT an ideal entry point; the current analysis suggests that the next level of resistance for the S&P 500 will be around 1700. That level could be attained very quickly even as the markets have already moved back into daily, and weekly, overbought conditions.  The sustainablily of the current rally will depend much on a continued LACK of headwinds, earnings beating much lowered estimates and economic data that continues to muddle along.  However, there are substantial issues on the horizon that could quickly change this view.  The rapid decline in economic activity in China, the bubbling issues in the Euro-zone and the upcoming debt ceiling debate could roil the markets and quickly awaken the overly complacent "zombie" herd sending investors panicking for the exits.

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