The US Federal Reserve, a private bank, is mulling issuing its own debt. There are several problems with this, one of which is that if the debt is backed by nothing, no one will buy it. If it is backed by the full faith and credit of the US Government it needs Congressional approval. Either way, the fundamental story is clear. The Federal Reserve has overextended itself and finds its balance sheet loaded with worthless assets that it can not sell. Karl Denninger has a nice rant about this on his blog that I recommend for your morning reading.
As reality quickly dismisses the holiday optimism that swept through markets last week, equity indexes are paring their gains and looking lower to reprice risk. The Yen is especially strong today as the carry traders give in to fear. This is likely the beginning of the next selling stage as outlined in my articles from last week. If I am correct, I expect we retest the 741 intraday lows and possibly break down below to the 600 area in the coming weeks and months.
Why have we witnessed four up days of trading that rocketed from the lows of 741 to nearly 890 on the S&P 500? Is it the start of a new bull market? This would be a very pleasant scenario, but bear market rallies can last days or sometimes even weeks and months. The most violent rallies, like those as of late, are generally short lived. The last time the market was up four days in a row was April, 2008.
How are bear market rallies possible?
Lately we’ve seen anything from government appointments to bail outs of multinational banks significantly lend to positive momentum. This is quite a contrast from the traditional inspiration of good earnings or economic data.
Bear market rallies are not created by investors buying to commit capital in to a stock for the long term, but instead by short covering and trading. The short term horizon of the participants and the lack of fundamental positive catalysts usually lends to these rallies collapsing to worse levels than they had climbed from, rather than a constructive bottom forming process.
When will we see the bottom?
A) The worst must be over: House prices are still dropping, unemployment is rising, consumer sentiment pushing all time lows and credit availability is tight. There is likely another leg down coming in both commercial mortgage backed securities and consumer credit card defaults.
B) There must be a positive catalyst within sight: Green energy has been promised to be the next bull market. Is there demand for these measures when oil is at $50 a barrel? The other question is, after committing half of last year’s GDP to financial bail out programs, how will the Federal Reserve and US Government continue to finance their spending? More importantly, will foreigners continue to lend to a less credit worthy nation?
C) The Federal Reserve must complete lowering rates and change to a neutral or tightening bias: The next Fed move will likely be another rate cut. To Bernanke’s Fed, deflation is still a bigger threat and he has the helo running full time dropping cash. Until this reactionary behavior is over, there is no sign that we are out of the woods.
D) Businesses must begin buying back shares: Many buyback programs have been halted, not accelerated. We have not seen corporations step back in and buy back their own shares. We also haven’t seen many insiders provide substantial equity commitments in their companies as of late. This is an important component of building a sustainable bottom.
E) Risk indicators must begin to show signs of significantly decreased aversion: The Japanese Yen, crude oil, one and three month T-bills (and lately even the long bonds) have all shown us that the flight to quality and away from risk (or growth) remains. The VIX is still above 50 and has major support at 45. Even gold prices are back above $800. Fear still seems to be a greater motivation than greed.
What are the charts saying?
The above S&P 500 chart is not confidence inspiring. The trend lines illustrate the wedge patterns and the horizontal lines show major resistance areas. Currently the stock market is bumping in to major resistance. My indicators confirm this rally is overbought and due for a correction soon.
Where are we heading next?
Based off the above analysis, I don’t feel this rally will get much above 900. Instead, we need to retest the intraday low of 741 on the S&P in the next few weeks. There will probably be support areas on the way down at 875, 850, 830, 800 and 776. If the 741 low doesn’t hold, 600 is the next level of major chart support.
If you’ve made some money on the rally, don’t fall in love with the upside. Remember that we still have a lot of problems to work through. Folks with investments should use this as an opportunity to raise cash. If you’re looking to trade this rally, you may want to begin adding to short positions. FinViz.com has some great tools for screening stocks if you use technical analysis to find your trades. Good luck and stay safe!