With Stocks at Multi-Year Highs – QE3 May Be Overkill

The Federal Reserve is the most powerful financial institution in the world. It manipulates the world’s stock market seemingly at will, yet there are reasons to conclude QE3 is farther away than many expect.

Skunks are best known for their ability to spray a liquid with a strong, foul odor. The smell, a combination likened to rotten eggs, garlic, and burnt rubber, can be detected by the human nose up to a mile downwind. Smell aside, the spray can cause irritation and even temporary blindness.

The skunks reputation is well known, that’s why it roams around by day in the open and fears neither dog nor man. Skunks rarely ever have to use their “weapon” since just the threat of getting sprayed keeps predators at a safe distance.

The Fed, a unique financial animal, possesses a similar defense mechanism – it’s called QE .Like skunks, the Fed has established a reputation to use it when needed. This keeps “enemies” – such as market pessimists, realists, and particularly short sellers – at a safe distance. The Federal Reserve doesn’t necessarliy have to spray QE to get the effect of QE, just the threat is often enough.

Why Change a Winning Strategy?

Ben Bernanke is well aware of this fact. Essentially since the end of QE2 (June 2011), which resulted in a 20% stock market meltdown, Bernanke has been telling investors that the “Fed is ready to spray more QE when needed.” That’s been more than enough to keep stocks from collapsing. In fact, just the threat of spraying QE3 has lifted the S&P 500 Index (SPY) to a 51-month high and the Nasdaq-100 (QQQ) to a 12 1/2 year high.

Another animal analogy comes to mind. As long as you keep the carrot dangling the rabbit keeps running.

Why would Bernanke change a winning strategy (that of bluffing to spray or dangling the carrot) if stocks are already trading near multi-year highs? What, the economy is bad you say? The Fed’s past actions tell us that the economy may not be Bernanke’s primary concern. It seems easier to downplay millions of Americans being out of work than big losses of financial institutions on Wall Street.

QE Side Effects

Fortunately for the free market, there’s one asset class that keeps Bernanke and his inkjets honest. Oil. QE is inflationary. Like water in the bathtub that buoys rubber duckies along with all other toys, QE inflates the price of all assets (aside from those that have an inverse relationship).

Higher stock, gold, and silver prices are good for investors, but higher oil prices suffucate the economy. Oil around $110 a barrel coincided with stock market tops in April 2011 and March 2012. Oil at $85 in Apirl 2012 was enough to contribute to a 17% decline in the S&P 500.

With crude oil already trading near $100 a barrel, QE3 now or in the near future could be a double-edge sword with little net benefit for stocks and the economy (see chart below).

More About Skunks and QE

Skunks are reluctant to use their weapon, as they carry just enough of the chemical for five or six uses. The Fed has sprayed outright QE twice since 2008. This doesn’t include covert maneuvers like Operation Twist, currency swaps or low interest rates. How many more sprays of QE-like substances is the Federal Reserve good for? It seems to be running out of bullets.

Ironically, skunks have poor vision. This makes it harder for the stinky little mammal to decide who and when to spray. Bernanke’s “eye sight” (ability to foresee side effects of his actions) is similarly poor (click here for Bernanke’s bloopers). The Federal Reserve failed to see the 2008 financial debacle, or what’s been dubbed the “perfect storm,” brewing and has been playing catch up ever since.

An ounce of prevention is worth more than a pound of cure, but that’s a tough concept to grasp for a blind financial “animal” with a potent weapon.

 

 
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S&P Doesn’t Show it, But Stocks’ Performance Has Investors Scared

An analysis of NYSE trading volume provides one of the most intriguing big picture forecasts available to investors today. Trading volume, although not a short-term timing tool, acts like a lie detector.

Technical analysis 101 teaches us that higher prices on rising volume (often considered a break out) are bullish. Rising prices on falling volume or falling prices on higher volume, on the other hand, are bearish.

Low Volume But New Recovery Highs

Volume/price analysis is fractal and can be applied to all time frames. The break out above 1,389 for the S&P 500 Index (SPY) on August 3 happened on low volume. The rally from the June 4 low occurred on low volume and low and behold the rally from the October 2011 low has seen low volume.

Theoretically that’s all bearish, nevertheless the S&P 500 Index (SPY) just saw a 50-month price high as the Nasdaq carved out a 12-year high. Obviously, volume is not a short-term directional indicator.

Does that mean we should dismiss ominous volume patterns? I don’t think so and here’s why:

Stock Market X-ray

Volume, and volume sub studies such as the advance/decline ratio, reveal underlying tendencies that price simply doesn’t reflect. It’s almost like an X-ray for stocks and what this X-ray reveals is extremely interesting and concerning.

The chart below plots trading volume on the NYSE against the S&P 500 (since 2005). The daily gyrations of volume make it tough to discern a trend (the big spikes are usually triple witching days), but the red 50-day SMA shows a clear down trend in market participation.

Why Volume is Low

There are three reasons why trading volume is low:

1) Since the 2007 market top the value of the S&P, Dow Jones, Nasdaq-100, Russell 2000 and pretty much all other indexes has been cut in half, doubled and jumped around like a jittery cursor. Investors simply don’t want to put up with the market anymore. Who can blame them?

2) High-priced stocks like Google and Apple (GOOG and AAPL trade close to $700 a share) contribute to lower share volume. According to Tom McClellan, the median share price of all NYSE-listed and traded issues was $14.50 in 2009. Today it’s $23.50.

3) Summer trading is always slow.

Volume Pattern More Worrisome than Shrinking Volume

More worrisome than shrinking volume is the actual ebb and flow pattern of trading volume. Within the overall down trend in trading volume there are times when volume spikes quite dramatically. Those spikes reveal investors true feelings about stocks.

The chart below plots the S&P 500 against a 10-day SMA of trading volume. Most declines since the 2007 market top have been swift, so a 10-day SMA captures volume increases nicely.

The gray boxes highlight that selling activity increases whenever stocks decline. Numbers don’t lie, and volume is like a lie detector that reveals investors true intentions. On balance investors are more eager to sell into declines than buy into rallies.

What’s the big picture message of trading volume? Prices for the S&P 500, Dow Jones and almost all major market indexes are still below their 2007 high.

This means that the current rally is a counter trend rally, which is confirmed by rising volume when stocks drop and anemic volume when stocks rally.

Obviously, the market’s behavior has been distorted by the record influx of faux Fed money, but volume analysis strongly suggests that the rally from the March 2009 low will remain a counter trend rally. This rally may not be over yet, but it looks more terminal than many believe.

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Will Small Cap Stocks Catch Up and Trigger a Buy Signal for the S&P 500?

“The stock market is doomed because small cap stocks are trailing behind the S&P” has been the financial media’s message. Obviously the market is doomed eventually, but for now this piece of Wall Street “wisdom” hasn’t paid off. Here’s what the Russell 2000 is telling us.

Small Cap stocks represented by the Russell 2000 and ETFs like the iShares Russell 2000 Index ETF (IWM) have received their fair share of media attention lately.

The focus has been on the under performance of the Russell 2000. This has been considered bearish for the S&P 500 (SPY), Dow Jones (DIA), and Nasdaq (QQQ) since small cap stocks are often viewed as a barometer for the market as a whole.

The Profit Radar Report has been promoting an individual and independant analysis of small caps, financials (XLF) and the Nasdaq to get a better read on the big picture.

Myth Buster

One detailed piece of analysis has shown that under performance by the Russell 2000 is not necessarily negative for the stock market.

There have been nine occasions over the last 20 years where the S&P was within 1% of a multi-month high (1,392 on July 30) while the Russell 2000 was more than 5% below a multi-month high (820 on July 5). This led to small negative returns only three times.

Above Resistance

Even though the whole lagging Russell doom scenario is busted, the Russell broke above key resistance. This happened on August 7, with a close above 800 (a day before XLF broke above resistance at 14.85).

Although the Russell was still lagging the S&P, this break was important and signaled more gains for small caps (financials) and the overall market.

The chart below plots the S&P 500 (SPY) against the Russell 2000 (IWM) and reveals divergences at various degrees.

In May 2011 the Russell 2000 Index recorded an all-time high. The S&P did not. Since then the S&P has nearly reclaimed its 2012 high while the Russell 2000 is about 5% away.

The S&P 500 is about 10% away from its 2007 all-time high, while the Russell 2000 is only 6% away from its 2011 all-time high.

If you are looking for a divergence between the S&P 500 and Russell 2000, you’ll find more than just one, some bullish, some bearish.

The chart below shows immediate resistance for the Russell 2000 and S&P 500 Index (red lines) and short-term support. There are indicators that suggest an upcoming sell off, but as long as prices remain above short-term support (green lines) the trend is up.

 

The Dow Jones – Close to a Once-in-a-Lifetime Signal?

The Dow Jones sports perhaps the most unique constellation of our generation. Constellations don’t make money, buy or sell signals do. The Dow’s constellation may double as a signal and is of importance for investors.

Since the year 2000 we’ve seen the tail end of a technology boom without parallel, the lost decade, the biggest decline and recession since the Great Depression, record monetary intervention and the strongest rally since the Great Depression.

Bulls and Bears can probably agree that we live in unique times. A look at a long-term chart (with long-term I mean going back all the way to 1896) of the Dow Jones Industrial Average (DJIA – corresponding ETF: Dow Diamonds: DIA) shows just how unique.

The chart below shows the Dow Jones in a monthly log scale. Here are the most salient points:

·      There are two long-term trend channels (dotted grey lines). One stretches from 1903 as far as 1954. The other one starts in 1937 and is still active today.

·      The 50 and 200-month moving average (blue and red line) are on track to cross each other for the first time since the Great Depression.

I find the Dow’s interaction with its trend channel very intriguing. The 1903 – 1954 channel offered support and resistance at no less than seven major turning points.

Most notable is sequence of trend line interaction that occurred following the bust of the 1929 bubble. The Dow sliced back below the upper channel line and continued tumbling below the lower channel line.

This led to a strong rally that once again tested the upper channel line (red arrow). The same thing is happening now. The strong post 2009 rally has lifted the Dow high enough to test trend channel resistance.

In fact, the Dow has been flirting with this upper channel line off and on since late 2010, but hasn’t been able to stay above it for long. Channel resistance is currently around 13,200.

What does this unique constellation mean for investors? Since we are looking at a multi-decade trend line, we can’t use it as a short-term investment tool or signal.

Long-term investors should closely watch the Dow 13,200 range. Based on the 1938 analogy, the likely current is a counter trend and long-term investors should use current prices to unload equities and nibble on short positions.

Financials – Is the Most Despised U.S. Sector Getting Ready to Rally?

Investors are shunning the financial sector. Although financials account for more than 14% of the S&P 500 (SPY), investors (by one measure) have only 2% of their money invested in financials. Some contrarians take this as a buy signal, is it?

Knight Capital, MF Global, LIBOR fixing scandal, JP Morgan losses, excessive Wall Street bonuses … there seem to be unlimited reasons to dislike the financial sector (Financial Select Sector SPDR ETF – XLF).

When it comes to financials, investors are not only talking the talk, they are walking the walk. Right now financials are the most despised sector in the United States. Of the $900 million invested in Rydex sector funds, only $18 million are allocated to financials, that’s just 2%.

However, the financial sector accounts for 14.21% of the S&P 500 Index (SPY), which makes it the second biggest sector of the S&P (behind technology).

Extreme pessimism often results in unexpected price spikes. Is the financial sector getting ready to rally?

The Technical Take on Financials

Financials appear to be at an important short-term juncture, but let’s provide some long-term context before looking at the short-term.

From the 2009 low to the 2011 high, the financial sector (XLF) jumped from $5.88 to $17.20. Before that, XLF dropped from 38.15 to 5.88. Today XLF trades 61% below its all time high price tag of 38.15. In comparison, the Dow Jones Industrial Average (DJIA) is less than 8% away from its all-time high.

Important short-term resistance for XLF last week was at 14.85. This resistance was made up of the July 3 and 27 highs and a trend line that connects the March 27 and May 1 highs.

On August 8, XLF was able to close above 14.85. Such a break out is generally bullish. However, the volume on which XLF broke out was significantly lower than average (see chart below).

Based purely on the chart and sentiment, the bullish message deserves the benefit of the doubt as long as XLF remains above 14.80. But a break below 14.80 would severely ding the immediate up side potential for XLF.

What about the down side risk? Aggressive investors may decide to sell or go short XLF with a break below 14.80. The initial down side target would be around 14.45 – 14.50.

Using Asset Class Correlations to Predict Stock Market Moves

Every day about a billion shares of stocks exchange hands on the New York Stock Exchange , but stocks are not the only asset class on the planet. Currencies and bonds are part of the same financial eco system, and we shouldn’t ignore their effect on stocks.

There’s a Bavarian saying that encourages people to “look beyond the edge of their own plate.” Translated in investment terms this means to expand your horizon and look at more than just one asset class.

Several times over the last couple of months the S&P 500  (SPY) has been declared “dead”. In fact, a recent CNBC headline said that: “Bill Gross is latest to join ‘stocks are dead’ club.”

The Fed could have jolted the S&P back to life with a dose of QE3, but decided not to. Against all odds, rather than rolling over, stocks have sprung back to life – a case of “dead man walking.”

On July 25, with the S&P trading as low as 1,331, a special Profit Radar Report outlined why stocks are not ready to decline just yet.

The key to this bold forecast was found in the correlation between various asset classes. Below are excerpts from the special July 25 Profit Radar Report.

July 25, Special Report: Asset Class Correlations

Some asset classes boom while others bust and vice versa. For example, bond prices typically rise when stock prices fall. Those types of asset class correlations should be taken into consideration for any market forecast.

Individual outlook for long-term Treasuries: Long-term T’s are butting up against long-term resistance while relative strength (RSI) is lacking price. This suggests that long-term Treasuries are in the process of topping out. Falling Treasury prices typically means rising stock prices.

Individual outlook for the euro: The euro has been trending down since March 2008 and is currently trading just above the June 2010 low. Although euro prices dropped below the June 1, 2012 low, RSI is solidly above the June 1 low. This suggests that the euro is trying to find a bottom that lasts for more than just a few days. Any bounce could gather steam if the euro is able to move above resistance. A strengthening euro is usually good for stocks.

What this means for stocks: If the euro rallies and long-term Treasuries decline, stocks should move higher or at least have a hard time declining.

The chart below shows how the iShares Barclays 20+ Treasury Bond ETF  (TLT) and Currency Euro Trust (FXE) perform during times when the S&P is in an extended up or down trend.

With Treasuries near a top and the euro near a bottom, stocks should rally or at the very least have a hard time declining.