With the Federal Open Market Meeting Wednesday and the June flash PMIs coming in yesterday, there are only three more macro catalysts left before we hit the earnings season. Those catalysts are the EU summit next week, the ECB meeting in the first week of July, and the payroll data in the first week of July. Those will be important news events to talk about, but first let’s talk about Wednesday’s Fed meeting.
The Federal Reserve Open Market Committee gave the market exactly what it was anticipating with no new surprises. It was expected we’d get an extension to Operation Twist in addition to a downgrade in the economic outlook. Risk-on investors were disappointed by no additional information on a possible third quantitative easing policy. Even though twist is helping to lower long-term interest rates, it’s being desensitized by selling the same dollar amount in short-term Treasuries. So net there’s been no additional money printing. It’s a very clever use of the Fed’s balance sheet to help bring long-term rates down to help home owners and businesses make long-term fixed investments all while keeping a lid on inflation.
Steve Liesman, of CNBC, was the first to ask Bernanke a question at the meeting and I thought he asked a legitimate one. He asked whether the Fed’s policies would be interpreted as being too incremental (see video). He mentioned that the Fed’s policies have been bold but also halting. Many times, CNBC and other market commentators have put up the very graph I’m about to show you, that of the Fed’s start and stop of quantitative easing and twist since the financial crisis. It is very plain that when the Fed eases policy the market responds as asset prices and commodities rise, even at the hint of it, and then it responds likewise when it stops easing. The market has topped heading into the end of each quantitative easing policy introduction along with the economy because the economy responds to consumer sentiment and that has always taken a hit every time the market has sold off.
Source: dshort.com
To say that the ebb and flow of the S&P 500 has been only influenced by the Fed and nothing else would be too simple. We’ve had the rise and fall of concerns over Europe’s sovereign debt issues and its economy. Additionally, Japan’s production last year came to a stand still for a period of time due to a tsunami and nuclear disaster. But looking at the chart above, it’s fairly obvious that central bank easing has had an incredible effect on equities and interest rates, both in its introduction and withdrawal from the market. And that’s exactly where Steve Liesman’s question is so relevant. It’s pretty clear that the market and consumer sentiment are very dependent upon Fed support right now and it hasn’t been able to wean off the bottle despite the Fed’s effort to remove dependency.
The other simple fact is that investors can’t stand volatility having been through two bear markets. Every 5%-10% correction becomes the basis for the next bear market; when in fact, they’ve been the best buying opportunities in stocks these past three, going on four, years. With Hindenburg omens, LEIs rolling over, and sovereign debt crisis after crisis, the S&P 500 is upnearly 100% from March 2009. The Central Banks of the world do not want to see another financial crisis on the back of the last one. They’re easing and they’re all prepared to do more; that said, we are in the midst of a correction and a bottom will be a process.
Source: StockCharts.com
The equity markets will continue to consolidate until we get the next quantitative easing bottle. So, we’ll suffer from a little withdrawal for a while. On Wednesday the Federal Reserve basically said that the economy hasn’t slowed enough to get the next program underway, and so the target for the market to bottom is lower than here. At the same time, the FOMC minutes last month made it fairly clear that they have already started to hint towards the next dosage of QE with many of the Fed governors falling back into the easing camp. It’s always been a process though. As Liesman stated, Fed policy has been and will be incremental.
It’s my belief, sometime during the next few months, we’ll get the same situation where the market corrects from the top, 5-10%, and out comes QE3. As of today, we’re down 6% from the top. Rephrased in a glass is half full point of view, the market is up 5.6% year to date. The market will likely bottom some time in between the hinting of QE3 and the implementation of it. We never saw the capitulation, technically speaking, that should have happened at 1266. Capitulation is when we get less than 30% of stocks trading above the 200-day moving average and a huge spike in volume. We got treated to a rally that lasted one month. A correction is a process just like the correction in 2010 and 2011. Both of those had one-month rallies before hitting fresh lows. So here we go, buckle up and get defensive if you can’t handle the volatility. I told staff last week the beginning of the next leg down would look like 2500 declining issues on the NYSE, TRIN above 2.5, and the S&P 500 could be down 2%. Yesterday, 2437 issues declined on the NYSE (includes non-stock funds), TRIN closed at 3.5, and the S&P 500 closed down 2.26%.
From a very short-term point of view, it’s critical for 1325 on the S&P 500 to hold. We broke the June uptrend yesterday based on a trendline violation, but 1325 is the last support . The equity market has taken a pause today in typical fashion after such a big loss yesterday and due to the ECB news, but we haven’t rallied back above 1335, or more importantly, back above the 50-day moving average. Those are the key short-term levels to watch for confirmation. We’ll likely trade sideways ahead of the EU meeting next week at which point, if it disappoints like the Fed meeting did for investors, we could thrust down in the direction my chart above shows.
Bull Correction
I don’t believe we’re heading into the next bear market from here because of two reasons: 1) People have been, and continue to be, way too bearish since the 2008 financial crisis and 2) Central Banks around the world are incredibly accommodative.
People are too bearish. I’m going to update the ICI fund flow data which I showed back in January that showed investors continue to flock to bonds and out of equities, all while the broad index of equities—the S&P 500—has risen 100% in three years. That’s not the recipe for a bull market top.
The ICI fund flow data shows market sentiment. Investors have been through two bear markets and they’re scared. Nobody wants to buy equities right now. They want fixed income, security, and guarantees. So bond funds continue to see money come in and equities see money come out.
I can remember a client seminar Jim Puplava did in January 2000. We had just liquidated all of our internet stocks. Some of our clients were furious. We were at the pinnacle of a mania in the stock market and especially in technology stocks. Investors had been through a 10-year bull market with very few hiccups (Asian Currency Crisis and Long Term Capital Management). I remember my girlfriend’s father asking me if I’d be out of the job with the new day-trading fad.
A small portion of our clients pulled their accounts, but we didn’t let that phase us. The moral of the story wasn’t that we got it right, but that the market psychology at the time was incredibly bullish on stocks. Nobody wanted to own bonds at the time, they wanted stocks. From a contrarian point of view, that meant there were very few investors left to keep buying. It was the end of a secular bull market and that was what investor attitudes looked like. With the stock market up 100% in three years as money continues to pour into bonds, this is what the end of a secular bear market looks like.
The second reason I don’t think this is the end of the 2009-2012 bull market is that central banks aren’t restricting access to cheap credit like they do at every market top. Just the opposite, central banks are being incredibly accommodative around the globe. Like the fund flow data shows, that’s just not the recipe for a bull market top.
Yes we have a fiscal cliff around the corner and no, the Eurozone’s debt problems haven’t been solved with austerity, but have you looked at credit markets in a while? Both the credit and equity markets are improving. With the infusion of cash into Spanish banks, yields are coming back down. It’s being hinted that the ECB is likely to cut rates at its next meeting early next month. Today they moved incrementally again with an easing of lending rules to lower funding stress. We’ve yet to see if investors will be satisfied by a new bank union, but they’re certainly moving in the right direction in the past two weeks ahead of so many catalysts. Here’s a few sovereign yield charts to examine:
Portuguese Yields hit Fresh Lows
Italian 10-year back below 6%
Spanish Yields Below 7%
Spanish Bank Rally
The uptrend in Spanish and Italian yields hasn’t broken, but they have eased very nicely recently. Commodity prices have plummeted over the past few months. That’s another form of easing for the consumer. It’s up to the politicians next week to form a banking union, deposit guarantee fund, and possibly a Eurobond or the first steps towards one. That might satisfy creditors and push yields lower, easing fears. Currently they are starting to show an appetite to buy bonds and equities in the region.
Summary
Although the Federal Reserve moved to ease incrementally by extending Operation Twist, it wasn’t enough for risk-on investors. Additionally, the flash PMIs for June yesterday were down. Technically speaking, a key resistance level held between 1358 and 1362 on Tuesday and Wednesday. It was a logical level for bears to begin shorting again. We have a number of events ahead and that may be why the shorts may not press any further unless 1325 gives, at which point the next down leg of the April correction would be confirmed.
