Stocks
Stock market bulls have said it is actually good news that the Fed has enough confidence in the economy to begin paring its QE3 purchases, especially if growth accelerates as forecast. Higher growth will translate into better earnings, since companies have done a great job in controlling costs. Increased revenue will drop to the bottom line, and allow for a further expansion in the market’s price per earning (PE) ratio. If the Fed begins paring its QE3 buying, even though the economy remains stuck in its 2% growth pattern, the stock market could be faced with an unpleasant outcome: very little increase in earnings and tapering. According to Bloomberg, absent the 27% second quarter increase in bank earnings, S&P 500 earnings would have fallen -1.2%. The majority of companies are finding it increasingly difficult to boost earnings without revenue growth, and buying back stock is not a long term growth strategy. The Federal Reserve has counted on the wealth effect from a rising stock market to keep the top 20% of wage earners spending. A sharp decline in the stock market could weigh on future growth and not be helpful. This is another reason to expect the Fed to very gradually exit QE3.
In our quarterly Macro Market Update webcast on July 10, we suggested selling into strength, if the S&P 500 approached 1,700 as we expected. Last month, we thought volatility was likely to increase in coming months as investors attempted to discern the Federal Reserve’s tapering plans. We noted that the S&P 500 was touching the upward boundary of the channel it has traded in since 2010, and for the first time in many months, the Advance/Decline line was lagging. We concluded it was time to lower exposure. After peaking on August 2 at 1709.67, the S&P 500 dipped -4.0%.
The Major Trend Indicator (MTI) is a proprietary indicator we use to measure the strength or weakness of market rallies and declines. Whenever a rally carries the MTI above 3 (shaded area), it is a sign of market strength. The recent rally that peaked on August 2 pushed the MTI to +4.41. This suggests that after the current correction runs its course, the probabilities favor another rally. In June we were fairly certain the S&P 500 would at least test the May 22 high. We are less sure now, since a rally back to the August high is more dependent in the short run on a reasonable decline in Treasury bond yields than the economy.
Based on the chart of the S&P 500 we can identify important levels. The trend line connecting the low on December 31, 2012 and the low on June 24 comes in around 1620. If the S&P 500 breaks below that support, the next stop could be near the June 24 low at 1560. There also two other trend lines that converge around 1550. Should the S&P 500 fall to 1550 – 1570, the market would be oversold and likely find good support based on the June 24 low and these trend lines. As we have noted each month, since the March 2009 low, the S&P 500 has continued to make higher highs and higher lows, which means the long term trend is up. This would change if the S&P 500 falls below the June low of 1560. We would also become concerned about the market, if the Major Trend Indicator failed to exceed 3.0 on a rally. The last time that occurred was in July 2011 and was followed by a 19% decline.
Bonds
Our experience has taught us that important turning points in a market are often revealed through technical analysis and before the fundamental news becomes apparent. The chart pattern in the bond market over the last few months is instructive. In our June commentary we stated, “The yield on the 10-year U.S. Treasury bond has risen above the peak from March of 2012 at 2.4%, which is a negative for the long term trend.” In our July commentary we wrote, “Any rise above 2.74% and the down trend line from 2007 would be a significant negative and imply that the major trend in longer-term rates had turned up.” The 10-year U.S. Treasury yield has decisively broken out above 2.75% and the down trend line from 2007.
The increase in the 10-year U.S. Treasury yield since May 22 has caused the bond market to become oversold and sentiment extremely bearish. This suggests the bond market is ripe for a rally. It would be normal for the bond market to test the down trend line from 2007, even if yields eventually go higher. At a minimum, a decline in the 10-year U.S. Treasury yield yield to 2.70 is likely in our opinion. If the economy fails to accelerate as we expect in coming months, and the Fed adopts a gradual approach to tapering, there is a chance it could fall to 2.5% in coming months.
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Definition of Terms
Advance Decline Line is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.
European Central Bank (ECB) is one of the world’s most important central banks, responsible for monetary policy covering the fifteen member countries of the euro zone. The ECB, established by the European Union (EU) in 1998, is headquartered in Frankfurt, Germany.
Fitch Ratings is a global rating agency that provides the world’s credit markets with independent, timely, and prospective credit opinions.
FOMC (Federal Open Market Committee) is the branch of the Federal Reserve Board that determines the direction of monetary policy. The FOMC is composed of seven Board of Governors and five reserve bank presidents. The FOMC meets eight times per year to set key interest rates and to decide whether to increase or decrease the money supply, which the Fed does through buying and selling government securities. The meetings of the committee, which are secret, are the subject of much speculation on Wall Street, as analysts try to guess whether the Fed will tighten or loosen the money supply, thereby causing interest rates to rise or fall.
Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.
HSBC Flash Manufacturing PMI Index is an index that monitors China’s estimate of the Manufacturing Purchasing Managers’ Index (PMI).
Loan-to-deposit ratio is a commonly used statistic for assessing a bank’s liquidity by dividing the banks total loans by its total deposits. This number, also known as the LTD ratio, is expressed as a percentage. If the ratio is too high, it means that banks might not have enough liquidity to cover any unforeseen fund requirements; if the ratio is too low, banks may not be earning as much as they could be.
Mortgage Back Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
Price-to-earnings (P/E) ratio of a stock is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income.
Purchasing Managers Index (PMI) is a composite index of five sub-indicators (production level, new orders from customers, supplier deliveries, inventories and employment level) which are extracted through surveys to more than 400 purchasing managers from around the country, chosen for their geographic and industry diversification benefits. PMI is an important sentiment reading, not only for manufacturing, but also for the economy as a whole. For this reason, the PMI is closely watched, setting the tone for the upcoming month and other indicator releases.
Quantitative easing (QE) refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.
S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.
Structured Investment Vehicles (SIV) is a pool of investment assets that attempts to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities (ABS).
10-Year U.S. Treasury bond is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.
Volatility is a statistical measure of the dispersion of returns for a given security or market index.
One cannot invest directly in an index.
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RISKS
Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.
This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.
Jim Welsh is a registered representative of ALPS Distributors, Inc.
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