Current Economic Status and How to Invest

Written by Macrotides

Note: Read the companion analysis article “Dealing with the Global Fianancial Crisis:  Focus Europe” for more background on the macroeconomic picture.

Our view has been the U.S. economy would gradually slow, Europe’s troubles would go from bad to worse, and China would avoid a hard landing. Since everything is unfolding as expected, why bore you with all the details. The charts below tell the story.

U.S.

China

Stocks

As discussed last month,

“Sell in May and go away” is an old Wall Street axiom that has gained traction, after working well in 2010 and especially last year. As natural contrarians we would be skeptical of it working for a third year in a row. However, if we’re right about Europe and a slowing U.S. economy, it is likely to work again this year.

The DJIA made a new recovery high on May 1, which was not “confirmed” by any other major average also making a new high with the DJIA creating a divergence. This divergence between the DJIA and the rest of the market has historically been a warning sign, sometimes an important one. We thought the S&P might be able to get above 1,422 and recommended becoming aggressively defensive if it did. Unfortunately, the market was not so accommodating.

Since reaching 13,338 on May 1, the DJIA has peeled off just over 1,000 points. Over the same span, the S&P dropped from 1,415 to 1,292.  We think the S&P will fall below 1,292 and test the 200 day average near 1,282 soon.  If this occurs before the S&P climbs above 1,358, it will suggest the long term trend of the market has turned down.  The market is oversold and sentiment has become fairly defensive.  As long as Europe doesn’t blow up in the next few weeks (no sure thing), the market should hold up and attempt to rally for a number of weeks, even if the longer term trend is down.  The tricky part going forward is guessing when the Federal Reserve or ECB will choose to launch QE3 or another round of LTRO.  The markets will likely enjoy a strong rally on that news, but it will be a fool’s rally.  Sooner or later, investors will learn that central bank stimulus is only a short term fix for the stock market, and won’t spur a sustainable economic recovery.  When that day comes, the market will be especially vulnerable to a sizable decline.  We will cross that bridge if and when we get there.

Bonds

Over the last few months, we recommended buying NYSE:TLT, the 20-year Treasury ETF.  The average price was $114.66.  Our expectation has been that it would exceed its October 4 high of $125.03 before year end.  It traded as high as $124.45 on May 21.  Sell half if it trades above $124.45, and raise the stop to $119.49.

Dollar

Last month we said,

“When Europe heats up, so will the Dollar”.

And so it has. Raise the stop on the dollar ETF (NYSE:UUP) to $22.00. We still believe the Dollar index will approach 89.00 over the next year.

Gold

For months we have felt Gold would decline to $1,525 – $1,550. Last week, Gold dropped to $1,527, which may have completed a triangle pattern from last September‟s high above $1,900.  We would recommend establishing a 50% position in Gold via the ETF NYSE:GLD on weakness, which is priced as 10% of Gold.  We would use a stop of $147.50. If Gold breaks below $1,500, it would likely suggest a systemic liquidity problem like last year, or selling by the European banks, since they may need to sell Gold to shore up their balance sheets.