Central Banks May Limit Severity Of Any Stock Market Correction

Pullbacks Do Not Always Come When Crowd Expects

Markets must climb a wall of worry. The long-time expression on the Street is backed by common sense. If investors are worried, then it stands to reason that they may have kept some money on the sidelines for the pullback they “know” is coming soon. Conversely, if investors were theoretically 100% confident that stocks would push higher, then everyone would be fully invested. Worry means cash is available to provide buying power. 100% confidence means buying power is limited.

Doubters Could Be Swayed By Money Printing

If you have cash on hand because you are expecting a pullback, what might cause a change of heart? One powerful source of motivation in the markets is the fear of missing out. The Fed persuaded some “wall of worriers” to redeploy cash Monday after making market-friendly statements. From Bloomberg:

Three Federal Reserve officials who vote on policy this year signaled the Fed may press on with easing for some time to reduce the jobless rate and push up inflation toward the central bank’s 2 percent target. “Monetary policy in the United States is likely to remain highly accommodative for some time,” Fed Governor Jerome Powell said yesterday in a speech in San Francisco. Boston Fed President Eric Rosengren backed further easing to “achieve full employment within a reasonable forecast horizon,” while James Bullard of the St. Louis Fed said in an interview on CNBC he wants the Fed to “meet our goals,” singling out inflation.

Improvement Was There For All To See

Clear and observable improvement in weekly trends began when the stock market found a bottom on October 9. Our market model, which uses binary and unbiased inputs, picked up on the change in investors’ tolerance for risk on October 10, necessitating some changes to our investment allocations.

Twitter Provides Sentiment Gauge

There is a reason traders who focus on price are successful. Price captures the aggregate opinion of all market participants about future economic outcomes, earnings, valuations, systemic risk, monetary policy, the Fed, etc. Technical analysis (TA) is the study of charts. Charts provide a vehicle to monitor price or what “is happening”, rather than what “we think will happen” or “what we want to happen”. The power of charts, and why they are used by the vast majority of pension funds, is they allow us to monitor the mechanism that sets asset prices. If you understand how assets prices are set, then the value of monitoring charts is easy to understand.

The table below shows the technical health of the weekly battle between bullish economic conviction and bearish economic conviction, which is what determines the value of our investments. The table summarizes visible evidence from charts. The 99% next to the S&P 500 ($SPX) means that 99% of the binary questions, relative to the weekly trend, returned “bullish” answers and 1% came back with a “bearish” response. Save the “it shows an overbought market” comments for another time; markets can advance for weeks or months with scores similar to the ones in the table below.

Despite the clear evidence of improvement since the October 9 low in stocks, the chatter on Twitter over the past four weeks has been sprinkled with doubt. Tweets about non-confirmations, divergences, short positions, rising wedges, and broadening tops have been easy to find as the S&P 500 tacked on over 100 points. That fits the profile of a wall of worry.

Cracks Could Fuel Pullback In Stocks

Is everything rosy when examining the battle between bullish economic conviction and bearish economic fear? No, some cracks have started to form over the past two weeks. The table below shows observable weakness in the credit markets (JNK vs. TLT), small caps (IWM), and financials (XLF). The green and orange tables are explained in more detail in this November 2 video segment.

Wonder Twin Powers Activate

As the little kids say on the AT&T commercials “more is better”. The waiting for a pullback crowd is also getting a little nervous about a dual money printing threat as the Fed and European Central Bank continue to hint at accommodative policy. From Reuters:

European shares touched a fresh five-year high and the euro dipped on Tuesday with speculation mounting that the European Central Bank will signal an easing of monetary conditions at its policy meeting this week. The likelihood of looser policy from the ECB comes as markets increasingly price in the prospect of the U.S. Federal Reserve maintaining its huge equity and commodity friendly stimulus into next year. Public comments by Fed officials on Monday stressed that the U.S. central bank was in no hurry to taper its asset purchases and would only begin when the U.S. economy showed clear signs of improvement.

To stay on the ECB’s low interest rate page, a European Union official recently called for diligence on the easy money front. From Bloomberg:

“We are seeing clear signs of an economic turnaround, but growth will pick up only gradually and will translate into jobs only with a lag,” EU Economic and Monetary Affairs Commissioner Olli Rehn told reporters in Brussels. “We must not fall into the trap of complacency. Further decisive action to boost sustainable growth and job creation will continue to be necessary in Europe.”

Market Breadth Quietly Improving

If you follow the markets closely, you know when the term taper burst onto the scene in late May, the tone of the markets changed significantly. The chart below shows the percentage of NYSE stocks above their 200-day moving average. The 200-day is used by traders to monitor longer-term trends. Healthy markets tend to have broad participation. The chart below is one way to monitor participation or market breadth. Market breadth was clearly in a bearish downtrend over the summer (see orange arrows). Three steps are required for a bullish change in trend; all three have been completed, which signals a change in the market’s bias.

Investment Implications – Pullbackers May Be Disappointed

Markets rarely fulfill the hopes and desires of the masses. The trading crowd still seems to be hungry for bearish evidence. Bullish evidence has been keeping company with crickets. While the previous statements are anecdotal, they align with the wall of worry theory of cash levels and buying power. The orange-filled table presented earlier tells us to respect the possibility of a pullback in stocks. However, those who have missed the sharp rally off the October 9 low may be quick to redeploy their cash with central banks ramping up the easy money rhetoric.

If weakness is in the probability cards, the blue trendlines (A and B) may attract buyers near 1760 or 1750 on the S&P 500. If 1750 fails to hold, horizontal support, based on key levels in September and October fall between 1733 and 1721 (see pink lines C, D, E, and F).

Our game plan, given what we know today, is to exercise patience during any corrective activity in stocks, but we are open to making adjustments based on the observable evidence if necessary. We continue to hold positions in the United States (VTI), Europe (EFA), and emerging markets (EEM).

This entry was posted on Tuesday, November 5th, 2013 at 10:51 am and is filed under Stocks - U.S.. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.