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Waiting for QE2

(October 17, 2010)

Dear Subscribers and Readers,

Let us now begin our commentary with a review of the 12 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145; giving us a gain of 917.78 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

A major prediction market for political results, Intrade.com, suggests an 85% chance the Republicans would control the House after the mid-term elections.  As shown in the following chart, the probability of the Republicans taking the House crossed the 50% threshold in July, and has since steadily increased:

At this point, it is safe to say that unless the Republicans lose the House, the impact of the mid-term elections should have minimal impact on the stock market (as discussed in last weekend's commentary).  Because of this, I expect Federal Reserve policy (to the extent that it differs from the “consensus”—whatever that may be) to dominate the action of the markets in early to mid-November.

Turning to Federal Reserve policy, there's no doubt that the Federal Reserve will expand its quantitative easing policy (aka “QE2”) at the conclusion of its next Fed meeting on November 3rd.  While Bernanke did not get into specifics in his speech at the Boston Fed last Friday, he did reinforce and emphasize the Fed's “dual mandate” of targeting a specific range of inflation and unemployment for the U.S. economy.  As of today, the Fed's inflation target is about 2% while its unemployment target is in the 5% to 5.25% area.  Bernanke even went as far as emphasizing that today's inflation rate is two low, while unemployment is too high.  Following are two charts (courtesy of Goldman Sachs) showing U.S. inflation and unemployment rates over the last five years:

Furthermore, both the ECRI Weekly Index for U.S. economic growth and the ECRI Future U.S. Inflation Gauge show no signs of either a sustained economic recovery or a pick-up in inflation.  If these did not provide strong enough signals of an impending QE2 policy, Charles Evans of the Chicago Fed indicated on Saturday that the U.S. economy is stuck in a “liquidity trap,” and suggests that the Fed should target a specific target for price levels, as opposed to a rate of inflation.  More specifically, Evans suggested that the Fed should aim to generate higher-than-normal inflation in order to make the price level the same as if prices had risen by an annualized 2% since December 2007.  Such a radical move would mean much more asset purchases, possibly including riskier assets such as AAA-rated municipal bonds, corporate bonds, or asset-backed securities.  While the Fed is nowhere close to adopting such a policy, the fact that it's been mentioned suggests that QE2 is “in the bag” at the conclusion of the November 3rd meeting.  We expect the Fed to expand its asset purchases by at least US$500 billion, with more purchases to be announced early next year.  Given the overbought nature of the market and the development negative divergences – as well as the fact that QE2 is already discounted into asset prices – I continue to expect the market to be range-bound going into Thanksgiving, if not into Christmas.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2007 to the present:

For the week ending October 15, 2010, the Dow Industrials rose 56.30 points, while the Dow Transports rose 66.39 points.  Both the Dow Industrials and the Dow Transports are now challenging heir cyclical bull market highs.  While the technical condition remains solid, the market is overbought on a short-term basis and still exhibiting negative divergences.  Subscribers should also be concerned about “whipsaw risk,” as the market has been mired in a trading range over the last five months.  Combined with the lack of bullish signals from our global liquidity indicators (as well as the fact that the market has already discounted the Fed's QE2 policy), the market action could remain range-bound into Thanksgiving or even Christmas.  For now, we will remain 50% long in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators increased from a reading of 12.6% to 14.5% for the week ending October 15, 2010.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1998 to the present week:

The four-week MA increased from a reading of 12.6% to 14.5% last week, and is at its highest level since mid-May.  This sentiment indicator is getting overbought—at least relative to its readings over the last few years.  In addition, our liquidity indicators are not yet flashing bullish signals, especially since the market has likely factored in the Fed's QE2 policy.  We will thus retain our 50% long position in our DJIA Timing System.  In the meantime, the action of the U.S. stock market will likely remain range-bound into Thanksgiving or even Christmas, even if the Republicans take the House in the upcoming mid-term election.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

The 20 DMA increased from 122.2 to 123.1 last week—reaching its highest level since early May—while the 50 DMA increased from 112.6 to 113.5.  The 20 DMA has been above its 50 DMA for five weeks, suggesting that ISE Sentiment is in an uptrend.  While this is normally a bullish signal, subscribers should keep in mind that the market has nonetheless remained range-bound for the last five months.  Moreover, our liquidity indicators are not flashing bullish signals—suggesting that the market will likely be mired in a consolidation period into Thanksgiving or even Christmas, even if the Republicans take the House in the upcoming mid-term election.  We will remain 50% long in our DJIA Timing System.

Conclusion: At this point, it is likely that the market has already factored in a Republican victory in the House and the beginning of the Fed's QE2 policy on November 3rd—starting with a commitment to purchase an additional US$500 billion in Treasuries.  Going forward, the QE2 program would likely hit US$1 trillion or more—and should inflation continue to stay low or should unemployment remain high, I would not be surprised if the Fed adopt a more radical policy and purchase riskier assets, such as AAA-rated municipal bonds, corporate bonds, or asset-backed securities.  Given that the market has been range-bound over the last five months, and combined with the challenging liquidity conditions, probability suggests that the market will likely correct or consolidate further in the short run.  We are staying with our wait-and-see approach, and remain 50% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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