Fed and Technical Updates
(April 28, 2011)
Dear Subscribers and Readers,
While we had expected the Fed to let its QE2 policy run until its June-end expiration, it was good to get that confirmation in the FOMC statement yesterday. More important, there is no evidence or common sense in expecting the Fed to begin another round of easing (QE3). Since this was the consensus, and I do not see any wild swings in the markets after the program expires in June. This is definitely not a surprise given the strength in the leading economic indicators, the weakness in the US$, and the recent pick-up in commodity prices (although the latter needs to be "corrected" through tightening by EM countries). Of course, there is still some "slack" in the domestic economy but capital expenditures are strengthening (e.g. Union Pacific just announced a record capex plan) and bank lending is no longer weakening and capital ratios and credit quality at commercial banks are very strong. Households' debt obligation ratios are also at their lowest levels since the mid-1990s given the (forced) pick-up in domestic savings and relatively low interest rates. Meanwhile, the ongoing weakness in the commercial and residential real estate markets is structural in nature and will take years to play out.
We believe it is counter-productive for the Fed to ease further under virtually all circumstances. For example, fiscal tightening will not occur until a couple of years from now at the earliest. The weakness in the US$ is also significant (nearly 10% against the Euro on a YTD basis); and a significant reason has to do with the Fed's QE2 policy (or at least investors' reaction to it; while the ECB tightens). Moreover, contrary to many standard international financial textbooks, we do not believe a lower US$ will really help net exports. Firstly, there is a significant lag in the response of exports to a lower currency (plants need to be built, etc.)—and a 10% lower cost of business would not do much to shift Asian manufacturing back to domestic shores (unless “3D printing” is commercialized on a mass scale). Secondly, energy demand is very inelastic. Since a lower US$ also translates to high oil prices, a lower US$ may actually result in a decrease in net exports (i.e. higher oil imports), at least in monetary terms.
In the meantime, the US and global equity markets keep powering higher, which is not a total surprise. As we've mentioned, we are currently neutral in our DJIA Timing System, but may shift to a 50% short position should the Dow Industrials rises to the 12,750 to 13,250 range. While valuations are still supportive for higher prices, our liquidity and technical indicators suggest that the underlying market is weakening. One of the more flagrant non-confirmation of the new bull markets has been the weakness in the NYSE Common Stocks Only (CSO) McClellan Summation Index, as shown in the following chart courtesy of Decisionpoint.com:
As shown in the above chart, the NYSE CSO McClellan Summation Index has been making lower highs since April 2010. It also made its high for 2011 in late February, and has weakened substantially since, despite new cyclical bull market highs. Another indicator—one of the most popular technical indicators in history—is the relative weakness in the NYSE CSCO Advance/Decline line (see following chart courtesy of Decisionpoint.com). Although the NYSE CSO A/D line has made a new high, the A/D Volume line (bottom panel) has not made a new high since late February:
Finally, the NASDAQ A/D Line has actually not made a new cyclical bull market high since April 2010, despite the NASDAQ Composite making a 10-year high just yesterday (again, see following chart courtesy of Decisionpoint.com):
The $64 trillion question is: Has there been too much technical damage done? We believe that the market is likely to move higher in the short-term, given the strong momentum. However, our liquidity and sentiment indicators do not support a sustained move higher for the rest of the year. Should the stock market rises to the 12,750 to 13,250 range, we will likely go 50% short in our DJIA Timing System. Subscribers will receive a real-time email once/if that occurs.
Henry To, CFA, CAIA