Lower Inflation Causes Bankers to Respond

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The market was extremely choppy last week. Markets began the week strongly and then sold off on disappointing jobs numbers reported before the open on Friday. The S&P 500 has rallied off the June lows. The rally has been led by continued strength in defensive names. Staples, health care and utilities have been areas of strength. Investors have been willing to add to their equity exposure, but they have done so in areas of moderate volatility. With the concerns over Europe and potential for lower earnings growth going forward this makes sense. 

Central banks have been accommodative. Recently, there have been some coordinated efforts to ease rates and increase liquidity on a global basis. Those in the bullish camp will say you can’t fight the Fed (especially on a global basis), the bears will say at some point we are going to have to see better growth.

Central bankers have taken further steps recently to support growth. Their timing is reminiscent of their efforts over the past several quarters. In the spring and summer of 2010 and 2011 we saw easing policy in response to lower growth (inflation) numbers. In the late summer to fall the economy has typically picked up and led to robust markets. The first part of the puzzle for 2012 is in place with accommodative policy actions. Will the result be another robust market late in the year again? Time will tell. 

Over the past three years concerns over waning growth have been met with aggressive moves by central bankers. These moves have been met by a bottoming process in the market and then sharp advances higher. We are definitely seeing an attempt by the markets to bottom. We are in a trading range here. There have been several false breakouts and breakdowns. This stalemate can be breached to the upside if economic numbers begin to surprise to the upside. Is that going to happen any time soon?

Lower inflation takes time to work through the system and lift economic numbers. The prices paid component of all economic measures have been declining for several months. If we look at the calendar for the past few years we are getting close to the time in the year where lower inflation numbers begin to have a positive impact on reported economic numbers. The runs we have seen in the stock market at the end of the year and early into the New Year coincide with the rise and peaking of inflationary pressures. Inflation measures cool and the market eases and the bottoming process plays out in June and July. Will that continue this year or will the growth not be revived in 2012? That is the question the markets are wrestling with right now.

The negative drumbeats are always the loudest prior to a run higher in the market and the bullish babbling heads are always the loudest right before things top out. If you look at the web sites of 100 investment advisors 98 to 99 of them will make mention of how they are free thinkers or contrarian to some degree. That obviously is nonsense by definition. I bring this up because advisors are always most bullish at tops and most bearish, in total, at bottoms. When you look at macro-economic trends and chart them against advisor sentiment they move in lock step. Shouldn’t it be the other way around? After great runs shouldn’t we be taking money off the table as the pros become bearish and buying stocks on pullbacks? The sharp decline in oil prices along with central banker moves has put us in the position where the economic numbers begin to surprise to the upside. 

The technical side of the market remains a range bound mess. False breakouts followed by false breakdowns shortly thereafter. The market remains extremely split. Roughly half the stocks in the S&P 500 are in sound shape technically. Please let me make this clear, the stocks that are not in good shape technically are getting punished. The gains in the broad indexes are covering the fact that many stocks have been in their own private bear market for months. Avoid the "yeah buts." Names that are rolling over technically are providing severe pain to people that make excuses for poor performers. Here are the intermediate resistance and support levels for the S&P 500/Dow/NASDAQ/Russell 2000: 1376/12,965/2990/822 and 1300/12,400/2800/748. Short term support levels are 1330/12,600/2850/775.

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About Thomas J Smith CFA

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