A Word Here, A Word There

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What a ridiculous sham. Every few weeks the financial community ‘heart beat’ stops for a few seconds to find out what pronouncements will be handed down from the mount at the latest Federal Reserve meeting. Every few weeks, the parsing begins dissecting each word to see if anything has been omitted, or added, or changed from the prior meeting's text. Immediately, all kinds of wild trading ensues, in some cases, even before any sane person has had a chance to read and digest the intended meaning of the words. It is ironic that all of these fireworks occur following the pronouncement from an institution that stood back literally for years at a time and watched as an enormous credit bubble grew out of control, and then stood back again and watched as that bubble burst.

Even within this institution, many now perceive growing discord within the Fed, as the rumor all day (ahead of the meeting) had been that potentially as many as three out of six board members might be dissenting votes. As it turned out, only Dallas Fed Chair Richard Fischer was the lone dissenting vote, with other potential dissenters likely politically assuaged by means of a tougher wording on inflation in the Fed’s statement. While the Fed still decided to cling to its statement of moderate growth, that conclusion sounds errant in light of the fact that there is a strong possibility that Q2 GDP was boosted solely by ‘one off’ government refund checks. Taking a broader view, a field at the trend of rapidly rising credit card delinquencies, still rising foreclosures, collapsing auto sales, ultra weak employment and ultra tight credit conditions, it is hard to imagine that anyone could feel comfortable with the forward looking prospects for growth. Add to this the substantial roll over that we now are seeing in capital markets for commodities like Energy and Base Metals AND the Emerging Markets and one wonders, is the Fed now missing the next turn, that of deepening recession, -- depression?

Even more to that point, we wonder at what point does an institution such as the Fed lose its credibility? At what point does an institution become irrelevant? The answer to that question is when events have taken on a life of their own, and when their words no longer have any real impact. We have fortunately not reached this point yet, but for all appearances seem to be heading in this direction at a rapid pace. The socialization of financial market bad debts has forced the Fed to act as the lender of last resort, placing its own balance sheet on the line for the ineptitudes which were sewn over so many years of the Greenspan Fed. How dare Mr. Greenspan comment on perils of the current collapse when he was the chief architect of the events now unfolding each and every week.

While the Fed is now focused on the cyclical inflation threat, there is almost no chance that the US economy is anywhere close to being out of the woods. At the present time, credit card companies are rolling over, signaling a likely deluge of rising bad debts, while at the same time both residential and now commercial real estate markets remain in deep trouble. The entire Auto industry is contracting with fresh layoffs announced last week, along with the financial services industry which resides atop a pile of Frankenstein derivatives, awaiting an ‘unknown/unknown’ trigger/catalyst which virtually no one can predict. It seems that against all of this declining tide, the Fed is quickly losing its credibility, and is running the risk of becoming irrelevant. In the days ahead, if foreign capital decides that investing in US Agency paper issued by Fannie Mae and Freddie Mac is no longer a great idea, we may just find out how irrelevant the Fed really is.

Over the last few years, only the rising tide of foreign mercantilist finance has allowed US long-term rates to remain low, an artificial edifice completely detached from the real world which has been governed by skyrocketing commodity prices. Thus, it seems that globalization is now in control, and that decisions on how to deploy foreign investment capital going forward by governments outside the US, and by governments looking out for their own well being, will have as much to do with what happens to the US Domestic economy as the addition or subtraction of a few words each month by a group of academic ivory tower theoreticians. When that day comes, and Wall Street realizes that the Fed is no longer in control of the path ahead for the US economy, bond yields will jolt higher and the Dollar will begin a long spiral down. Only precious metals will prevail, and will prevail on a global scale, rising against all paper currencies as the urge to inflate becomes a global contagion. Sadly, it is a prospect looming larger with each passing week.

Elsewhere, and of greater significance, we note that in his latest pronouncements, Nouriel Roubini, one of a handful of economists including Paul Kasriel, to correctly predict today’s dire circumstances, predicts that we are only in the 2nd inning of this recession and that before it is over, hundreds of banks will fail.

Taxpayers will pay a big price for helping bail out the rest of the financial services industry as well, Roubini said -- at least $1 trillion and more likely $2 trillion. The banks will become insolvent because of mounting losses as a result of the housing bust and because they have only written down their subprime loans so far, he said. -- Still in front of them are their consumer-credit losses, for which they lack the reserves”

Once again, we would agree with him on all counts, as the Fed backstop is far too small to deal with the huge problems that now prevail. Of course, this train of thinking did not seem to worry too many of the longs on Wall Street who appeared to have jumped on the band wagon thought process that the bull market in commodities is now complete. Lower Oil equals higher stock prices was the simple path beyond all the hyperbole which seems to have jump started the DJIA and SPX. Of course, with Oil and many other commodities now moving into deep oversold condition, one wonders how well stock prices will fair should commodities stage a rebound.

Above: S&P 500 with Medium Term ARMS Index

To this end, as far as we are concerned, this is a good time to use a technical approach to markets. Being a lot more quantitative and paying less attention to the babble of CNBC and the Open Mouth Committee can pay useful dividends. A prime focus for us is the Medium Term ARMS which we base on 1500 NYSE stocks. In bear market conditions, the ARMS Index tends to undergo a positive scale shift, with oversold readings pushing the index to new highs in fear. As a result, within a bear market, interim trading bottoms tend to form with the ARMS Index at readings of 1.30 or higher, while subsequent tops tend to form when the ARMS Index drops down to value of .90 or lower.

Looking back at the data we have in hand so far for the bear market, we note that back in August 2007, the ARMS Index peaked at an oversold reading of 1.5040 on August 13th, with the S&P near 1497.00. Three days later the S&P bottomed and began a strong rebound rally, with the ARMS still at ultra high oversold values above 1.30. That rally took control of the stock market for eight weeks and ended with the ARMS Index falling to an overbought reading of .8189 on October 15th, 2007. At that time, the S&P topped at 1560. From there, stock prices then reversed lower and fell a hefty 14.75% over a period of 15 weeks, ultimately bottoming in late January 2008 with the Medium Term ARMS once again well above 1.30, this time peaking on January 24th at 1.4782.

Once again, with excessive fear acting as the prevailing sentiment, prices began a multi-week counter trend rally, with the S&P 500 moving from a low of 1270 in late January to a subsequent peak of 1430 in late May. This time, the counter trend rally phase, which included a test of the lows in March, lasted a total of 15 weeks peaking at the late May high. At that time, the Medium Term ARMS Index once again dropped down to a fully overbought value with a reading of .8690 on May 21st, 2008, back below .90. This was then followed by another 9-week decline and a precipitous slide to new multi-year lows.

Again, selling pressure mounted and the ARMS Index, along with other sentiment gauges like the VIX spiked sharply to the upside as a sense of growing panic prevailed. On July 10th, the Medium term ARMS reached a reading of 1.5147, with a reading on July 11th of 1.4776 with the S&P 500 hitting its intra day low two days later on July 15th at just over 1200. Since then, sentiment has once again reversed course, and is now swinging back toward Greed, another ‘go-round’ on the “Fear & Greed” see-saw that is the discounting mechanism we see as the financial markets.

So where are we right now? Well, on a preliminary basis, the Medium Term ARMS ended today at 1.1021, indicating that while the level of absolute fear has come down appreciably over the last few weeks, the market is still not overbought. However, because this is a medium term moving average, the true impact of strong days like today is not felt on a day over day change, but tends to manifest itself over a period of a week or two. Going back over the last 9 months, we find that there have been three occasions when the ARMS Index fell from around 1.10 to a reading near .90 or lower. Those instances were: April 25, 2008 a reading of 1.0818 which took 14 days to fall to a reading of .8469 seen on 5/14/08, 12/6/07 a reading of 1.0954 which took 12 days to fall to a reading of .9030 on 12/24/07, and 8/31/07 a reading of 1.1199 which took 13 days to fall to a reading of .9120 on 9/20/07. In all instances, we are talking about trading days. Thus, assuming something of a 12 to 14 day time period, we would not expect to see a set of overbought readings prior to the time frame of August 21st to August 25th. Will the market generate an overbought ARMS Index reading below .80 in that time period? We have no idea. The good thing is that all we have to do is recognize the reading when it comes as an indication that the most recent swing from Fear to Greed may be complete. In the world of the stock market, there is absolutely no need for any of us to become “the Great Carnac” as Johnny Carson used to do on “The Tonight Show.”

Instead, in order to avoid losing a great deal of money in the stock market all that is needed is the ability to recognize overbought readings in real time and understand when not to put money at risk. Trying to predict “where the S&P will make its next peak” is simply not necessary; all that is necessary is to understand what the signals are that would indicate another top is emerging and to that end, very low ARMS Index values below .90 are a key ingredient.

Above: A/D Line with 10 day Average Detrend Oscillator

Yet another gauge we watch is based on the action of the Daily Advance-Decline Line. In this case, we are using the cumulative advance-decline line for our universe of 1500 common stocks (operating company only). Once we construct the A/D Line, we then compute a 10 day moving average from which we compute the percentage above and below the average using the end of day data for the A/D Line. Often, when the Daily A/D line is 30% above its 10 day moving average, prices are overbought and near a short term peak. Like all gauges, it can take a few sessions for an indicator to catch up with a fast moving market as was seen today. Most recently, we saw a reading back on July 29, 2008 with the 10 day Detrend Oscillator at a value of +29.39%. That reading was followed by a vicious three day decline in the S&P and the high that day had capped the S&P until today, a period of 9 trading days. Will we see another such reading in the near term? Our answer: it is very possible and indeed likely. With today’s strong advance, the oscillator closed at +11.29%, up from a –6.09% on Monday. If the S&P is able to build on today’s gains and hold onto its gains for another few days, it is possible that another signal could be seen within a few sessions from today. In bear markets, signals like this tend to be rally killers.

Finally, we end today with a look at one last chart, which we believe may also be a useful reference two to three weeks from now. In this case, we are looking at the 20 day average of Advance-Declines, which forms an oscillator between roughly –100 and +100, although the high end of the range has been reading of +80 to +100, while the low end of the range in a bear market can be more like –150 to -175. From a deeply oversold value of –223 on July 11th, the indicator is making its way steadily back up across the range, ending at +.60 with today’s close. Yes, there is still room to the upside on this gauge and that means that die hard BEAR’s need to stand back and let the stock market squeeze out more shorts. The S&P may go a bit higher, but at some point, we will see another round of overbought values, and that will be another signal to consider turning more aggressively bearish.

Looking back, all of the recent peaks in the +80 to +100 zone have been a veritable “Who’s Who” of stock market tops, and if our big picture analysis is correct, that the worst is still in front of us, then missing the next signal could be an expensive proposition. For now, it appears as though the latest swing from Fear to Greed still has more time on the clock, and we are watching price resistance on the S&P at 1292 very carefully. In the end, a word here, or word there, from the Fed isn't going to mean much to most investors, but a high confidence sell signal in a bear market, -- well, that can make a huge difference.

At the close, stock prices soared with the DJIA gaining 331.62 index points to close at 11,615.77 for a gain of 2.94%. The S&P 500 gained 35.87 to finish at 1284.88, for a gain of 2.87%, while the NASDAQ Composite gained 62.53 index points or 2.74% to finish at 2348.09. Yields on the 10 Year Bond ended at 4.04%, with nearby August Gold ending down $22.10 to finish at $885.80.

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About Frank Barbera CMT