Don't Fight the Fed

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The market is singing a new tune. The first verse, “Don’t fight the ECB”, is followed by a continuous chorus of, “Don’t Fight the Fed.” Back and forth the market is singing with iPhones and lighters held high, while drowning out a minority of those unswayed by the crowd's euphoria.

That minority currently consists of permabears and deflationists who continue to pound the table of an imminent collapse precipitated by a spiraling depression in Europe, break up of the EU, and the abolishment of the euro. There was a lot of fodder to work with over the last two weeks to make such claims. Here is a breakdown of the bearish points:

  • Company Earnings
    • Intel warns
    • Federal Express misses and guides lower
    • Norfolk Southern misses
    • Caterpillar warns about 2015 growth? Really?
    • Jabil Circuit misses
  • Doubts over the ECB’s new bond purchase program (OMT)
    • German Bild talked about legal challenges of the new program
      • Reuters said ECB thoroughly studied the legal question before introduction of OMT
    • Bundesbank head, Weidmann, hinted others at the ECB share doubts over Draghi’s plan
  • The Spanish and Greek question
    • How much austerity can the country take?
      • Protestors swarm Spanish Parliament Tuesday – demand new elections
      • 60,000 people rioting in Athens Wednesday throwing gas bombs and marble
    • Will Spanish Prime Minister Rajoy seek the conditional aid to trigger the OMT?
    • Unemployment remains high in Greece. Will they be able to continue to cut to appease the Troika?

To me, these are all just excuses to take profits. The real cause was mentioned on the Financial Sense Newshour two weeks ago. The market was overbought September 14th. Additionally, post the Federal Reserve meeting, the market would be void of any major catalysts. It wouldn’t be until Spain accepted conditional support from the Troika and/or the earnings and EU summit events next month that any major positive development would surface to drive the market higher. A quiet market and overbought conditions were the perfect setup to cash in some 3rd quarter profits – especially with underperforming managers are nervous about ytd returns.

An overbought market September 14th

Breadth indicators in overbought territory (70%+)

  • 90% of the S&P 500 was above 10-day moving averages (short-term)
  • 86% of the S&P 500 was above 50-day moving averages (intermediate)
  • 81% of the S&P 500 was above 200-day moving averages (long-term)


Momentum overbought

  • 14-day RSI of 74.74. When overbought is a reading above 70 for a bullish trend
  • September 14th’s close was more than 2 standard deviations away from the 50-day moving average.

sp overbought

So the market was overbought on September 14th after two weeks of shock and awe from the ECB and the Fed. The logical conclusion after that move was a correction, especially with the void of major catalysts. The more important question isn’t why the market is correcting, but where will it find support? As I showed in the chart above, there are two logical areas of support nearby for the current uptrend. The first is the 1429 to 1439 zone  the S&P 500 reached after the ECB announcement. Yesterday’s low was 1430. Coincidence? No, it’s called technical analysis. Additionally, we have an accelerated trend (dash line above) since the September low couldn’t quite reach the 50-day moving average. Those two supports mark the first important support area. As such, the market rallied today from that area based on technical support and two catalysts. A major support under 1430 is near the rising 50-day moving average and the May high near 1415.

The two catalysts were China and Spain. China rumors continue to mount regarding more stimulus. Recall their last package was two weeks ago, announcing 150B yuan towards scientific and technological innovation with another 300 billion between 2016-2020. Fiscal is now meeting monetary stimulus in China. The Shanghai was up 2.6% overnight leading into our opening. They have one more session before a week-long holiday. Shortly after mid-October will be the leadership change and policy will likely be a lot more laid out after that. As such, investors might be thinking it’s a good time to cover shorting or invest – especially at psychological support near a nice round number, like 2000.

The second catalyst was Spain, which held its economic reform and budget press conference that was announced last week. Spain will implement austerity measures that they believe are enough for the ECB to activate its OMT program. That last comment hit around 11:55 a.m. ET which helped the market breakout intraday from 1440 to hit highs near 1450. So why would Spain announce new austerity measures without first applying for aid from the Troika?

Maybe it’s because the object of the conference was to tell Mario Draghi of the ECB: look at us, we’re preparing for the conditionality of the EFSF, ESM, and ECB terms for help. Essentially, the ECB can start buying bonds with the mere “possibility of EFSF/ESM primary market purchases” which I explained on the Financial Sense Newshour two weeks ago; such that the ECB could buy bonds without the bailout funds being tapped first. They created a second tier of rescue support. There’s the Greek/Irish/and Portuguese-like full enchilada package that carries a bad stigma in the credit markets because they’re adding more debt or they have a taco a la carte with just ECB bond purchases to assist in stabilizing the bond market – without taking on more debt. That equals a happy credit market. That’s the best buffer the ECB can offer while politicians continue to bide their time (kick the can) for a better economy or more cutting and taxes to set in.

Tops and Bottoms are a process

Personally, I think the recent dip was a buying opportunity so I bought some stocks yesterday. That’s what we’re supposed to do as investors in uptrends right? Short-term indicators have hit oversold areas and the market pulled in 40 points from the September 14th high. Tuesday’s economic numbers were great with consumer confidence seven points above consensus at 70.3 and the Richmond Fed survey that turned positive for the first time in a few months.

Let’s say the worst case scenario is upon us and the market is beginning a topping process, like in April. Here's what you should be looking for:

  • A shift out of risk assets and into defensive sectors. (false)
  • Leading economic numbers and Fed surveys roll over (false)
  • Transport or Industrial indexes not confirming each other in new highs (true)
  • A lower high, or at least a break, in the market trend (false)
  • Momentum failure (false)
    • Flat/sideways market from support to break (false)
    • Momentum divergence at a higher high (false)
  • Distribution with 2400 or more declining issues on the NYSE in a given day (false)

Almost every one of those steps were checked in the market top this Spring. It took two months for the S&P 500 to roll over from March to April when it finally broke in May. It broke for one month and then central bank accommodation jumped to the rescue again. That began on May 16th when the FOMC minutes said “several members indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough?” as opposed to only a “couple” the month before. That was the day I bought gold again after selling it in August 2011.

Fight the Fed if you must, but bring a few trillion dollars with you to the match. Even then, it pales in comparison to the unlimited “printing” capacity of the Central Bank. The definition of “printing money” isn’t as literal today as it was decades ago. The Fed doesn’t have to physically print Federal Reserve Notes to increase its balance sheet. It can do it electronically now with a powerful tool called digits. They add them...quite effortlessly I may add…$40 billion more a month now until it works, they said. That’s the difference this time around. The time clause for QE3 is “through the end of the year” unless – and a very big unless at that – the labor market does not improve substantially. The end of QE3 isn’t based on a calendar date, but on a statistical figure and the subjective definition of “substantial improvement”. QE 3 is open-ended and there will be a lot of speculation around its end point. The end result of that speculation will be a volatile end to the next cycle up in risk assets.

On September 24, 2010, David Tepper, President of the Appaloosa Fund, was interviewed by CNBC for 30 minutes. The setting was a month after Bernanke’s notorious Jackson Hole speech that indicated to the market they were leaning towards buying Treasuries to bring down interest rates. David said he’s was buying stocks at the time, because “everything will do well” in the near-term. If you want to know what “smart money” does when the Central Bank says they’re going to buy assets, you need to watch this interview. It was timely, simple, and wise advice. Again, the advice to listen to in this environment is: Don’t fight the Fed.

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About Ryan Puplava CMT