Backed Into a Corner

The Federal Reserve Board has backed themselves into a corner for now, by not showing enough confidence that many investors desired this week. The Fed made clear that they will refrain from shrinking the Fed balance sheet. However, the bulls were looking for additional quantitative easing that just didn’t get announced. Don’t get me wrong – the Fed has the ability to act before their next meeting and if push comes to shove they probably will. So what would be the market’s reaction to some sort of new policy, if it were to be released mid-meeting? Would investors wonder if the Fed has lost control? Would the Fed appear desperate, thereby spooking investors into thinking that things are actually worse than what we already see on the surface (which is not very positive to begin with)?

Economic numbers being what they are (very poor); we should expect a downward revision of second quarter GDP to 1.5% from the originally disappointing number of 2.4%. As more data is being released it is apparent that we are witnessing even further deterioration here in the third quarter. Will we have a double dip or since it officially has never been declared that we have come out of the recession; is this just more of the same?

Globally governments have spent trillions of dollars to revive their economies. We are seeing mixed results from that largess, as some countries such as Germany and China are doing better than others, such as Greece, Ireland and the US. Will more government intervention help? I think not.

We may have reached a tipping point where many are tired of others being the benefactors of taxpayer money. Timing is now important. This week the markets broke their uptrend from early July. The rally from March 2009 was violated a few months back and has not recovered. The Fed will appear to be (once again) behind the curve ball if they make some kind of mid meeting announcement. It may cause more harm than good should the Fed take some action prior to their next meeting September 21st.

Volume has been pathetic, but it has been noticeably lighter on the up days than the down days. There are some technical patterns that have formed that are important to be aware of. Technical analysis DOES NOT predict the future. However, there are trends and formations that have been repeated on chart patterns over time, that indicate a higher than average probability of a predictable outcome. The beauty is, now is a perfect time for a low risk entry point on the short side of the market. Investors will know very quickly, without a large percentage loss, if theses patterns fail.

For example: There was a bearish wedge pattern forming on most of the major market indices. This resulted in a “double top” to be formed at 1132 on the S&P 500. That number is derived from the intraday high on June 21st and August 9th. The wedge pattern is drawn by connecting the lows from July 1st through the bottoms over the subsequent five weeks. The upper band was formed by drawing a line that connected the high on June 25th through the highs over the following several weeks. The technical rules state that if a “rising wedge” is broken to the downside, then prices should decline (at least) to the level at the start of that pattern. That would be 1010 on the S&P 500.

So you could invest in an inverse S&P 500 ETF such as SH (single inverse) or SDS (double inverse for more aggressive investors), and stop yourself out if the S&P rises more than 5% from Friday’s close (above 1132 on the S&P). This is what I call a low risk trade.

Technically you have the double top and the rising wedge pattern suggestion downside risk for the market. We are seeing significantly lower than normal summer volume as well. Low volume usually is the results from a lack of conviction by investors. A possible reason that investors don’t have conviction is that they aren’t clear what action they should take next or possibly there is fear among traders. Generally bad things happen when investors are uncertain or fearful. A final negative technical pattern on the charts is the fact that the S&P 500, Russell 2000, and the NASDAQ Composite all dropped below their respective 21, 50, and 200 day moving averages. Some technicians feel that markets above those respective averages should be bought and markets trading below those averages should be sold.

Fundamentally, we have pretty bad news coming from most every economic report. We have the FOMC announcement itself, which cautioned about a potential slowdown. We have heard individual Fed Governors comparing our future economy to the last 20 years of Japanese styled deflation. Talk about quantitative easing, more government stimulus and state bailout packages usually don’t occur when we have a self sustaining economy. One look at bond prices and interest rates should also yield caution for those investors that think that the coast is clear for the stock market. Investors run for fear to the safety of government bonds in times of trouble. That seems to be the case today.

Both technically and fundamentally I feel we have problems that give a higher probability for lower market prices in the future. Next week is options expiration week and markets tend to go up. The markets are also near term oversold, so the potential for a small bounce exists. However, I think the next primary move for the markets is down. I will remain on the defensive until we go above 1132 on the S&P 500 and 2342 on the NASDAQ.

A couple of good things to close with: Now that interest rates are so low, it is a great time to refinance your mortgage if you can. Corporate America is refinancing their debt at much lower rates in this environment. In the long term that is a very good thing. Many times when fear is this high it actually works contrary to popular belief. Fear is rising, but it is not yet at extreme levels that would set off a rally. Caution remains the word of the day.