Nothing to Cheer About

My daughter is a cheerleader at her school. As you know cheerleaders have to cheer for their teams through good and bad times no matter what. It seems that investors today are acting as cheerleaders for the Federal Reserve. The current chant goes something like this; “Go Ben – Print more money – Buy more Bonds! Go Ben Go – Buy more Assets!”

It doesn’t matter that this same Fed that back in the beginning of 2007, when New Century Financial (the first big time subprime lending company) failed, the Fed continued to talk about ‘excess liquidity.’ When the problems became worse the Fed said that the problems would be contained to only subprime loans. When the problems spread from subprime to prime loans - this same Fed clearly announced that the problems would be minor and not extend into the rest of the US economy.

When the economy started into a full blown recession in 2008– Fed officials were saying it would only be a soft patch in a robust economy until it was too late. They were behind the curve ball all the way down. The first Quantitative Easing program, which had the Fed buying mortgage securities in an attempt to keep interest rates low to stimulate the housing market, was only partially successful. Because, while interest rates for mortgages stayed low, seniors on fixed incomes suffered and the housing market still remains vulnerable. So far Fed actions have not been too successful are reviving our economy on a widespread basis – just look at job growth or the lack thereof.

Some will argue that without the Fed things would have been much worse. That is debatable. My contention is that we would have dropped farther and faster, but the recovery would have also been much quicker without the humongous debt burden we created that will likely last for generations. But that is not the point of discussion in this prose. The real concern is that if investors feel that America is on the road to recovery – what do we need to print another trillion dollars for (QE2)? Could it be that structurally we still have some issues? One would never know it judging from the complacency of investors.

The VIX fear index is at extreme low levels. The AAII investors’ sentiment gauge also shows a high level of bullishness and an extreme low level of bears. The spread from bulls to bears is one that is normally associated with market tops. This could mean that investors either trust or fear the bearded one who wields a big printing press. Institutions are also very bullish as mutual funds are carrying near record low levels of cash today. Also adding to the mutual fund dilemma has been the record amount of redemptions by individual investors from stock funds over the preceding several months.

From a technical perspective, I see a very extended rising bearish wedge pattern formed since the August 31st lows on the major indices. The market run up over that timeframe also has an eerie similarity to the run up from February to the April highs of this year. I observe a double top formation with the current and April highs and the markets are currently intersecting their respective 200 week declining moving averages, adding resistance to the uptrend. We have more volume on the down days than on the up days, signaling distribution. The High Frequency Traders that caused the flash crash in May still constitute the majority of the volume each trading day – which to me still demonstrates potential instability.

The market set up is very similar to the April highs, but the only thing missing is a catalyst to get the market moving up or down from here. I am very concerned about the inverse relationship markets have with the US Dollar. Sentiment on the dollar is 100% bearish! The old adage is to invest opposite of everyone else – especially when everyone is all on one side. You cannot get more bearish on the dollar than what it is today. If the dollar reverses back up and the inverse relationship holds true to form – then the stock market could be in for a reversal. Now the dollar bears are going to see the QE2 that’s coming and state that the dollar is going to continue its slide. It wasn’t too long ago that many pundits were saying that the Euro would not only drop to par with the US dollar – but it would cease to exist as a currency. Look what has transpired since. The only certainty is change.

Now is a time for caution! Some major events are coming soon. The election on November 2nd and the much anticipated Fed announcement the next day to name a few. Clearly investors are cheering, hoping, and waiting for the next move by the Fed. November 3rd cannot get here soon enough. Is this going to be one of those buy on rumor and sell on news events? Can the Fed live up to the expectations built into current market prices for another round of quantitative easing? Will the Fed’s action really spread to the overall economy and create jobs and boost our nation into a self sustaining recovery? I’ll keep my daughter cheering on Ben Bernanke and his friends – “Go Bernanke – the economy doesn’t want another spanky” – or something like that.