Are Stocks About To Break Out Relative To Fear?

December 22, 2014

While there are numerous reasons for recent volatility in asset prices, the market has primarily focused on concerns related to economic weakness in Europe, the possibility of a widespread Ebola outbreak, and the Federal Reserve. The chart below shows the performance of stocks relative to the VIX Fear Index over the past seven months. The orange lines show three recent “fear spikes”, with the spike in the middle (Ebola) being larger than the other two (Europe & Fed).

Bullish Chart Patterns

The chart above has some common characteristics found in a potentially bullish formation known as an inverse head-and-shoulders pattern. A break of the orange neckline will improve the odds of the current rally in equities carrying quite a bit further. The chart above is not alone in terms of the potentially bullish look. In this week’s stock market video, we cover similar patterns in small caps (IWM), stocks (SPY) vs. bonds (IEF), and the broad NYSE Composite Stock Index.

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Investment Implications – The Weight Of The Evidence

The market sold off prior to last week’s Fed meeting on the expectation the removal of “considerable time” would signal a sooner-rather-than-later rate increase. Instead, the Fed delivered a more stock-friendly message and equities took off in the other direction. As of Monday’s close, the market’s risk-reward profile allows us to hold an equity-heavy allocation. Given the recent wild swings between confidence and fear, we will continue to take things day-by-day while remaining flexible to both bullish and bearish outcomes.

How Long Could The Current Stock Rally Last?

December 19, 2014

Can Stock Charts Predict The Future?

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Market Model

December 17, 2014

As of Wednesday’s close, current allocations are in line with the market’s improving, but still mixed profile. Given the S&P is trying to make a stand at a logical level (1980ish), we will be keeping a very close eye on the data/evidence/rules and our accounts.

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Today’s Close – What Does It Mean?

December 16, 2014

The S&P 500 closed below 1980 today or the first Fibonacci retracement level described in this week’s video (see clip).

Does a close below 1980 mean it’s game over for the bulls? No, it is not unusual for a rally to retrace to the other Fibonacci levels above (1950, 1919). However, the deterioration in the market’s risk reward profile cannot be ignored. Thus, by rule, we reduced risk (again) before Tuesday’s close.

Right Back To Where We Started

The market has returned to a conviction-less and trend-less state. On Tuesday, the S&P 500 closed at 1973, which is the exact same closing level as July 1. Said another way, the market has popped up and down numerous times, but made no progress in 5.5 months.

Ready For Anything

With a Fed announcement coming Wednesday, we have to remain open to all outcomes, including a sharp rally into yearend.

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December 16, 2014

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Stocks: Is It Time To Panic?

December 13, 2014

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VIDEO

December 12, 2014

Video should be posted between 11:30 and 11:45 pm ET Friday night. More here.

Could The Fed Trigger A Deflationary Slide In Stocks?

December 11, 2014

Policy Change Coming Next Week?

In Tuesday’s Wall Street Journal, a reporter with excellent contacts at the Fed, Jon Hilsenrath, penned the following:

Federal Reserve officials are seriously considering an important shift in tone at their policy meeting next week: dropping an assurance that short-term interest rates will stay near zero for a “considerable time” as they look more confidently toward rate increases around the middle of next year.

Is The Market Really Worried About Inflation?

As noted recently, inflation expectations are what ultimately determine interest rates. It is difficult to believe the market is expecting widespread price increases when crude oil is dropping like a stone. As shown in the chart below, oil has plummeted more than 40% over the past six months.

Bond Market Seems Unconcerned

Fixed-income investors can buy bonds with an inflation-protection component (TIP) or they can buy a standard bond (IEF). The chart below shows demand for inflation-protected bonds has been much weaker than demand for standard bonds, which does not look like a market concerned about a big spike in consumer prices looking out several years.

Investment Implications – The Weight Of The Evidence

While the Fed looks at many factors when considering a shift in interest rate policy, it is difficult to make the case that longer-term inflation expectations are becoming problematic. In fact, our friends across the pond are concerned about deflationary, rather than inflationary, forces. From Reuters/The Fiscal Times:

French core inflation turned negative in November, with the first drop in the indicator since records started in 1990 pointing to a growing risk of deflation in the euro zone’s second-largest economy.

During Wednesday’s big selloff, we noted (see tweet) it was possible stocks would find their footing near support. During the early stages of Thursday’s trading day, buyers did step in at a logical level. The S&P 500 chart below is an updated version of the one tweeted Wednesday. Before stocks can push higher, they must clear a short-term resistance hurdle near 2055.

The Million Dollar Question

The market will be looking to see if the Fed drops the phrase “considerable time” from their upcoming December 17 statement. Changing the language would increase the odds of an interest rate hike coming in the next six months, something that could spook the stock and bond markets.

The Reaction Is More Important Than The Statement

Rather than attempting to anticipate the market’s reaction to next week’s Fed statement, our approach will be to remain patient and wait to see the actions of market participants after the release of the Fed’s December 17 statement. If considerable time is dropped, will the market take the “this is bad news because rates will be moving higher” approach or “this is good news because the economy is gaining positive momentum” approach? Time will tell.

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December 9, 2014

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The Most Important Variable For 2015

December 8, 2014

What Drives Bond Yields And The Fed?

Since the Fed is the largest player in the bond market, it plays a big role in the direction of interest rates. However in the end, interest rates are determined by all bond market participants. If consumer prices are stable, conservative bonds are more attractive. Conversely, if prices are rising at 4% annually, a 2% bond yield starts to look less attractive. Therefore, investor expectations about future prices could be the most important variable for stocks and bonds in 2015. From Bloomberg:

“Over time, what drives the bond yield is the inflationary expectations,” said Lacy Hunt, the 72-year-old chief economist at Hoisington Investment Management. “If you wring all the inflationary expectations out, you are going down to 2 percent on the long bond over the next several years. That is the path that we are on.” Based on bond yields, inflation expectations over the next 30 years have fallen below 2 percent and reached a three-year low of 1.96 percent at the end of last month.

If inflation expectations remain relatively stable and low, the Federal Reserve can be more patient when it comes to raising interest rates. All things being equal, low rates are better for stock investors.

What Is The Market Telling Us Now?

The stock market has been hesitant in recent weeks. This week’s stock market video compares the present day market with the 2010 flash crash correction in order to better understand the stock market’s risk-reward profile.

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Shorter-Term Inflation Expectations

The 30-year Treasury yield tells us longer-term inflation expectations remain very tame. How do things look on a shorter-term time horizon? From Reuters:

Falling oil prices and a stronger U.S. dollar did not dampen Americans’ inflation expectations last month, according to a Federal Reserve Bank of New York survey… Median expectations of inflation one and three years into the future have remained steady at 3.0 percent since August, even while one-year-ahead gasoline price predictions fell for a fourth straight month, according to the New York Fed’s relatively new survey of consumer expectations… A global drop in energy prices and a stronger dollar has put pressure on overall U.S. inflation, which remains below the central bank’s 2 percent target. Fed policymakers are not expected to raise interest rates from near zero until about the middle of next year.

Investment Implications – The Weight Of The Evidence

Even in the context of intraday weakness in stocks during Monday’s trading session, the intermediate-term outlook remains favorable from a risk/reward perspective. Therefore, we continue to hold an equity-heavy allocation (SPY), with a small complementary stake in bonds (TLT). With a report on producer prices coming this Friday, we will get some additional data to help shape inflation expectations.

Fed Calls For Investor Flexibility

With the Fed considering a shift in policy, it is important that we remain flexible and open to a shift in investors’ appetite for risk. If the S&P 500 finishes the week below 2049, our market model may call for an incremental reduction in risk. During Monday’s session the S&P 500 was trading at 2,054.