Saturday, January 26, 2008

Kneecapped by Helicopter Ben

In spite of the fact that a number of sentiment indicators suggest capitulation by the players, I do not believe last week was a major bottom for the US stock markets. A considerable amount of technical damage has been done. Price momentum, as measured by both the daily and weekly MACD's, is extreamly negative and indicates to me that the current rally will fail. The question to be asked is what happens next? Assuming we get a sucessfull retest, which I consider likely, will the market blast off to new highs? I don't think so.

S&P 500 and Dow Jones Industrials - Daily
Something is seriously wrong in Peoria, and LA and New York City and... Did the Fed panic and lower interest rates because of the sharp decline in the stock market? Are both political parties falling all over themselves to provide a stimulus because they want to stave off what appears to be only a mild recession. No, something else is happening, something that no one wants to talk about, there is a big crack in the financial system. It is not just the banking system which is having problems, but the bond insurers which are on the hook for more than they have in assets, in essence they are going bankrupt. So, when the Fed stepped in with it's magnum 3/4 point rate cut, it was in an attempt to increase liquidity by increasing loan profitability for the banks (Loan Rate-Borrow Rate = Profit ;-). If I was a bank, I wouldn't be in such a hurry to lend money to a bond insurance company, what's in it for me besides a chunk of risk I can't quantify?

No, the Fed wasn't worried about the stock market. One has to assume that Bernanke knows what he is doing, or at least that he knows what he needs to change (fix). So, I'm assumming that the shit has hit the fan, no one at the Fed is exactly panicing, but that they are taking whatever measures they feel are needed to try and fix the problem. "Whatever measures" means whatever they think will work, regardless of the short term consequences such as inflation. There's is a very good chance that the Fed will lower rates another notch at the meeting next week.

S&P 500 Index Weekly
A short term bottom only.

I personally do not think these rate reductions will immediately be inflationary. Inflation occurs when the demand for goods outstrips the supply and demand at the present is moderate to declining. Where I do think that the rate reductions will have an effect is in the US stock market. Lowering the base rate in effect makes stocks appear undervalued relative to fixed income investments.

So, the markets should rally. Oops, this conflicts with my opening paragraph where I suggested that a bottom is not in place yet. I do think the indexes will retest last weeks lows and do it fairly quickly. At that point I would expect a very sharp rally which should hit major resistance at the 1350-1360 level on the S&P 500 (12750 DJIA). This is the neckline of the double top I marked on the chart. It prices can move up through this level, the downside projections will be invalidated. This would be the outcome for reading the current market behaviour as bullish. In my opinion I don't think this will occur and that the markets will back and fill, with a negative bias, until more is know about the current financial problems in the banking and insurance sectors.


Nasdaq Comp and Russell 2000 - Daily


Finally, it looks like the small caps may benefit from the rate reductions, the Russell 2000 is now leading the charge, either to the trough or to the slaughter.

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