The bulls lose their nerve

The latest AAII investor sentiment survey is quite revealing: it shows that the percentage of bullish dropping to its lowest level in seven months. 

While the percentage of bears rose only slight – to 36% compared to last week’s 33% -- the bulls fell to 28% from the previous week’s 42%.  That’s a sizable drop in bullish sentiment in only a week, especially given that stocks retreated only 2.5% from last week’s high. 

Specifically, the sudden drop in the AAII bulls illustrates a “run for cover” mentality among the buyers and shows just how sensitive investors have become to even the smallest of pullbacks in the market.  Such fragile psychology is a sign that the “wall of worry” is still intact and likely to provide an underlying support for equities while the latest cycle bottoms.  

W.D. Gann’s 28 Trading Rules

1. Never risk more than 10% of your trading capital in a single trade.

2. Always use stop-loss orders.

3. Never overtrade.

4. Never let a profit run into a loss.

5. Don 't enter a trade if you are unsure of the trend. Never buck the trend.

6. When in doubt, get out, and don't get in when in doubt.

7. Only trade active markets.

8. Distribute your risk equally among different markets.

9. Never limit your orders. Trade at the market.

10. Don't close trades without a good reason.

11. Extra monies from successful trades should be placed in a separate account.

12. Never trade to scalp a profit.

13. Never average a loss.

14. Never get out of the market because you have lost patience or get in because you are anxious from waiting.

15. Avoid taking small profits and large losses.

16. Never cancel a stop loss after you have placed the trade.

17. Avoid getting in and out of the market too often.

18. Be willing to make money from both sides of the market.

19. Never buy or sell just because the price is low or high.

20. Pyramiding should be accomplished once it has crossed resistance levels and broken zones of distribution.

21. Pyramid issues that have a strong trend.

22. Never hedge a losing position.

23. Never change your position without a good reason.

24. Avoid trading after long periods of success or failure.

25. Don't try to guess tops or bottoms.

26. Don't follow a blind man's advice.

27. Reduce trading after the first loss; never increase.

28. Avoid getting in wrong and out wrong; or getting in right and out wrong. This is making a double mistake.

Mergers and market tops

A prominent feature of the stock market recovery since 2009 has been the declining trading volume trend.  NYSE trading volume has visibly diminished over the last four years after reaching a climax in March 2009 (see below chart). 

To many savvy investors this is a negative sign which forebodes disaster.  A declining volume trend suggests a lack of broad-based participation; and while it’s true that this is detrimental to the market’s long-term health, the dynamics of today’s market have changed from that of yesteryear.  A market can rally on declining volume for weeks, months or even year at a time without seriously jeopardizing the market’s forward momentum.  What’s the reason for this anomaly?

The reason for this can be found in an understanding of liquidity.  When the Federal Reserve unleashed its easy money policy four years ago, it opened the floodgates of liquidity which allowed the equity market to bounce back from the credit crisis.  Some of this money was channeled into the financial market via institutional trading, but much of it was used by corporations for stock buybacks, dividends and, more recently, corporate mergers and acquisitions.  This explains how the bull market to date has been a volume affair: cash-rich companies have been the driving force behind it, taking the place of broad participation among individual investors. 

As Randall Forsyth observed in the latest Barron’s, “It’s more likely that the oceans of liquidity loosed by the world’s central banks and sitting idly on corporate balance sheets spurred the burst of deal-making…”  Examples include the $23 billion acquisition of H.J. Heinz by Berkshire Hathaway and Brazilian firm 3G Capital, Comcast’s $16.7 billion purchase of the 49% of NBC Universal from General Electric it didn’t previous own, Dell’s $24 billion proposed leveraged buyout, the $11 billion merger between bankrupt AMR and US Airways Group, and the $16 billion merger of Liberty Global and Virgin Media. 

“All told,” writes Forsyth, “some $160 billion of M&A deals have been announced so far in 2013, the fastest start to a year since 2005, according to Dealogic data cited by the Wall Street Journal. 

But doesn't the increasing wave of mergers harbinger a major top?  Historically, feverish merger activity does tend to coincide with major equity market peaks and this time should prove no different.  The devil is in the details, however.  In other words, timing is by no means an easy affair if M&A activity is your sole guide.  

A more practical solution is to incorporate technical analysis along with market psychology and other reliable guideposts for the timing of the market’s inevitable top and use the M&A boom as merely anecdotal evidence that we’re getting close to one.  Just be sure and leave plenty of leeway for the “whipsaws” that are sure to come between now and the time of the final “hard down” phase of the deflationary long-term cycle.

www.clifdroke.com

Investor psychology shows signs of complacency

An increase in news headline optimism has been noticeable in the last week or two which, from a contrarian’s perspective, give some pause for concern.  While the market is very far from outright exuberance, there’s more than enough optimism to suggest that a short-term top is possibly near.

The feature headline in this morning’s Yahoo Finance web site was one from Reuters: “Wall Street rallies on growth optimism.”  Historically whenever words like “optimism” appear in a headline it’s a “heads up” indication that investor complacency has risen to levels that could produce at least a temporary trend reversal.

The lead sentence in the aforementioned Reuters article stated that “investors grew more confident that the global economy would continue to grow.”  That’s another cue that investors’ expectations have reached the complacency stage.  Complacency doesn’t usually produce long-term tops – it takes extreme enthusiasm on the part of investors to do that – but it does signal that the short-term trend has become vulnerable to a correction. 

The Reuters article also quoted a direction of an economic think tank, who said, “The major trend is that indexes will keep moving higher.”  When economists use their favorite tool, linear extrapolation, to make stock market forecasts the outcome is often less than satisfactory.  

www.clifdroke.com

Jesse Livermore’s Trading Rules

1.    Nothing new ever occurs in the business of speculating or investing in securities and commodities.

2.    Money cannot consistently be made trading every day or every week during the year.

3.    Don’t trust your own opinion and back your judgment until the action of the market itself confirms your opinion.

4.    Markets are never wrong – opinions often are.

5.    The real money made in speculating has been in commitments showing in profit right from the start.

6.    At long as a stock is acting right, and the market is right, do not be in a hurry to take profits.

7.    One should never permit speculative ventures to run into investments.

8.    The money lost by speculation alone is small compared with the gigantic sums lost by so-called investors who have let their investments ride.

9.    Never buy a stock because it has had a big decline from its previous high.

10.  Never sell a stock because it seems high-priced.

11.  I become a buyer as soon as a stock makes a new high on its movement after having had a normal reaction.

12.  Never average losses.

13.  The human side of every person is the greatest enemy of the average investor or speculator.

14.  Wishful thinking must be banished.

15.  Big movements take time to develop.

16.  It is not good to be too curious about all the reasons behind price movements.

17.  It is much easier to watch a few than many.

18.  If you cannot make money out of the leading active issues, you are not going to make money out of the stock market as a whole.

19.  The leaders of today may not be the leaders of two years from now.

20.  Do not become completely bearish or bullish on the whole market because one stock in some particular group has plainly reversed its course from the general trend.

21.  Few people ever make money on tips. Beware of inside information. If there was easy money lying around, no one would be forcing it into your pocket.

[Credit goes to Jeffrey Saut of Raymond James Financial for supplying the above list.]

Critical reading in the hi-lo indicator

The number of NYSE stocks making new 52-week lows on Wednesday [Feb. 20] was 40, which was the highest number November 16.  There were 43 new lows on Thursday.  Remember that 40 new lows is the historical dividing line between a healthy and an unhealthy market.  A few days of more than 40 new lows would indicate an unhealthy amount of internal selling pressure and a possible interim trend reversal, so we’ll need to watch this indicator closely in the next few days. 

The decline and fall of fear

Consider the latest technical development for gold and the gold ETFs: for only the second time since 2001, the 450-day moving average has been decisively broken by the gold and gold ETF price lines.  What’s so important about this event you may ask?  Unlike the last time the 450-day MA was violated (briefly) during the 2008 credit crisis, relative strength for gold was increasing at that time. 

Moreover, trading volume expanded noticeably during the 2008 violation of the 450-day MA, which indicated both capitulation on the part of retail traders and heavy accumulation on the part of “smart money” investors.  This time around there is no such increase in relative strength, but rather a decrease in relative strength.  Trading volume has also diminished rather than expanded.

The following chart is courtesy of Don Hays Market Advisory.  Hays pointed out the relevance of the recent breakdown below gold’s 450-day trend line in a recent market commentary.  He has always referred to gold as the “Fear Index” based on his belief that the price of gold is primarily function of investor risk aversion at the expense of equities.

Indeed, the steady erosion of gold's price is part and parcel of the decline of fear that has been ongoing since last fall when the latest equity rally kicked off. My take on the "Fear Index" is that the decreasing fear is that the cyclical bull market for equities, while not over yet, could be fairly soon. Just as the early stages of the 2009-2013 market rally were characterized by high levels of fear, so the latter stages of a recovery are typified by declining fear. An accompaniment of tihs is declining levels of short interest, which in turn renders the stock market more vulnerable for negative shocks.

Today’s equity market is priced to perfection.  Anything that comes along in the next few months to undermine the status quo could become a catalyst for a trend reversal. 

Bottom line: stay bullish for now, but be careful where you tread.

Some interesting Dow 30 charts

A daily review of the 30 individual stock components which comprise the Dow Jones Industrial Average (DJIA) is a useful exercise for getting an overall “feel” for the broad market’s internal condition.  My latest review of the Dow 30 components yielded some intriguing finds.

Among the short-term technical chart patterns which show the most promising, from a momentum perspective, are American Express Co. (AXP).  AXP appears to have chart strength and potential short-term upside potential, along with being above its rising 15-day and 30-day moving averages.  I’d consider using the 30-day MA as a stop loss on a closing basis on long positions. 

AT&T (T) is much closer to its latest quarterly high than its nearest pivotal low, which is always a key factor in evaluating forward momentum.  A probe above the nearby high of 35.60 is possible before this latest run is through.  A caveat is in order here, however.  T is a notable laggard in the broad market rally, however, and doesn’t enjoy as much intermediate-term momentum as some of the other Dow 30 components.  Neither is it as fundamentally strong as the other stocks mentioned here.  The 30-day MA looks like a good rolling stop loss guide.

Cisco Systems (CSCO) is in a technical position to feed off additional strength in the NASDAQ.  It wouldn’t take much energy to propel CSCO to a new quarterly high above the nearby 21.30 level.  CSCO isn’t one of my favorites right now, though.  I’d exit the stock on an intraday move below 20.40.

General Electric (GE) is a momentum leader at present, having just recently made a fresh new high and encountering little in the way of overhead resistance.  I’d watch for potential resistance between the $25-$27 area and use the 30-day MA as a rolling stop loss guide. 

Proctor & Gamble (PG) is one of the current momentum leaders among Dow 30 stocks.  A probe of the nearest round number 78.00 level is likely, and a move to the nearest psychological resistance at 80.00 is possible before this latest rally has met its terminus.  For PG I’d consider using a stop loss roughly mid-way between the intersection of the 15-day and 30-day moving averages on an intraday basis.

Disclaimer: The foregoing overview is intended for merely instructive purposes and should not be construed as formal investment advice.  Do your own due diligence before entering into any trading or investment position.

Has Japan finally turned the corner?

After more than 20 years of deflation, Japan appears finally to have turned a corner.  The country’s benchmark Nikkei 225 Index has risen for three consecutive months – its longest rally since 1959.  Japan’s new Prime Minister, Shinzo Abe, has unveiled an aggressive policy of forced inflation to bring the country out of its long-term malaise.  Will the turnaround last or will the latest effort to reverse the deflationary tide fail like previous attempts?

Abe has pledged to pull the Japanese economy out of its long-term slump with an unprecedented stimulus plan.  He has also urged the Bank of Japan to loosen monetary policy by making bond purchases and has also suggested the bank take measures to directly boost the stock market.  He has made a 2% inflation target the centerpiece of his plan. 

While the Nikkei still trades some 70 percent below its 1989 peak, it has gained over 32 percent since last year and is currently at a 4-year high.  The Nikkei has a lot of catching up to do to the major indices of other developed nations and, from a technical perspective, looks like it has room to continue its recovery rally.

One reason why Japan’s stock market has had a difficult time rebounding in years past is because of the reluctance of Japanese households, which have 1.5 quadrillion yen in wealth, according to Bloomberg, to return to the stock market.  “Stocks only accounted for 5.8 percent of household assets in September [2012] before the rally took off, according to the latest Bank of Japan figures,” reports Bloomberg Businessweek.  That figure compares with 32.9 percent in the U.S. and 14.3 percent in Europe.  This compares with 23 percent stock ownership in Japan back in 1988.

Japan was the first to enter deflation well before any other nation and will likely be the first to emerge from it.  It may turn out that while the U.S., China and other nations are experiencing their own fight against the deflationary headwinds created by the 120-year Kress cycle in 2014, Japan bucks the trend and leads the way into a new period of long-term inflation.  In the post-2014 world, Japan is worth keeping an eye on as a potential leader.

Is the crowd always wrong?

A truism of contrarian investing is that the crowd is usually wrong at major turning points.  That is, small investors as a group tend to be wrongly bullish at tops and incorrectly bearish at bottoms.  For the most part this observation holds true, but there is an important exception to this.

The crowd actually tends to be on the right side of the trend starting around the middle of a long-term swing and continues on the right side of the trend until the trend terminates.  Countless examples could be offered of how the crowd “gets it right” during long-pull bull markets, such as the ones of the 1980s and 1990s.  Moreover, crowd participation in a major bull market is what gives the bull its impetus; without the crowd the trend would only go so far before reversing. 

As powerful as institutional traders are, they can’t create long-lasting trends without broad participation of millions of retail investors.  This is one of the reasons why the bull trends of the ‘80s and ‘90s were so powerful and long-lasting compared to the truncated and volatile bull moves of the last 10 years or so.  The public isn’t participating as much in the stock market today like it did in previous decades.

Writing in the latest issue of the Cabot Market Letter, Michael Cintolo observes: “While the crowd is ‘wrong’ at the very end of the trend, the crowd is actually ‘right’ in the weeks and months leading up to the turning point.  Contrary-minded investors who fail to understand this nuance often find themselves acting far too early, like the people who sold out of the market in 1997 when sentiment was deemed ‘too high’ (and thus missed out the final years of the great bull market) and those who bought into the market in the fall of 2008, thinking sentiment was as bad as it could get (and quickly had their heads handed to them).  In both cases, market trends proved to be longer lasting and more powerful than expected.”

So before you’re tempted to dismiss the market’s latest bull run by thinking the public is “too bullish” on stocks, consider that investor sentiment as measured by AAII hasn’t reached the vertiginous levels associated with previous major tops.  And don’t forget that the crowd (that is, those that actually have a stake in the market) might just be right…for now at least. 

Where have all the trend traders gone?

The broad market advance from the 2009 lows, despite the periodic volatility, reminds us of the late 1990s bull market.  The only thing missing is the presence of the retail investor.  That is to say, the typical “trend trader” of the ‘90s and earlier 2000s is nowhere to be found.

What’s ironic is that the stock market environment of the past few months has been ideal, even textbook, for trend trading.  Indeed, the methodology based on identifying upward trends in actively traded stocks via trend lines or moving averages and then riding those trends has been perfectly suited to the trading environment of most of 2012 and 2013 to date. 

So why have retail traders remained mostly on the sidelines, missing most of this impressive rally? The main reason for their absence is the long-term fear engendered by the historic 2008 credit collapse.  Psychologists tell us that it takes the average investor about 3-4 years to recognize a reversal of the major trend.  Based on those numbers, it’s not surprising that many small time traders and investors are only now recognizing the enormous gains that equities have achieved since 2009.  This partly accounts for the recent liquidation of safe haven investments like gold and bonds – the two areas that investors flocked to after 2008.

Yet there has hardly been a major rush back into equities of the kind we witnessed in the late 1990s and mid-2000s.  The fact that trading volume on the NYSE has been relatively low considering the magnitude of the rally is telling (see chart below).  The diminished volume trend over the last couple of years overwhelmingly suggests that the public hasn’t bought into this rally.

Diminishing volume suggests the public has missed this rally.

Another point to consider is a phenomenon known as “trading range trepidation.”  This is a term I coined several years ago to describe the angst that many traders and investors experience whenever a long-term trading range ceiling is reached by the major indices.  Whenever a trading range top is being tested by, say, the S&P 500 (SPX), instead of investors getting excited at the possibilities of a breakout above the ceiling, you can always expect to see an increasing reticence to buy.  This is one reason why the market often backs off several times after reaching a major trading range ceiling before finally punching through it.  Many investors use this test of the trading range ceiling as an opportunity to take profits and reduce long commitments instead of increasing them.

Note that in the 10-year monthly chart of the SPX shown here, the market is once again testing what could be described as a major long-term trading range ceiling.  Knowing what we do about the psychology of trading ranges, this would partly account for the reluctance of retail investors to enter the market right now.

Trading range trepidation

Psychologists also inform us that it takes the average retail investor anywhere from 5 to 10 years – or even longer – to recover from the psychic effects of a major financial collapse.  The more an individual investor lost in the crash, the deeper and longer-lasting the psychological scars tend to be.  Painful memories of the 2008 credit crisis have undoubtedly kept many a retail investor from re-entering the equities market as a participant.  Yet we also know from studying behaviorism that rising prices will eventually attract the more skittish investors.  The thought of missing out on an historic opportunity can entice even the most reluctant investor to enter the market fray. 

There are some who believe that this cyclical recovery won’t end until the public rushes in en mass as buyers.  There may be some truth to that, but the market doesn’t necessarily need the return of the retail investor (or trend trader) to put in a major top.   Trading today is dominated by institutions, HTFs and hedge funds.  The market has obviously done just fine without the public’s participation and can probably continue doing so without it.  For clues as to when the market’s next major top is in traders need not focus on the retail investor.  Instead, look to the technical and fundamental data, i.e. to the market itself for clues.  

Why are people spending if jobs are scarce?

In Thursday's blog we looked at the New Economy Index, which measures the strength of the U.S. retail/consumer economy in real time.  It’s currently telling us not to worry about the near term economic outlook, which is clearly still up.  One of the components of the NEI which is lagging, however, is Monster Worldwide (MWW).  MWW is a reasonably good gauge of the U.S. employment outlook and as you can see by looking at Monster’s chart, the jobs outlook has been less than stellar lately.

If the employment outlook is so weak, then how can the increased consumer spending of the past several months be explained?  The answer can be found in the real estate market of all places.  The Fed’s QE3 stimulus program has had its desired effect of lifting housing prices, which in turn has triggered a refinancing boom for U.S. homeowners.  The powerful lift the real estate bounce has given to the U.S. economy is reflected in the Philly Housing Index (HGX), which is currently at a 5-year high.

Yet when viewed from the vantage point of the 10-year chart, we can see that the house market has a long way to go to recover its 2005 highs before the housing bust.

Currently three out of four mortgages being made today are to refinance existing loans.  According to The Kiplinger Letter, “About 11 million homeowners will use refis this year to cut interest rates, putting more cash in their pockets each month.  All told…$27.5 billion in savings this year, available for spending on groceries, apparel, gasoline and other items.”  

Kiplinger forecasts that the refi boom will settle down by the end of next year and estimates that by 2014, less than half of all mortgages will be made to refinance existing loans, roughly the same as before the recession.

Storm watch: Rising gasoline prices

“Even though America’s drove more fuel-efficient cars and consumed less fuel than ever in 2012, an Energy Department report says households spent almost 4 percent of their pretax income on gas – the highest percentage in 30 years.” – Los Angeles Times

As we continue our watch for potential storm clouds on the horizon that could derail the equity market rally, the gasoline price surely rates as one of them.  An unnaturally high fuel price in mid-2008, after all, was one of the catalysts to the broad market and economic collapse of that year.  Since the recovery started in 2009, each time the retail gasoline price has threatened to exceed the psychological $4/gallon, stocks have been knocked down and retail sales begin to suffer.  At the present time the nationwide retail gasoline price is averaging $3.60. 

The following chart show the futures price of gasoline, which forms the basis for retail prices.  It has been in a clearly defined upward trend since November and threatens to break above the highs seen last winter.  Is it too early to be concerned about a gas-related economic reversal?

Our in-house New Economy Index (NEI) measures the strength of the U.S. retail/consumer economy in real time.  It’s currently telling us not to worry about the near term economic outlook, which is clearly still up.  As long as this constructive trend remains in place we needn’t worry too much about the gasoline price.  If the NEI reverses at any time in the next few weeks, however, it will definitely be time to increase our defenses in anticipation of a potential gas-related economic downturn.  For now, at least, consumers seem to be at peace with current gas price levels.  

Moving averages Q&A

Question: “Some time ago I purchased your book, Moving Averages Simplified, personally signed by you.  I have a question in relation to moving averages and I wonder if you could help with the interpretation of my question and provide some insight.

“The moving averages I trade with are the 5- & 8-day simple MAs and the 20- & 40-day exponential MAs.

“I can’t seem to determine from my charts whether price penetrates a moving average or retraces back to it without penetrating it, because I seeing both penetration and non-penetration.  I would be grateful from your experience if you could help me.”

Answer: I wouldn’t worry about whether or not the price line penetrates above and below the moving averages -- at least not in the initial stages of a trade.  Volatility, within certain limits, is only natural in a stock or commodity and you have to expect that the moving averages will be at least temporarily violated from time to time without actually reversing the trend.  

What’s important is to find the nearest pivotal low and use that as your stop-loss guide.  Don’t worry about using the moving average as a stop-loss at all time -- just find the nearest pivotal low and use that as a basis for whether or not to stay in the trade.  

In the chart of the S&P 500 Index (SPX) shown below you’ll see that if you entered the market in late November based on the close above the 15-day moving average, you could use the November 28 pivotal intraday low of 1,385 as the initial stop loss.  Since that level was never violated you would have stayed long the market until now.  This would have been a much more reliable guide than the 15-day MA itself in terms of a stop loss.  

Bottom line: look for the nearest pivotal low when it comes to stop-loss placement and don’t worry about moving average penetrations, especially in a momentum market.

What would Kress say about the euro zone crisis?

On Monday the president of Germany’s Bundesbank, Jens Weidmann, said there is "no indication euro foreign exchange is seriously overvalued."  The comments led to immediate strengthening of the euro currency which translated into dollar weakness.

There was a troubling note to Weidmann’s statement, however.  There’s an old saying: “Official denial is tantamount to tacit admission.”  In other words, when a bureaucrat insists that a problem is either under control or doesn’t exist, the problem is usually far greater than is being admitted.  I can’t help thinking what my late friend and cycle mentor, Bud Kress, would say about the euro zone crisis which everyone thinks has been “solved for now.” 

I strongly believe Bud would have said something along the lines of, “The euro crisis is a cancer which is only beginning to metastasize.”  Those are the exact words he spoke to me concerning the U.S. credit crisis in 2007 and his words at that time proved prescient.  To think that a problem which only a few months ago was threatening to engulf Europe in its own version of the credit crisis has now suddenly been “solved” by the confident pronouncements of a couple of central bankers is hard to fathom.  The ECB may well be ready and willing to launch the monetary equivalent of a bazooka at the euro zone debt problem, but history suggests the bank will be seriously challenged before this crisis is over.  To date there has been no serious challenge.

If the Kress cycle “echo” forecast for this year is correct, we should eventually see problems begin to manifest in Europe later this year.  As the second part of the year progresses and we head closer to 2014 (when the 120-year cycle is scheduled to bottom), the problems in Europe should spread overseas and envelope the global economy, including the U.S. and China.  As Kress used to say, “The cycles have a way of bringing out the dirty laundry of the nations.”  This time around should prove to be no exception.

Who says Christmas is over for the retailers?

According to stock market seasonal trends, retail stocks are “supposed” to turn bearish shortly after the holiday shopping season.  The first quarter of the New Year is typically the worst for most retailers.  This year is proving to be an exception to that rule.

Retail stock internal momentum has soaring to higher levels on a daily basis of late.  Note the chart below, which shows the short-term directional indicator (blue line), the short-term momentum bias (red line), and the internal trend (green line).  All are traveling in unison in a near-vertical path.  This implies the path of least resistance for the retail stocks is still to the upside in the near term.

A-D Line leadership

Short-term weekly cycles can be skewed by excessive emotion – in this case greed – as retail and institutional investors continue to push money into the market seeking to capture the proverbial “last eighth.”  I would also point out that the NYSE Advance-Decline (A/D) line made a token new high today (Feb. 6) even as the NYSE Composite Index did not.  Leadership in the A/D line is usually followed by a move higher in the indices.

[Excerpted from the Feb. 6 issue of the Momentum Strategies Report, www.clifdroke.com]

Forget the economy -- it's all about corporate profits

Many investors are wondering what has been behind the relentless rally in stock prices.  Look no further than corporate profits.

Consider that in the third quarter of 2013, corporate earnings were $1.75 trillion, up 18.6% from a year ago. That took after-tax profits to their greatest percentage of GDP in history.  For the most recent quarter, earnings for S&P 500 companies are estimated to have risen 4.7 percent, above a 1.9 percent forecast at the start of the earnings season.

Moreover, corporate profits are up 40% in just the last five years.  After-tax corporate profits are at record levels, totaling almost $2 trillion.  Real wages, meanwhile, are declining.

Of course, Wall Street doesn’t care about wages.  Rising profits are the main concern at the end of the day, and as long as the profit rally continues, investors will have reason to enough to remain bullish during the rest of the earnings season (i.e. until late February).  When it comes to evaluating the disparity between strong corporate profits and a still-tepid job market, it will do us well to remember the maxim of market analyst Steve Todd, who said: “Record earnings are behind the market rally. Looking at the economy is worse than useless.  It’s harmful to your portfolio.  It keeps you out of the market when you should be in.”

[Excerpted from the Feb. 6 issue of Momentum Strategies Report, www.clifdroke.com]

How the Fed creates bubbles and crashes

Are the lunatics running the asylum?  A news report released last month would seem to suggest so.

Consider the shocking revelation that the Federal Reserve officials were oblivious to the financial crisis brewing in 2007 until they found themselves in the middle of it.  According to 1,300+ pages of transcripts released in January, the Fed was consistently behind the curve in the months leading up to the start of the Great Recession in December 2007. 

At the beginning of 2007, many Fed officials, including Chairman Ben Bernanke, thought one of the biggest risks was that the economy might grow stronger than expected rather than weaker.  At the time, the Fed's key interest rate was at 5.25%, and amazingly, the central bank was leaning toward further tightening.

“My recommendation also is to take no action and to maintain a bias toward further tightening,” Bernanke said at the first meeting of the year.  “The housing market has looked a bit more solid, and the worst outcomes have been made less likely,” he said.  Bernanke obviously failed to foresee the subprime mortgages crisis and the fact that it would ignite the deepest financial crisis since the Great Depression.

It wasn’t until September 2007, after months of the brewing credit storm, that the Fed finally decided to take action and reverse its insane policy of monetary tightening.  But even then, the Fed’s actions in lower interest rates were tepid at best and were a case of too little, too late.  The Fed didn’t become serious about extinguishing the flames of the credit crisis until well into 2008, by which time most of the damage was already done.

Writing in the latest issue of Barron’s, Milton Ezrati chronicles the Fed’s long-term history of employing the wrong monetary policy in response to the economic cycle.  “The Fed should simply guide money-creation according to the economy’s fundamental needs,” he concludes, “draining liquidity when foreign flows create an excess and injecting it when events create a shortfall.”  Unfortunately, history leaves us little reason for assuming the Fed will ever embrace Ezrati’s sensible recommendation.

Ezrati noted that between the 1990s and today, the Fed’s erroneous monetary policy created no less than three major bubbles which in turn created major economic instability.  History leaves no doubt that the ongoing monetary stimulus response of the Fed to the latest crisis will eventually create even more instability down the road.  I’m betting that 2014 will be the year those chickens come home to roost.

Oil stock seasonal strength

A client writes, “It’s interesting that you mention that the energy sector is starting to heat up. I remember from my economic vs. market cycle readings that oil is the last sector to move in the market as the economy is peaking.  An example is the oil price peaking in July, 2008 after the economy had already peaked and we went into recession.  Is the fourth quarter GDP a sign of a peaking economy?”

Regardless of whether the economy is peaking or not, there’s no denying the exceptional strength in the oil/gas sector.  As I highlighted in the Momentum Strategies Report last month, the longer-term internal momentum for the oil stocks (OILMO) has been accelerating in recent weeks and went vertical in late January.  Not surprising, the equities of oil companies fed off this internal strength with many actively traded oil stocks making new highs.  Where internal momentum leads, stock prices always follow.

Along these lines, I came across the following chart which shows the historically bullish seasonal tendency of the oil/energy sector, courtesy of Seasonalcharts.com.

An "overbought" stock market

The stock market as measured by the S&P 500 has become exceptionally overbought in the last couple of days.  The 20-day price oscillator which is used to measure the short-term internal condition of the market reached its most overbought reading on Tuesday, Jan. 29, since January 19 of last year. 

I would point out that the market continued to rally until late March last year after reaching this overbought reading, so it’s not necessary for the market to pull back sharply from here.  What is needful, however, is for the 20-day oscillator to pull back from here and drop closer to a normal reading before traders can start making new long commitments.  At the very least, traders should be very selective when purchasing stocks.

The Gambill Oscillator, which measures corporate insider buying and selling interest, has also reached a level which suggests the insiders have swung to the sell side of their own company's stocks.  The following chart is courtesy of Hays Advisory.

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