Publication Note

Publication will be spotty this week, as, unfortunately, I have a number of more pressing and urgent personal issues to attend to.  I will do my best to get at least one more update published before the end of the week (possibly tonight, with any luck...).  Thank you for your understanding. 

Dow Theory Gives Warning; Can the Fed "Print Over" It?

In this article, I'm going to discuss Dow Theory, the dollar and inflation, and how they relate to the Federal Reserve in today's market.

Dow Theory views directional divergences between the Dow Jones Industrial Average (INDU) and the Dow Jones Transportation Average (TRAN) as important, and the two markets are diverging significantly right now. 

There are six basic tenets behind Dow Theory but, for discussion purposes, the one we'll focus on today is the tenet that the market averages must confirm each other.  As its name suggests, the Dow Jones Industrial Average is concerned primarily with industry, i.e.- the production of goods, while the Transportation Average is more concerned with shipping those goods to market.  The logic behind the theory is fairly simple:  If the economy is improving, then economic production should be increasing (positive for INDU), which also means there will be more goods needing shipment (positive for TRAN).  Logic tells us the reverse should also be true: less production should equal less demand for shipping.  Thus the two averages would seem inexorably linked in an economic sense, and should generally be moving in the same direction.

According to Dow Theory, when the two indices diverge, it's a warning that a trend change may be brewing. 

 
Here's where things get a bit interesting...   

Dow Theory finds its roots in editorials written by Charles Dow, who founded the Wall Street Journal.  He remains a household name with investors because he also co-founded Dow Jones and Company (presumably his co-founder had the last name of "Company."). 

Mr. Dow passed in 1902 and therefore never had to contend with the Federal Reserve, since the Fed wasn't an entity until 1913.  In Dow's day, the gold standard still existed, so money couldn't simply be "spoken into existence" by Mr. Bernanke and his printing press.  Back then, money was viewed, first and foremost, as a way to exchange goods and/or services without the need for direct barter.

In other words, in 1902, wealth could only be created through the archaic concept of production.

SPX Update: Keeping Things Simple

There's not much to add to the last several updates, so I've prepared a series of charts that should help with pointing the way over the next few sessions.  This isn't infallible, but in an attempt to keep this update as simple as possible for readers, I'm trying to work with the highest probability options.

Below are four charts of the S&P 500 (SPX), each at different time frames, with different successive levels to watch on each time frame.

First is the daily chart.  Because the beginning of the structure is unclear, I feel that it would be a bit misleading for me to imply too much confidence in the final outcome -- as such, upward prospects for this wave will be adjusted as needed (shown in gray).  I have also tried to simplify the labeling on this chart.

Interesting to note that yesterday the market "recognized," and bounced off of, the upper boundary of the potential diagonal that I've been blathering on about for several weeks. 

The next chart is the SPX 3-minute, and adds more detail to the chart above. 

Nine Charts of a Market in Long-Term Flux

Lots of charts to cover today, since the next week or two should be important.  While price action has been nothing but bullish, the market has stalled right at the level it needed to in order to keep bears' hopes alive.  Most indicators suggest higher prices still to come, but the market has reached an inflection point, and it is presently unclear if the longer-term wave counts will extend upwards more significantly or not. 

The first chart of import (pun intended) is light crude oil, which I discussed a few days ago -- and which then immediately whipsawed the recent breakout.  I mentioned that the green trendline was a "must defend" level for bulls, and the results of the whipsaw beneath that trendline have been ugly. 

The problem oil presents for equities bulls is that continued weakness in this market could imply a failure of the QE-Infinity reflation trade, and thus ultimately drag equities down with it.

The next chart is the US Dollar, which started a relentless crash immediately after I switched from long-term dollar-bullish to dollar-neutral.  It has now reached important support, and if it's going to muster a bounce, this is a zone dollar bulls must defend.  One can already see the potential of a head and shoulders top formation if we get a decent bounce to form a right shoulder, but I'm not yet entirely convinced it can't put in a meaningful bottom soon. 

SPX and IBM: Overbought Market, but No Divergences Yet

Last night, in an attempt to keep up with the Fed and ECB, the Bank of Japan announced an increase in their monetary stimulus programs, and the yen reacted accordingly.  The "race to zero," as countries devalue their currencies against each other so that they don't end up priced out of the world economy, is a spectacle to behold.  Somewhere down the road, it seems there will be an ugly endgame here, but these things can go on for much, much longer than seems reasonable.  I remember I felt the same way about the housing bubble back in 2005.  I felt quite certain by mid-2005 that things would end very ugly, but housing just kept ramping higher anyway.  Eventually, of course, it did end ugly... but it first ran much farther than I thought it would.

Most know the old John Maynard Keynes quote: "The market can remain irrational longer than you can stay solvent.  My personal twist on that is: "The market can remain insolvent longer than you can stay rational."  In any case, no matter what the endgame looks like (and who really knows what that will be), things can always keep plugging along in the meantime.

Bears are hoping for a turnaround here, and I've heard a lot of bearish theories floated recently -- on everything from "QE3 is out now, so there's nothing more to fuel speculation and drive stocks higher" to "bullish sentiment is too high."  I'll admit, the contrarian (and the long-term bear) in me wants to jump on that bandwagon.  But there is the issue of central bank liquidity, and since everyone who has access to an inkjet is printing more money, it's hard to imagine that liquidity won't find its way into equities. 

Market Update: I Fought the Fed and the... Fed Won

Part of my weekend self-amusement was to hastily re-write the Bobby Fuller Four's "I Fought the Law" (my lyrics below -- the original song can be found here):

Makin’ trades in the ... hot sun
I Fought the Fed and the ... Fed won
They printed money, 'cause they ... had none
I Fought the Fed and the ... Fed won

(chorus one)
Don’t get bearish and don’t be sad
or Ben will toast your buns,
The economy will be fine if you buy an iPad…
I Fought the Fed and the ... Fed won
I Fought the Fed and the ... Fed won

They’re robbin' people with an . . . inflation gun
I Fought the Fed and the ... Fed won

I miss reality and the ... good fun
I Fought the Fed and the ... Fed won

(chorus two)
Quantitative Easing is the latest fad
it seems they're never done,
Ben doesn’t care if it all ends bad…
I Fought the Fed and the ... Fed won
I Fought the Fed and the ... Fed won

Friday saw the rally extend, with the central bank liquidity pumps running at high speed.  It seems reasonable to assume the bullish wave counts are probably in control, given the Fed's announcement of QE-Infinity -- and the behavior of momentum indicators, which have accelerated accordingly.

QE-Infinity: Poking Holes in Bernanke's Logic

I'll start off by saying: I was dead wrong about "no QE3" this time.  With the dollar in crash mode and equities trading at multi-year highs, I did not expect the Fed to do anything more than continue their "Virtual QE3" talking-points program. 

With that bit of crow-eating out of the way, it's time to adjust to the new realities and discuss what the program means for the market and the economy; additionally, one simply cannot avoid some discussion on the moral hazard and the politics of it.

Let's start off with what the program entails.  Quantitative Easing is government-speak for "printing more money" (although, in today's world, this is less about the physical printing press and more about digital transfers).  The Fed has been reduced to printing because their usual go-to monetary tool, which is lowering interest rates, has long been maxed-out and ineffective.  Fed fund rates are already effectively negative; thus there's nothing more to be done in that regard.

The Fed has departed somewhat radically even from previous QE programs, as this is the first program with no fixed end-date.  Therefore, instead of calling it "QE3," it seems more appropriate to name the new program "QE-Infinity" (I would simply use a lemniscate after "QE," but my font doesn't allow it).  On Thursday, the Fed committed to buying $40 billion worth of Mortgage Backed Securities (MBS) every month in an ongoing open-ended program, which, for those keeping tabs, equals a total commitment of $85 billion a month when combined with existing programs.  This will cease when the Fed "sees substantial improvement in the labor market."

Of course, this immediately begs the question, "What will the Fed view as 'substantial improvement?'  What are the qualifiers, and where will it end?" 

The answer is a resounding: "Nobody knows."  In Bernanke's own words: "We haven't yet come to a set of numbers, but we're guaranteeing that we won't tighten too soon."  That statement alone should create some discomfort with American taxpayers, as the unaccountable (to voters) Fed is admittedly setting a far-reaching policy with no qualifiers.  But naysayers are glibly refuted, as Bernanke demonstrates in a statement discussed later.

Printing money floods the market with more dollars, which makes dollars worth less (supply and demand: more supply equals lower value), which means that tangible assets priced in dollars -- such as oil and food -- end up costing more. This is euphemistically referred to as "inflation."

One of the arguments against prolonged low interest rates and flooding the money supply is that these actions punish savers in two ways: artificially low interest rates hit savers' accounts directly; and printing money hits them a second time and forces them into high-risk assets as they try to keep up with inflation.

In a weak attempt to address the fact that his policies punish savers, Bernanke responded with this glib straw-man argument: "You can't save without a job." 

Yes, that's a true statement.  But it's not a legitimate argument.  Even in this depressed labor market, there are still far more Americans with jobs than without them; and there are more and more retirees struggling to survive on savings being held in accounts that currently yield virtually no return. 


Bernanke's argument that trying to add a few percentage points to the employment rate justifies punishing everyone else because "you can't save without a job" is akin to the automotive industry announcing that, henceforth, they're only going to produce super-cheap cars that have no seatbelts, no bumpers, and no other safety features -- on the justification that these dirt-cheap cars will allow more people to afford cars.  Ben's simplistic logic is essentially: "You can't die in a car wreck if you don't have a car!"  Can't argue with that statement.  But it doesn't address the real issue at all; it merely reframes it into terms where he can seemingly win the argument.

His statement also assumes the underlying presupposition that an ongoing QE program will actually improve the labor market -- and that assumption is not a given.  There is an ongoing debate over how much influence the Fed actually holds over the labor market, and the question was asked of Bernanke yesterday:  "How does boosting assets really help the real economy?"  Bernanke replied, "There are a number of different channels: Mortgage rates, corporate bond rates, and increase in home prices and stock prices."

This is another non-answer that avoids the real question.  Bernanke responds that there are "different channels," but he does not establish that these channels have any direct causation in creating more jobs (he also argued this earlier, but again in a cursory manner based on unproven presuppositions). 

Nor does Bernanke establish how these "channels" materially differ from what's already been tried.  In fact, Esther George, president of the Federal Reserve bank in Kansas City, recently asked this rhetorical question: “Is there anyone not borrowing today or purchasing a house because interest rates aren’t low enough?  Do we expect that businesses will hire if their long-term rates are lower?”

The follow-up question that needed to be asked was, "I understand that, Mr. Bernanke; allow me to rephrase:  How do these 'different channels' actually help the labor market?"

QE1 and QE2 did not appreciably help the labor market, as shown on the employment chart below.  But, hey, this time will be different, right?

While the QE programs haven't helped the labor market, they have pushed up the stock market and commodities through inflation, as shown on the chart below: