The Fed and Trend Are Your Best Friends

12/20/2010 12:35 pm EST

Focus: MARKETS

Dan Sullivan

Editor, The Chartist

Nothing matters now more than the Fed and the steely determination of stock buyers, writes Dan Sullivan of The Chartist.

There are no guarantees. But if everything goes according to the Federal Reserve’s script, we can expect a rising market over the next several months. “Don’t Fight the Fed” is a true market axiom. There is nothing more bullish than an accommodating Fed, which is exactly what we have at the present time.

The Fed appears to be on track with their plan to expand their balance sheet. It bears repeating a quote from former Fed Governor Larry Myers. Myers said you must focus on three things: “what happens to the equity markets, what happens to the dollar, and what happens to interest rates. Don’t be concerned with printing money! Don’t be concerned with the growing Fed balance sheet or how to unwind it! The primary purpose of the Fed’s bond purchases is to improve our financial condition. A higher stock market is good for aggregate demand, a falling dollar improves our global competitiveness, and lower borrowing costs improve aggregate demand.”

The following three quotes from key Fed players add emphasis to the role they expect the Fed’s bond purchases to play:

“I think we are underestimating and continue to underestimate how important asset prices, very specifically equity values are, not only for shareholders and the like, but for the economy as a whole.” Alan Greenspan, CNBC interview, Friday, Dec. 3, 2010.

“And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” Ben Bernanke, Washington Post, Nov. 4, 2010.

“Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.” Brian P. Sack, New York Fed, Oct. 4, 2010.

Small Caps, Midcaps Bust a Move
Since our last letter, several key indices have recorded bull market highs. The strongest move was turned in by the Russell 2000 [small-cap average], which broke through its early November highs as well as its April 23rd bull market highs with authority. The S&P Small Cap Index as well as the S&P Midcap Index are exhibiting similar patterns and are in clear-cut uptrends.

The Value Line Geometric Index also closed at bull market highs. This index, consisting of 1,700 stocks, represents approximately 95% of the market value of all securities and gives a strong indication of how the average investor is fairing. Its ability to record new bull market highs is very encouraging.

No Letdown for the Buyers
We are also encouraged by the fact that on Dec. 1 and Dec. 2 upside volume exceeded downside volume by 13.3 to 1 and 5.6 to 1. Frequently you will see upside volume lead by ten to one or more during a single session but with little follow through the following day. During the last bear market there were several occasions in which this occurred.

The one-day rallies were certainly impressive, with upside/downside ratios coming in at 20.9, 19.6, 10.1, 18.3, and 18.8; however, the follow-up readings frequently saw downside volume leading, and when upside volume led, it was always under two to one.

The last time upside volume exceeded downside volume by ten to one with a follow-up reading in excess of four to one took was on Aug. 31 and Sept. 1 with readings of 24.67 and 4.99. Over the next month, the S&P gained 6% and two months later was closing in on a 10% gain. Going back still further, upside volume exceeded downside volume by 21.1 to 1 on July 7 and 4.4 to 1 the next day. One month later the S&P was 14.5% higher.

Too Many Bulls Don’t Always Spoil Broth
One negative that many analysts are focusing on is the recent numbers from Investors Intelligence which now show 56.2% in the bullish camp, the highest reading since late 2007, versus 21.3% bears. No question, in most instances this preponderance of bulls calls for caution, but it is not always the kiss of death. In mid 2003, which was very early in the last bull market, the percentage of bulls hit 60%. The bullish contention jumped above 60% in December 2004, which was in a bull market that still had close to three years to run. The bulls hit 60% in December 2005—the bull market lasted another 2 3/4 years. [For more on this, see the recent excerpt from James Stack—Editor.]

Our great lesson to be learned from this period is that it pays to follow the price action of the market. We cannot emphasize enough the importance of staying with the market’s trend.

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