The Week Ahead: Austerity Didn't Work in '37...What About Now?

10/26/2012 5:56 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

An alarming amount of the rhetoric being used by some experts in calling for austerity parallels the 1930's disastrous balanced-budget policies that plunged us back into a recession, writes MoneyShow's Tom Aspray. Also, he explains what investors should watch after a tough week for stocks.

It was a very rough week in the stock market, as the S&P 500 cracked the widely watched support at 1,420 on Tuesday. Prices closed the week just above the next key support in the 1,395 to 1,400 area. Friday's close was mixed, as the major averages moved in and out of positive territory for much of the day.

The action last week clearly did some technical damage, and it has now been six weeks since the September 14 highs. The decline from the early April highs lasted nine weeks and took the S&P 500 9.8% down from its highs. A similar decline would last until well after the election, and the same percentage decline could take the S&P as low as 1,322, but I do not think that is likely.

With the resurgence of the Romney campaign, which is considered to be more "business friendly," why are stocks so weak? The airwaves have been flooded with gloomy forecasts from business leaders who are focused on the fiscal cliff and high debt levels.

The fiscal conservatives favor more austerity, as they conclude that our increasing debt levels have to result in much higher inflation. Many are hoping that this will be like 1980, when Reagan's election spawned a 20-year bull market.

One election year that no one mentions is 1936, when the country was coming out of the only recession that was worse than our recent one. The debate was similar back then: Kansas Governor Alfred M. Landon wanted government regulation to be removed, and states be given more control. At the time, many businessmen challenged the programs of FDR, as they felt overtaxed and overregulated.

As noted in an excellent paper by Marshall Auerback from the Roosevelt Institute, "the Roosevelt administration reduced unemployment from 25% in 1933 to 9.6%% in 1936, up to 13% in 1938 (due largely to a reversal of the fiscal activism which had characterized FDR's first term in office)."

The author also notes that, "By 1936, many economists and financial experts (notably FDR's Treasury Secretary, Henry Morgenthau) feared the country would go bankrupt if the government kept deficit-spending." (Sound familiar?)

"And after all, they argued, the government deficits had "pump-primed" the economy. The private sector could now take off on its own and get back to close to the full employment level of 1928 to early 1929."

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Though I did know the basics of this from my college days as a US history major (before I turned to biochemistry), I found the similarity of the rhetoric quite surprising. Of course, the charts pointed me in this direction, as the chart of the Dow Industrials shows a nice uptrend from the 1934 lows.

There was little in the way of a correction in 1936, as FDR had a landslide victory, but the uptrend was broken in September 1937. By April 1938, the Dow had dropped over 50% from its highs. It was in 1938 that Roosevelt submitted a budget where the deficit had been eliminated...but unfortunately so had the recovery.

Though other economists argue about the conclusions of Auerback, it is interesting to note that in 1936, the path to austerity was widely accepted. Now there seems to be a similar view that inflation is inevitable. and the hope is that by cutting our spending quickly, the inflationary spike won't be that bad.

Unlike a few years ago, no one now seems to be concerned about the threat of deflation-yet most economists agree it is much harder to stop.

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Therefore I found this chart of the deflationary cycle quite interesting. A careful examination of the various stages look similar in ways to our recent past. With the recent debate over our policy with China, the Protectionism & Tariffs phase especially stood out. Hopefully, a deflationary period is not ahead of us.

NEXT: How Does This Affect Us Today?

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The good news is that these concerns are unlikely to impact investors until 2013.

The string of earnings disappointments are likely to last for a few more weeks, with Amazon.com (AMZN) and Apple (AAPL) the latest companies to disappoint the markets with their earnings last Thursday.

The markets interpreted their earnings much differently. On midday Friday, AMZN was up 3.6%, while AAPL was down 2.6%.

Even though the tech sector has dropped more than I expected, it is still holding above important support, which will need to be watched in the coming weeks. There were some bright spots, such as Expedia (EXPE), which surged over 10% Friday in reaction to its strong earnings.

As the US stock market has dropped for the past month, the emerging markets-especially China-have done quite well. Since September 14, when the Spyder Trust (SPY) peaked, the large-cap iShares MSCI China Index Fund (MCHI) is up 3.8%, while the SPY is down 4.7%.

Last week, the Eurozone crisis continued to fester. While the economic data showed more deterioration, as Spanish unemployment reached 25%, German consumer confidence hit a new five-year high.

It is interesting that despite the selling in the US stock market, the Euro STOXX 50 Index is still in its broad trading range. This suggests that the overseas markets may lead the US once the correction is over.

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The better than expected GDP report on Friday surprised many, and helped prop up a sinking stock market. The 27% increase in new home sales gave the GDP a boost, but as the long-term chart shows they are still well below the peak from just a few years ago.

The economy will be on the front burner this week, as we get the widely anticipated monthly jobs report. Overall, the economic calendar is quite full, with the Dallas Fed Manufacturing Survey on Monday, followed by the S&P Case-Shiller Home Price Index and Consumer Confidence on Tuesday.

On Wednesday we get the ADP Employment Report, as well as the Employment Cost Index. In addition to the jobless claims on Thursday, the Productivity and Costs, ISM Manufacturing Index, and Construction Spending are also going to be released. On Friday, we also get the latest report on factory orders.

NEXT: What to Watch

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What to Watch
Stocks finished the week on a choppy note, as futures were sharply lower Friday ahead of the GDP report, but rallied in early trading before the sellers again took over. The short-term analysis suggests a near-term low is likely this week, if the futures did not make their lows early Friday.

The December S&P 500 E-Mini futures hit a low of 1,394.50 before the GDP report, which was still above the 38.2% support level at 1384.50. The Dow Industrials have just tested their 38.2% Fibonacci support level at 13,041, which makes it a pretty normal correction so far.

Still, the correction has gone further than I expected. Last Tuesday's drop indicated my expectation of another push to the upside before the election was wrong. The earnings reports-and more importantly, the increasingly negative corporate outlook-has turned the mood on the Street quite negative.

While the price action in some stocks has been quite ugly, the stock market is not yet that oversold. It will likely take a more broad-based drop before it can form a short-term oversold low. Typically, such a low is needed before we can actively start looking for an end to the correction.

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The bearish sentiment did not show much increase last week, from either individual investors or financial newsletter writers. The put/call readings and VIX analysis also suggest that stocks can still drop further.

The first decent rally will tell us more about the downside targets, but it would take a close below 1,370 (the 50% support) in the S&P 500 to weaken the positive intermediate-term outlook.

The daily chart of the broad-based NYSE Composite continues to act the best, as it is just testing its uptrend from the June lows (line a). The next key support is at 8,022, which is the 38.2% Fibonacci support. It is about 2% below Friday's close. The more important 50% retracement support is considerably lower at 7,869, and the longer-term uptrend follows that at 7,400.

The NYSE Advance/Decline line has reversed after moving above the early October highs, and is now very close to breaking support at the lows from the last month. There is more important support now at line c. The A/D line is still well above the longer-term uptrend (line d), and did confirm the September highs.

S&P 500
The daily chart of the Spyder Trust (SPY) shows that the recent low at $142.58 and the uptrend (line f) were decisively broken on Monday. The low on Friday was not far above the 38.2% Fibonacci retracement support at $140.11. This also corresponds to the lows from late August.

There is additional chart support in the $138.50 to $139 area, with the 50% support at $137.64. The break last week suggests that at a minimum some backing and filling in the $140 to $143 area is needed before a bottom could be in place.

Any rally should find tough resistance now at $142.58 to $143.50, and then $145.

The S&P 500 A/D line tried to bounce after breaking support (line h), but turned lower again Friday, as the A/D numbers were negative. The A/D line is in a fairly narrow sideways range, with key resistance still at line g.

NEXT: Stocks, Sector Focus, and Tom's Outlook

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Nasdaq-100
The PowerShares QQQ Trust (QQQ) broke its daily uptrend (line b) just over a week ago, then violated the 50% Fibonacci support at $65.30 this week.

This makes the next downside target the all-important 61.8% support, now at $64.05. Tech giants like Apple (AAPL) and Amazon.com (AMZN) will both need to rally in order to keep the QQQ from dropping below this level.

The Nasdaq-100 A/D line has continued to make lower lows, but is not showing any increase in downside momentum. It needs to surpass its recent high and then the downtrend (line b) before a bottom can be in place.

The daily chart now has resistance at $66.50 and the former uptrend, with the declining 20-day EMA at $66.87. There is key resistance at $68 to $68.30.

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Russell 2000
The iShares Russell 2000 Index (IWM) is acting much better than the tech sector, as it is still holding well above the 50% retracement support at $79.85. Its uptrend (line d) has held so far.

The Russell 2000 A/D line has broken its uptrend (line e), suggesting that IWM could also break its corresponding support. There is next support for the A/D line at the early August lows.

There is initial resistance in the $82 area, with further levels at $83 to $84.

Sector Focus
The iShares Dow Jones Transportation (IYT) was lower last week, but is one of the few industry groups holding well above the lows from three weeks ago. It still needs a decisive close above $94 to turn positive.

Last week, I covered the Select Sector SPDR ETFs in detail, and reviewed their yearly and quarterly performance. I also looked at which funds were down the most from the highs made in the past month or so.

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Two of these funds were the Select Sector SPDR Materials (XLB) and Select Sector SPDR Energy (XLE), which dropped 5.7% and 6.3% from the recent highs. These two funds had looked quite interesting last month, and continued strength in emerging markets should boost these sectors.

The Select Sector SPDR Materials (XLB) broke through its downtrend (line a) in September, but has since turned lower, closing the week on its 20-week EMA. It is still holding above the 50% support at $35.57, with key chart support in the $35 area.

The relative performance looks like it is trying to bottom, as the long-term downtrend (line b) has been broken. It shows good support (line c), but needs to surpass the prior two highs to signal a bottom.

The OBV is trying to base but has key resistance now at line d. The weekly resistance to watch is at $38.10.

The Select Sector SPDR Energy (XLE) dropped below its 20-week EMA last week, but closed well above it. It is retesting the breakout level (line e) from September. It is trying to hold the 38.2% support at $71.12, with the 50% retracement support nearby at $69.19.

The weekly relative performance is holding above its WMA, and a turn higher this week would be a positive sign. The on-balance volume (OBV) broke through its resistance (line g) in July, and is holding just above its WMA. This is a sign that the selling pressure on the decline has not been too heavy. There is weekly resistance now at $75.20.

NEXT: Interest Rates, Commodities, and Tom's Outlook

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Crude Oil
The December crude oil dropped below the key 61.8% support level at $87.40 that we have been watching. There is some support in the $83 to $84 area, but a test of the lows at $79 cannot be ruled out

Interest Rates
The yield on the ten-year T-Note declined a bit last week, but at 1.75% are well above the September lows of 1.54%. This may be an indication that the fear level in the market is not nearly as bad as some of the price action in the equity market suggests.

The break of the long-term downtrend last month (line a) suggested that yields were stabilizing.

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Precious Metals
The SPDR Gold Trust (GLD), iShares Gold Trust (IAU), iShares Silver Trust (SLV), and Global X Silver Miners (SIL) all bounced late in the week after hitting new correction lows earlier.

The SPDR Gold Trust (GLD) is holding above the 38.2% Fibonacci support at $164.21, with the daily uptrend (line b) now at $163.30. The 50% retracement support is at $161.17.

The daily OBV is still below its WMA, but the bounce could be the start of the bottoming process. However, one more new correction low is likely. Some of my buy levels have been hit. For specifics, see my recent article.

The Week Ahead
As I expected last time, the selling did carry over to last week. Despite Friday's mixed close, we may see another push to the downside early in the week.

Even if stocks do bounce this week, I expect the odds of further new correction lows are still high. The intermediate-term analysis suggests we should get a good buying opportunity in the next two to five weeks.

As for new recommendation, I still think that the current drop in the precious metals is a buying opportunity. More conservative investors could wait until we get new daily buy signals, which we do not have yet.

The other markets that look interesting are the emerging markets, though I would wait for a better entry in the China ETFs, which are now overbought. I still like the Vanguard Emerging Markets Viper (VWO), which I recommended recently. As surprising as it may seem, I will be also looking at some European stock markets, as some have held up quite well.

As I have done in the past, I will be taking a long weekend prior to the election, as I hope to escape the barrage of political ads. The next Week Ahead column will therefore be published on Friday, November 9, but I will be updating my outlook for the stock market this Thursday, November 1.

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