The Fed’s Dilemma

• May 13, 2005
• Mark Boucher

Important
Test of Critical Levels, AGAIN

We continue to await a break by
the Nasdaq below 1885,  by the SPY below 113, and below 100 by DIA’s to confirm
a new leg down in progress and establishes a clear downtrend here.  Until then
we’re in a mess of a trading range that could easily chew up the nimblest of
traders.  The DIA retested its 200 day ma from below it and turned back down. 
The SPY has not CLEARLY broken below its 200 day ma and stayed. 

Our bias continues to be that
investors are best to stay on the sidelines here.  It seems any breakdown is
accompanied by higher bond prices that act as a stabilizer and prevent a more
serious decline.  On the other hand persistent rate hikes are likely to prevent
a sizeable and sustainable uptrend. 

The EURO (EUR) broke down below
1.2750 while the Dollar broke out above 85.5.  Follow through up in the dollar
will make it tough sledding for oil, gold, and commodities and for the stock
market as well here.

We still like health care,
Defense/aerospace, soft drinks and some staples over the market and over weaker
groups;  while the best short-side groups appear to be home retail, discount
retail, electronics and computer retail, auto parts, and restaurants.  We
suggest fairly balanced long/short mix for those brave or foolish enough to try
to trade these markets. 

The Fed’s
Dilemma

The Fed has a real balancing
act to play, and it is important for investors to watch it carefully, understand
it, and monitor whether the Fed errs on the side of deflation or inflation — as
the impact on markets will be substantial.

The Fed certainly does not want
the economy to become so weak that the business expansion is aborted.  To do so
would risk global deflation, as the US is the main consumer for global goods and
one of two primary engines of growth.  A recession now would be disastrous and
have global ramifications that could be extreme.  It is highly unlikely that
Greenspan would risk such a scenario for long during his last year as Fed
Chairman.  But deflation is on one side of the balancing act.

On the other side is
inflation.  Domestic core consumer price inflation has risen consistently and
steadily and is now clearly above Fed projections and targets for 2005.

Even through a slightly cooling
economy, inflation pressures have not receded much, and it is likely that growth
will have to cool further before inflationary pressures fade.  Thus more
restrictive monetary policy is demanded on the inflation front.  We suspect that
as long as more restrictive policy is ahead, stocks and commodities will be
vulnerable and find it difficult to mount sustained advances.

However a major set of relief
valves have tended to kick in every time it looks like a significant economic
swoon is possibly beginning.  First oil prices tend to back off when economic
news darkens.  Second, the biggest relief valve is the long-term US bond
market.  A huge supply of excess savings mostly from Asia hunts for yield and
this keeps heavy downward pressure on GLOBAL bond yields that in turn keeps
pressures on US bond yields.  Normally during a period of strong economic
growth, a weak dollar, rising commodity prices, and rising inflation, bonds
would weaken to undervalued levels.  That did not happen this time.  Even with
Greenspan talking down long-bonds and the reintroduction of the 30-year bond,
bond yields have not risen enough to put bonds in an undervalued zone.  The
answer to this conundrum is that powerful global forces of excess savings from
Asia and global deflation from the rise of China as a manufacturing hub are
keeping bond yields from rising as much as normal. 

Thus while the Fed has raised
rates more than a handful of times, Fixed-rate mortgages are now cheaper than
when the Fed started raising short-rates last June — so money continues to
stampede into real estate enough that the Fed has commented on it negatively and
looks set to target real estate at least to try to cool it down a bit.  US real
estate equities are not yet signaling success here however.

Investors need to watch bond
rates carefully.  As long as long bonds act as a stabilizer and relief valve to
slower economic growth, the market downside action is limited.  Yet as long as
the Fed is tightening, market upside is probably limited too.  Eventually the
Fed will strive to tighten just enough to weaken the economy slightly more than
is required to quell inflationary pressure but not enough to risk
recession/deflation.  But if bonds continue to act as a relief valve during this
slowdown, stocks may not be as hard-hit as in other soft-landings such as 1994. 
Too much tightening and a resulting recession would be a very bearish scenario
for the market and would be discounted by the market by a substantial decline. 
So far the market appears to be signaling a trading range type environment where
sustainable rallies and declines await a clearer scenario outcome.  Investors
should watch the global balancing act carefully.

In my book and courses I’ve
talked a lot about the link and leading nature of bond prices and US stocks. 
However over the last ten years a new fascinating relationship has evolved
between US bonds and Japanese stocks.  As Japanese excess savings are a primary
component of demand for US bonds during this period, the relationship bears
watching.  Essentially whenever Japanese stocks are sliding, Japanese savings
get increasingly shifted into US bonds.  Conversely when Japanese stocks move
higher consistently, Japanese savings are shifted from US bonds to Japanese
stocks.  Thus Japanese stocks and US bond yields correlate incredibly highly
during this period.  Japanese stocks have been in a volatile 10% trading range
so far this year, but it is difficult to see a sustained advance materializing
in the absence of new stimulus and with Chinese redirection of demand away from
capital goods that has resulted in weakening Japanese economic statistics in
response.   From this outlook, unless Japanese stocks breakout surprisingly on
the upside, bond yields are not likely to move materially higher, further acting
as a stabilizer to any Fed tightening.

Our model portfolio followed in TradingMarkets.com with specific entry/exit/ops
levels from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in
2001, 7.58% in 2002, and we stopped specific recommendations up around 5% in May
2003 (strict following of our US only methodologies should have had portfolios
up 17% for the year 2003) — all on worst drawdown of under 7%.   This did not
include our foreign stock recommendations that had spectacular performance in
2003. 

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 56, 50, 40, 47, and 38 with 30 breakouts of 4+ week ranges, no
valid trades and no close calls.  This week, our bottom RS/EPS New Lows recorded
readings of 13, 13, 13, 21, and 32 with 4 breakdowns of 4+ week ranges, no valid
trades and one close call in LNN.  Valid signals remain in place in LCAV and
CHTT on the long side and BOBE on the short-side.    Notice that neither new
highs or new lows are exceptionally strong this week, AGAIN. 

For those not familiar with our long/short strategies, we suggest you review my
book

The Hedge Fund Edge, my course “The
Science of Trading,”

my video seminar, where I discuss many
new techniques, and my latest educational product, the

interactive training  module.
Basically, we have rigorous criteria for potential long stocks that we call
“up-fuel,” as well as rigorous criteria for potential short stocks that we call
“down-fuel.” Each day we review the list of new highs on our “Top RS and EPS New
High List” published on TradingMarkets.com for breakouts of four-week or longer
flags, or of valid cup-and-handles of more than four weeks. Buy trades are taken
only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts
are similarly taken only in stocks meeting our down-fuel criteria that have
valid breakdowns of four-plus-week flags or cup and handles on the downside. In
the U.S. market, continue to only buy or short stocks in leading or lagging
industries according to our group and sub-group new high and low lists. We
continue to buy new long signals and sell short new short signals until our
portfolio is 100% long and 100% short (less aggressive investors stop at 50%
long and 50% short). In early March of 2000, we took half-profits on nearly all
positions and lightened up considerably as a sea of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.

My advice remains:  Tread lightly and carry a big wad of cash awaiting a better
odds environment.  A soft landing later this quarter could set the stage for
some fantastic opportunities down the road a ways.

Mark Boucher