The Fed vs. The World: A Draw, for Now

The S&P500 finished the week almost unchanged.  Again, volume signalled that there’s more selling pressure than buying pressure; on the two days when the S&P fell, average volume was higher than it was on the three days when prices rose.  Volatility was also unchanged for the week, but it spiked on the two sell-off days.

The macro data was mixed to weak.  Personal income beat expectations; spending missed.  But personal income missed, badly, when the effects from the one-time late 2010 tax relief are removed.  Pending home sales missed.  ISM manufacturing and services beat expectations, but both are at levels that are almost always associated with cycle peaks; it’s highly likely they will fall in the near future.  Initial jobless claims were lower than expected.  Nonfarm payrolls missed, slightly.  Just as importantly, the average workweek did not increase as expected, and average hourly earnings did not grow at all (they were expected to rise).  The headline unemployment rate dropped to just below 9 percent, but shockingly the labor force participation rate remained at multi-decade lows (64.2%).  This means that the job conditions are so bad that a record number of unemployed folks are just no longer even looking.  If the labor force participation rate simply returned to its 25 year average of 66.1%, the headline unemployment rate would be a depressing 11.6%.

Technically, the S&P has not broken its uptrend line on the daily charts.  Just as importantly, it has not broken (and closed) below the 50 day moving average.  Some technicians have declared the uptrend broken because a rising wedge pattern (that began in August 2010) has been broken.  But until the S&P closes below about 1295, the Fed-induced melt-up is still in effect.  The weekly charts support this argument.  As overbought and overstretched as the stock market is, it has still not technically broken.

Last week we commented on the non-financial forces that could overcome the massive power unleashed by the Fed in pushing up stock prices.  And last week’s action in the oil market supported this argument.

On the two days when (in this case primarily due to Libyan unrest) oil prices rose the most, the stock markets fell the most.  The high (and the threat of even higher) price of oil swamped the Fed’s stated goal of boosting stock prices.

What ironic is that the Fed’s actions (primarily its quantitative easing) have been one of the most important drivers behind the rise of oil prices.  First, the Fed’s creation of billions of additional dollars has spilled into the hard commodity markets (like oil), thereby boosting their prices.  Second, the Fed’s QE has helped stimulate general demand in the global economy (even if much of it spilled over to developing nations such as China); this additional global economic demand naturally pushed up the cost of oil, which is used to satisfy this new demand (for raw material in making products and for fuel in transporting products).  Third, the increased prices in fuel oil and food commodities exploded into social stress in developing countries all over the Middle East and North Africa (MENA).  The generally poor people there suddenly found it much more difficult to eat.  And since so much of the population is young, it expressed this hunger-driven stress through protests and rioting, leading to revolutions in Tunisia and Egypt, so far.  This social and political turmoil has reduced oil production in MENA and threatens to slash it much more, should the unrest explode in Saudi Arabia, for example.

The Fed, in many ways, shot itself in the foot.  While it temporarily “solved” one problem (by boosting stock prices), it created another massive set of problems, problems that are only now beginning to boomerang back to the Fed.

So last week ended in a draw.  While oil prices shot up again, the stock market—thanks directly to the continuing QE2 program—did not change, for the week.

Once again, we are left to ponder: what happens when QE2 winds down over the next two months? 

It’s very possible that the stock market benefits will disappear, and that alone would give stocks a strong reason to pull back. 

But it’s also possible that—in addition to the elimination of the stock market support—the “massive set of problems” will remain:  high oil prices, high food prices, global social and political stress. 

So if the benefits of QE disappear, and all the nasty side-effects remain, that would give stocks a stronger reason to pull back.

Scratch that.  That would give stocks a reason to crash.

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