Up Next….The Fed

Well it finally happened—the much anticipated bounce.  The S&P500 jumped 5.35% last week on reasonably strong volume, but much of this volume was NOT comprised of suddenly enthusiastic buyers (retail investors are still pulling money out in droves). Rather, it had more to do with professional traders covering their short positions (which requires them to buy stocks).  Not surprisingly, volatility also dropped quite a bit, as folks who previously bought options to hedge against further downside risks reversed these hedges.

On the economic front, nothing that would argue against the onset of a new recession emerged. Import prices spiked much more than expected; this cuts into corporate profits.  Similarly, producer prices were higher than expected.  On the consumer front, retail sales (headline and excluding autos) were flat; they were supposed to rise. Consumer prices also rose more than expected.  The Empire State manufacturing survey was supposed to improve; it got worse. Unemployment claims spiked up back into the mid-400,000 range which is solidly in recession territory.  The Philly Fed survey was worse than expected.  And consumer sentiment, while slightly better than expected, came in a the worst level since February 2009.

All in all, consumers (by far the largest segment of the US economy) are losing more jobs, paying higher prices and spending less at stores. Meanwhile, corporations are selling less stuff, paying more for their goods, and staring at profit margin squeezes in the near future.

Technically, here’s what we said last week:

If the S&P drops another couple of percent next week, even the daily charts will revert to a bearish status.  On the other hand, if the S&P finds its footing, it could rise all the way back up to 1,300 without breaking the downtrend that’s established on the weekly charts.

And last week, this second scenario played out—the S&P found its footing and rallied, in the face of all the horrible economic data.   The main reason was that the world’s major central banks got together and agreed to make available hundreds of billions of US dollars to troubled borrowers in Europe.

Does this solve the Euroland debt woes?  Not a chance.  But it does buy time, and when combined with even MORE dollar liquidity, risk markets tend to go up.

Will this rally last for a long time? It’s doubtful, mainly again, because the underlying debt rot has not been removed.  But per the scenario outlined last week here, the S&P could continue to bounce for a another 5+% (up to 1,300) before running into stiff resistance.  In other words, there is no good reason why this bounce must come to an end anytime soon.

Except for one thing—the Fed and its meeting announcement this upcoming week.

Because risk markets have risen in reaction to central bank actions and promises, they have already priced in a continuation of liquidity support by the Fed.  This means that for the bounce to hold—never mind continue higher—the Fed must come through with a strong dose of medicine at its announcement.

If so, the bounce will hold and even continue higher…..to say 1,300.

If not, then the bounce will most likely reverse itself……quickly…..to say 1,150 or lower.

So today’s markets are walking on eggshells.  As Euroland risks blowing up on a daily basis, the rest of the world is sliding into another recession.  And the US Congress is about to slash fiscal stimulus (via its debt commission) and join the austerity march that much of Western Europe has already started.

That pretty much leaves the world’s central banks—led by the Fed—as the last resort tool to prop up the equity markets.  And even if the Fed whips out another rabbit out of its hat this week, it will keep the charade going for only a short while longer.

Because unless the Fed can “print” corporate earnings and create a miraculous “fix” for the solvency crisis in Europe, the stock markets of the world WILL come down.  Earnings will plunge and a relatively stable P/E ratio will force prices to fall.

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