When Will The Fed Cry Uncle?

Last week was brutal for risk assets, especially equities. The S&P500 dropped 4.3% which was the worst weekly loss of 2012. Volume rose, BUT not dramatically. Volatility rose, BUT not to super high levels. This means that the selling has NOT climaxed. In almost all selling climaxes, when markets reverse and jump back up, both volume and fear typically rise to much higher levels.

In macro news, consumer prices behaved as expected….rising not at all on headline CPI, and rising 0.2% on core CPI. Retail sales, excluding autos, disappointed. While housing starts were better than expected, housing permits missed. Initial jobless claims were worse than predicted. Leading indicators also missed. And the big surprise of the week was the Philly Fed Survey which, instead of rising, fell into negative territory, representing one of the biggest misses in a year.

Technically, the S&P is oversold on the daily charts. It was already slightly oversold last week, but now it’s very oversold. A bounce, even if only temporary, is very much overdue. On the weekly charts, the picture is ugly. The S&P is about to hit the 200 day moving average, which was around 1,278 as of Friday’s close. Should this critical support level not hold, then the US stock markets could be at risk of another severe leg down, very likely down to, or below, 1200 where the markets rallied starting in December 2011. Next week’s trading will be critical.

So now that the S&P500 is down about 8% since the end of March, the question on everyone’s mind is: how much more damage will the Fed allow before stepping in with more monetary “easing”, or financial repression by either creating credit money (via quantitative easing), or by shoving long-term rates down even further from their current 50 year lows (via Operation Twist)?

The answer to this question is critical to trading and investment decision-making. If you think that the Fed will not allow much more damage, then now is the time to “buy the dip’, by loading up on beat up stocks and high yield credit.

If you think that a total drop more in line with the spring 2010 and spring 2011 drops is needed (18%-20%), then now is not the time to buy, but to exit from winning positions and even to enter into short positions. Since there’s another 10%+ drop ahead of you, it’s much too early to buy now.

But there’s another problem. Over the last three years, the “effect” of the Fed’s monetary programs has been dwindling. QE1 in late 2008 and 2009 had the most effect, in terms of boosting asset prices. QE2 in 2010 had less effect, and Operation Twist in 2011 has had even less effect. Just as bad is the trend in the “duration” of the effect. QE1 worked its magic for about over a year. But QE2 boosted prices for under a year, and Operation Twist has had, arguably, the shortest effect.

So the question is, even when the Fed initiates its next stimulus program (whether it’s soon, or after another 10%+ drop in equity prices), is it possible that the effect will be very minor, and fleeting?

What if the spark that shoves asset prices further down comes from Europe, say Greece leaving the Eurozone and repudiating all its sovereign debts, leading to a disorderly default, a banking crisis, and numerous spillover effects across the rest of Europe, and even the world?

Will the Fed’s magic have the same effect….as it did in 2008-09, 2010 and 2011?

Here’s a piece of advice—don’t hold your breath.

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