Can't Fight The Tape

I’ve been asking for the equity market to break out of its trading range for nearly a month now and, like it or not, share prices blew through the 1,131 resistance level today and closed at 1,142.71 (up 1.52%).  Apparently, ‘news’ of the recession’s end in June of 2009 from the National Bureau of Economic Research was enough of a positive headline to bait investors into snapping up shares.  Technically speaking, this is a fairly significant development as the door is now open for the rally to continue up to the 1,174 in a relatively unhindered fashion.  To be sure, much of the move above 1,131 was accentuated by numerous sell stops that were placed at or near this level.  That said, in order for 1,174 to become a real target, equities will need to hold above 1,131 tomorrow as well as the 200-week exponential moving average of 1,142.71 on the week (prices have failed numerous times at the EMA since mid-2008).  This could prove challenging if tomorrow’s statement on interest rate policy from the Federal Reserve differs meaningfully from market expectations.

Since April, each interest rate release from the Federal Reserve has been met with fairly significant selling in subsequent sessions, so a continuation of this rally, while technically possible, is still far from assured.  My sense is that the market is looking for some sort of change in the Fed’s statement that would confirm that additional monetary stimulus (outside of the mortgage-backed securities reinvestment that has already been announced) is imminent.  If this doesn’t materialize, though, I wouldn’t be surprised to see today’s gains washed away as quickly as they appeared.  In many ways, this expectation mirrors that which was seen prior to the Fed’s August meeting.  While the rumors of intervention this time around have not been as shrill as those heard in August, today’s sharp move higher in the absence of any meaningful corporate or economic news suggest, to me, that traders are betting on the Fed once again.  However, if there is no meaningful change in the Fed’s statement and equities continue to rally, we could be looking at a fairly sharp rally from here as such price action would suggest that investors are less concerned about economic fundamentals and more focused on simply gaining equity exposure.

In what has become an almost regular occurrence, Treasury yields failed to reflect the jubilation seen in the equity markets today and saw yields fall across the curve.  The long end, once again, was the primary focus of investor purchases.  Ten-year Treasury notes saw their yields drop 3.49 basis points to 2.7081% while thirty-year bond yields fell to 3.866% (-3.8 basis points).  This divergence between the equity and fixed income markets continues to reflect the extreme divergence of opinion among investors on the ultimate direction of the domestic and global economies.    As I’ve mentioned in previous posts, I tend to believe the price direction implied by the Treasury market a little more than that of the equity markets due to the sheer size and broad-based participation present in Treasuries.  Therefore, the continued resiliency of these securities, especially after the sharp rally of late, suggests that all is not yet clear on the macroeconomic front.  There is no doubt, though, that the Federal Reserve’s intervention in the Treasury market in recent weeks is affecting the yield curve to some extent which could, therefore, reduce the market’s predictive power.  But given the market’s size, the Fed is ultimately powerless to control longer term rates for any significant period of time.  Investors must be a willing accomplice for these rates to remain low, which is exactly what they are doing.  As a result, Treasuries will remain a good indication of investor concerns, whether they are related to deflation, geopolitical events, or currency fluctuations.  And for now, they’re still signaling a challenging economic environment for the foreseeable future.

As further evidence of the concerns that still underlie this market environment, gold remained resilient throughout the day while the U.S. Dollar saw continued weakness.  For the day, gold bullion prices finished up a modest $4.10/oz. to $1,278.50 after putting in a new intraday high of $1,283.50.  Some of this strength was probably attributable to the weakness of the U.S. Dollar, but the yellow metal’s methodical move higher since breaking the $1,265 level suggests that investors are willing to set aside yield to obtain assets they believe will remain stable.  From a technical perspective, both the daily and weekly charts are indicating that gold is reaching a highly overbought condition that would imply that a correction of some sort if coming.  The scale of this correction, whenever it materializes, will be interesting to watch as it will say a lot about the conviction currently underlying this market.  From my viewpoint, demand still appears strong.  I will continue to look for an opportune time to add gold exposure to my personal portfolio when/if gold pulls back to the $1,265 level.  If it holds there, I’ll be a buyer.

Despite bouncing off the lows of the session, the U.S. Dollar Index moved lower again today in what seems to be an inevitable test of the 79.50 - 80 level that was last seen in early August.  This will be an important level for the dollar bulls to defend in the coming days/weeks since break down would likely see a move down to 77 in short order.  Based upon the well defined inverse relationship between the Dollar Index and equities seen since mid-2008 (shown below), this move lower would be highly supportive of share prices.  But as any good statistician knows, correlation does not equate to causation.  As such, this relationship is prone to breakdown at any time.

Simply put, I was quite surprised by the break above 1,131 today, especially in light of the light news flow during the session.  I suspect that today’s breakout may have been driven in large part by the HFT (high frequency trading) players and other program traders who were looking to shake the shorts from their positions and make a little extra money along the way.  Today’s relatively light volume reading of 3.1 billion S&P 500 shares is a good indication, to me, that the session was filled more with gamesmanship than fundamental conviction.  Despite this, though, the technical breakout I’ve been looking for appears to have emerged and is suggesting that equities are moving higher.  To an extent, this rally is being confirmed by the weakness in the U.S. Dollar, though safe-harbor assets like gold and Treasuries continue to see meaningful bids.  With so much contradictory data both inside and outside of the marketplace, I continue to believe that a defensive strategy is warranted for now.  I will admit, though, that the price action of late is lending credence to the bull’s case.  But as it’s still September (and it’s one of the best September performances we’ve seen) and I continue to have real concerns about corporate earnings and economic performance for the balance of 2010, I simply can’t buy into this rally as yet.  Let the market hold on to today’s gains for another session or two and I’ll definitely have to take a look at a short term equity position at the very least.

Until tomorrow…..