Federal Reserve Wordsmithing and ‘Hopium’ Pushing Stocks Higher

Stock Market Analyze
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Stocks around the world are in the second day of their Federal Reserve induced love swoon. I wonder how long this honeymoon period will last? Our mate Kris Sayce, currently dragging his family around the cold climes of the Mother Country, reckons we’re at a tipping point, and thinks strong ‘tactical’ gains are available for those willing to take a punt. You can read Kris’ reasoning here

In overnight trade, both the S&P 500 and the Dow finished up by around 2.4%. Top European stocks closed the day up 3.3%. Meanwhile, oil finished down again, with Brent crude off by nearly 2.8%. Gold was steady while copper fell nearly 1%.

Wasn’t this whole sell-off a panic over falling oil prices in the first place?

Apparently it was…until the Federal Reserve came along with a ‘look into my eyes’ routine, swapped some words around, and dropped something into investors’ drinks. Now it’s all back on!

Even though commodity prices had another poor trading session overnight, the stocks exposed to these prices did ok. In early trade in Australia today, most commodity stocks are doing well.

This is a guess, but maybe traders are pre-empting a correction in the US dollar index. For months now, it’s been all about US dollar strength. King dollar…the mighty greenback, and all that. But have a look at the chart below. As you can see, since late June it’s put in a massive rally.

Bear in mind this is a weekly chart, which reduces a bit of the ‘noise’ you tend to get in daily price charts. On a weekly basis, the US dollar index has been ‘overbought’ since September. You can see it by looking at the top panel, the ‘relative strength index’.

That’s a testament to the global financial system’s insatiable demand for dollars. Overbought levels lasting a period of months are quite unusual.

But if I had to bet on either the run continuing or it taking a bit of a breather instead, I’d put my money on the latter. The trend may be up, but it’s stretched and in need of a rest. This isn’t it for the US dollar bull market, but the trade is a little crowded and it’s time to shake loose some of the latecomers.

What does this mean in terms of investments? Well, commodity prices might get a short term reprieve. Oil in particular looks set for a short covering bounce. But given the amount of damage done to the oil price in recent months, it will be a rally to hang around in for a short time, not a long time.

My colleague and designer of the Quant Trader system, Jason McIntosh, has a slightly different take on it. He’s looking at this play through a traders’ eyes. Here’s what he had to say when I asked him about it this morning:

Trends are amazing creatures. They often run further than anyone initially believes possible.
 
You can make a lot of money following trends. It’s one of the most profitable trading strategies you’ll find.
 
But rather than ride the trend…many people want to fight it.
 
People have been calling for a USD pullback for months. I remember reading some vocal corrective cries back in September. But the market wasn’t listening. It just went higher and higher.
 
So where to from here? 
 
Well, if you have a position…let it run. You never know how far it will go. A trailing stop is your ideal trading companion. It will get you out when the trend turns.
 
Those without a position should stand aside. The USD has been edging lower over the past week. This may be just another blip before the rally continues…or it may be the long awaited correction.    
 
No one knows which it is. I’ll leave that for the crystal ball gazers.  
 
But I will say this: Buying the dip is dangerous. You never know how far the market will dip. And it’s just as hazardous to sell a winning position on the first sign of weakness.
 
The market hasn’t yet told us this trend is over. So set your trailing stop and sit tight. 

If you want to check out Jason’s revolutionary Quant Trading system, click here.

Back to the markets in general, and while the Fed’s wordsmithing continues to ring in punters’ ears, stocks should push higher on that delightful gas known as hopium.

Meanwhile, back in the real world, problems persist. Do you remember yesterday when I discussed the issue of unintended consequences? Well, the Financial Times came out with a great article last night pointing out an example of this in China.

China’s stock market has soared to multiyear highs since the central bank cut benchmark interest rates last month, as stock investors anticipate more aggressive easing steps to come.

‘But a funny thing happened on the way to loose money: actual interest rates rose.’

Huh?

That’s right — money market interest rates increased following the cut by the People’s Bank of China last month. This type of move reflects a lack of liquidity in the system. Higher money market rates are the mechanism to try and encourage cash back in.

This could be because of issues in the shadow banking sector or people using cash to plough into the sharemarket. Either way, it’s not a great sign for the Chinese economy. As I said yesterday, this rebalancing thing is going to take time and involve a bit of pain.

On the other side of the coin, you’ve got the Swiss National Bank making interest rates on deposit accounts negative above a certain threshold. It’s an attempt to stop the flow of money seeking a short term safe haven. No one wants a strong currency in this environment.

The financial system, in its current guise, is clearly flawed. Negative (nominal) interest rates are an aberration…a historical anomaly. The famous Austrian economist von Mises identified the desire to abolish interest as a very dangerous one.

…there cannot be any question of abolishing interest by any institution, laws, or devices of bank manipulation. He who wants to ‘abolish’ interest will have to induce people to value an apple available in a hundred years no less than a present apple. What can be abolished by laws and decrees is merely the right of capitalists to receive interest. But such decrees would bring about capital consumption and would very soon through mankind back into the original state of poverty.’

Mises’ apple analogy is the same thing as saying zero interest rates makes people value a dollar of earnings from a stock due in 100 years’ time the same as its value today. That is, there is no discount for the risk of perhaps not receiving that dollar in the future. Or not being around to receive it because of nagging mortality issues.

His point is that abolishing the rate of interest causes massive distortions. It’s stops us from saving and encourages us to consume…eventually we will consume our capital stock (by borrowing against it), then find we can’t service the debts…and then we’ll be in all sorts.

That’s the dangerous path we’re heading down. No one really sees it right now because we’re deep in the forest. But from a bird’s eye view, we’re going the wrong way.

Regards,

Greg Canavan+
For The Daily Reckoning Australia

Join The Daily Reckoning on Google+

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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