Why This Stock Market Rally Has Run Out of Puff

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Here we go with the Fed again. After falling markets unnerved her a few months ago, Fed boss Janet Yellen reckons a rate hike for December is a possibility…again.

What’s changed exactly? It’s not as if the US economy has changed all that much over the past few months. It’s still limping along, suffering the long term effects of the great credit bust of 2008.

It’s a different story in the markets. Stocks tanked in August as investors worried about the effect of the first Fed rate hike in about a decade. That made the Fed worry too. So Yellen pulled her head in. She said the financial market turmoil was reason enough to hold off on rate rises.

That soothed the angry beast. Stocks rallied. All was good with the world.

But the Fed, not understanding the trap they have made for themselves, saw the rally as an easing of financial risks. This put a rate rise back on the table, possibly as soon as next month. Yellen told the financial world as much last night.

There could be a little problem with this, though. I don’t think the market will play along with this simpleton narrative.

Let me show you what I mean. Take a look at the chart below. It shows the Dow Jones Industrial index over the past two years.

Source: StockCharts

You can see the August price plunge quite clearly. This was a considerable drop. It took out the lows of October and August 2014. Prior to that the Dow was weak. You can see that the moving averages (blue and red lines) crossed to the downside in early August. That was an indication of a change in trend.

The August plunge confirmed this trend change.

Then the Fed came into it and talked about delaying interest rate rises. This restored market confidence, resulting in a big rally.

But the market is now ‘overbought’. This is a technical term meaning it’s gone up too far too fast. The speculators lurched to one side of the boat in August, and then rushed over to the other side — with similar force — in October and early November.

You can see by the position of the moving averages that the trend is still in a bearish position. This suggests that downside risks remain. I think the Dow will turn back down very soon, perhaps in the next day or two.

If it does, it will confirm the downward trend and return momentum to the bears.

Have a look at the chart again. When a market has a sharp fall from a peak, as happened in August, you ALWAYS get a rebound. The strength and duration of the rebound reflects the strength of the overall market.

If the market DOES turn down from here, it will represent a lower high within an existing downtrend. That’s bearish.

Put another way, what you’ve seen is the Dow selling off and rebounding. But the rebound will most likely fail to make a new high. As I said, this is a bearish development.

So I’m tipping you’ll see another bout of weakness in US markets, and by extension, weakness in Aussie stocks too. This could last up to a month. The Fed doesn’t meet again until mid-December, so unless the Fed does ANOTHER backflip on rates, the market will head into Christmas assuming a rate hike is a possibility.

Of course all this could change. As Jim Rickards, editor of Strategic Intelligence  points out, you have to be nimble in an era of currency wars.

The key to investing during currency wars is to focus on the underlying dynamics and stay nimble.

That’s exactly what we do.

We never put a permanent stake in the ground. We look for signals that tell us when the turning points are coming and adjust our recommendations accordingly.

Now looks like one of those times.

To find out how Jim is playing it, click here.

Jim’s right. In an era of currency wars and interventionist central banks, you simply must be flexible in your thinking. You can’t be a ‘bull’ or a ‘bear’. You have to be prepared to be both, depending on the circumstances.

This is one of the greatest handicaps of the DIY investor. That is, many investors lock themselves into a view and find it hard to mentally adjust. So while the market changes back and forth, presenting opportunities, investors find it much harder to change their mental positioning to profit from this.

So do yourself a favour. Don’t be a bull or a bear. Dump your preconceived notions and become more mentally agile. You’ll become a better investor for it.

But if you ARE of a bearish persuasion, Jim has some good news for you. He wouldn’t be surprised to see the US economy dip into recession very soon.

The average U.S. economic expansion since 1980 (a very favorable period for growth) lasted 77 months. As of now, the U.S. economy has been expanding for 76 months, since the end of the last recession in June 2009. Admittedly, it has been a weak expansion, but it’s an expansion, nonetheless.

Does this mean the U.S. economy goes into recession next month?

Not necessarily, but no one should be surprised if it does. Monthly job creation stalled out last November and has been shrinking ever since.

Disinflation and deflation have the upper hand on inflation. Many industrial production and purchasing manager indexes are flashing red. The Fed’s tough talk on interest rate increases hasn’t helped.

Jim thinks the Fed won’t raise rates in December. If US data remains weak and the Fed hasn’t raised rates by March 2016, Jim reckons it won’t happen at all next year.

That’s because 2016 is an election year, and no Fed governor wants to raise rates in the lead up to an election.

We shall see how that plays out. In the meantime, get ready for further market falls. This rally has just about run out of puff.

Regards,

Greg Canavan

For The Daily Reckoning

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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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