Is the recent market softness something to be worried about?
Not if U.S. President Barack Obama & Co. comes through with a second stimulus package – as I’m expecting.
Let me explain …
There are a few reasons to suspect that the softness we’ve been seeing will continue for a week or so. Small-cap stocks – which continue to drag along like road kill caught on the rear bumper of the market – are our main cause of concern at the moment.
There is also the possible head-and-shoulder reversal pattern on the Nasdaq Composite Index and “double top” patterns on the Russell 2000 Index and Standard & Poor’s 500 Index. And a number of short-term indicators have moved into over-bought territory.
As you can see in the chart that follows, there's a battle going on at the 85-day moving average, which was the support level back in July. Small-caps fell below that level two weeks ago, pressed above it last week, and now could go either way. If they drop more decisively below the 850-day moving average, the weakness is likely to persist.
Within the context of a bull market elsewhere, the most sensible response is to step away from small-cap stocks. More aggressive investors may actually wish to short them. With the index in suspended animation at the moment, though, neither action should be taken yet. The next move will come soon enough, and is likely to be both explosive and just the start of something larger.
And with good reason.
More Stimulus? Count on It
Stocks are most likely still just consolidating, because that's what they do. They go up, they back off, they go sideways, they go up again.
Let’s just call it wash, rinse and repeat.
The development of a “double top” now in the S&P 500 is going to get bears excited, and the fact that a head-and-shoulders topping formation may be forming to boot will also renew their courage.
For a new round of buying to emerge, we’ll need a catalyst to provide a spark. And just what might come along to spark a new round of buying? What would bring people who are currently on the sidelines into the market, and what would cause investors who currently have a high bond allocation to make the switch into equities?
A company like Swiss eye care products maker Alcon Inc. (NYSE: ACL), which was one of my newsletter positions this summer, is a great example of a leader so far, with a perfectly lovely recovery chart (See below).
But what will lead skeptic to blink and join the action?
I might have an answer. Late Thursday, I learned that Goldman Sachs Group Inc. (NYSE: GS) is telling its clients that the Obama administration is going to announce another major stimulus package. That would mean that the combined monetary and fiscal infusion package that is already historic in proportions might actually be kicked up a notch.
Of course the administration would have to persuade Congress to pass the legislation at a time when conservatives are already screaming about the extreme state of the nation's deficit. But this would fit into my view, expressed here many times, that the government has gone all-in with low interest rates and fiscal stimulus, and is ready to go way overboard in its attempt to get the U.S. economy rolling again.
This is not because the politicians are altruistic, mind you. It's because they're, well, politicians. And my many years of covering government at the Los Angeles Times led me to realize that the first, second and third motivation of politicians is to get re-elected. Everything else pales in comparison.
If President Obama wishes to make sure it retains a Democratic majority in Congress in the mid-term elections, it must act swiftly to boost employment. Stimulus packages act with a lag, so Obama & Co. must get the new package passed and get the money spent as quickly as possible.
In that context, Goldman says that we should pay attention to two developments that suggest a greater likelihood of more stimulus ahead:
- First, we have comments from U.S. Senate Majority Leader Harry Reid, D-NV that the Senate was likely to consider a jobs bill in early 2010.
- Second, President Obama announced Thursday that the White House would convene a jobs summit in December.
Goldman says a more-explicit focus on job creation would achieve four things:
- Increase the likelihood of new polices, rather than simple extension of existing ones.
- Raise the odds of additional fiscal assistance for states and infrastructure spending.
- Incrementally increase the probability of additional tax relief in 2010.
- And push healthcare reform and energy legislation down lower on the agenda for 2010 – and probably increase the likelihood that Congress scales back the legislation it is contemplating in these areas.
Goldman analysts believe that Congress will enact $250 billion in additional fiscal measures to support growth over the next three years, including $75 billion more in 2010. However, recent developments – including the $45 billion bill to help homebuyers enacted last Friday – make this assumption look conservative.
The analysts say that the timetable would be similar to what we've seen in each of the past two years: policy formulated internally in December, debated publicly in January, enacted in February. But they note that it would likely take longer to create and pass due to concerns about the effectiveness about prior efforts.
So how would stocks react? Considering that the entire rally out of the March lows has resulted from the first major Obama stimulus package, I would think that the reaction to a second package would also be positive. This could be news that kicks off the next leg higher, or at least forestalls the recent consolidation phase that seems to have gotten under way.
Week in Review
Stocks swept higher on Friday after recovering from an early bout of anxiety over a weak consumer confidence report. The Dow Jones Industrial Average gained 0.7%, the S&P 500 gained 0.6%, the Nasdaq gained 0.9%, and the Russell 2000 gained 1%.
There was plenty of good news. Government reports showed that the Eurozone economy returned to growth in the third quarter with an expansion of 1.5%. U.S. home foreclosures slowed for the third straight month. Global policy makers from Asia to Europe indicated that stimulus efforts will continue at least through 2010 and possibly into 2011. Canada's financial minister added that he sees "very substantial" risk from ending stimulus early. And thanks to the Fed's ongoing purchases of mortgage debt, mortgage rates fell to a seven-month low.
All the major sector groups, save the bank stocks, moved higher. Consumer discretionary stocks were the top performers, with the Consumer Discretionary SPDR Exchange-Traded Fund (NYSE: XLY) rising 1.8% after a number of retailers expressed increased confidence. High-end teen retailer Abercrombie & Fitch Co. (NYSE: ANF) gained 10.7% after it reported better-than-expected quarterly numbers.
Technically, though, the Friday action stayed within the bounds of Thursday's sell-off. Known as an "inside day" – or a "bearish harami," in the lingo of Japanese candlestick chartists – it suggests that that activity may have been a temporary pause within the small downtrend that started this week. The pattern can be erased with a modest up session on Monday or Tuesday.
Volume dropped 6.2% as just 985 million shares traded on the New York Stock Exchange. This continues the slide in activity we've seen since the market bottomed and turned higher last week: Since Oct. 28, Big Board (NYSE) volume has dropped 41% in what is normally a fairly active time of the year. Paul Desmond and his team of veteran technicians at Lowry Research Corp., noted that, while light volume rallies "often prove fragile, they most frequently lead to short term rather than major market tops."
There are other signs that the market's recent softening isn't indicative of something more severe. There has not been a large and sustained increase in selling pressure. Large-cap stocks remain buoyant. And breadth – net advancers vs. net decliners – has been improving after a brief slip.
Monday: Stocks rallied after G20 leaders meeting over the weekend in Scotland pledged to maintain stimulus programs despite rising fiscal deficits. Although the global economy has shown signs of renewed vitality, the central bankers and finance ministers called the recovery "uneven and … dependent on policy support."
Elsewhere, the International Monetary Fund said the U.S. dollar was still slightly overvalued – a statement that acted like a shot of Red Bull to traders using the dollar to fund ultra-leveraged carry trades.
Tuesday: Again we saw equities respond closely to the vagaries of the foreign exchange market. Tuesday's action was driven in large part by what was happening in the United Kingdom. First, analysts at Fitch Ratings Inc. said that Britain was "potentially most at risk" of losing its AAA credit rating as fiscal deficits soar. This sent the pound lower and the dollar higher. Risk assets like stocks and gold sold off as a result.
Then, U.K. trade minister Mervyn Davies said the government's credit rating was "absolutely" safe. The pound stabilized and the dollar slipped, and in turn risk assets recovered from their lows.
Wednesday: Stocks pushed higher again on Wednesday, continuing a global wave of strength that started overnight in Asia after China release a slew of solid economic reports. Industrial production increased 16.1% year-over-year; well ahead of the 15.5% consensus estimate. It was the sixth consecutive monthly increase and the fastest growth since March 2008.
Thursday: Jobless claims continue to improve. Claims fell 12,000 to 502,000. The four-week average dropped 4,500 to 519,750. This is the lowest level since last November and is a sign employers are beginning to slow down payroll cuts.
Friday: The Reuters/University of Michigan's Consumer Sentiment Index made a surprise drop to 66. This is well below the consensus estimate of 71 and the previous reading of 70.6. Weakness was divided between the current conditions and expectations sub-indices. The reading on expectations had increased to 74 in September before falling to 69 in October and just 64 now.
Separately, the U.S. trade deficit widened to $36.5 billion from $30.7 billion previously as a weakened U.S. dollar helped drive up oil prices. The result was below the consensus estimate of $32.5 billion. Exports rose 2.9% but it wasn't enough to overcome the 5.8% jump in imports. The trade deficit is a drag on gross domestic product (GDP) growth.
The Week Ahead
Monday: The Commerce Department’s report on October retail sales is due. Analysts expect sales to have increased 0.9% for the month after September's 1.5% decline. The result will be an important gauge of consumer health as we head into the holiday shopping season. Watch motor vehicle sales to see if demand has bounced back after the expiration of the cash-for-clunkers auto rebate program.
Tuesday: Industrial production data for October will be released. The consensus estimate stands at 0.4%. This is down from the 0.7% growth seen in September and the 1.2% jump in August. Investors will be closely monitoring this release for clues into the recovery underway in the manufacturing sector.
Wednesday: A read on inflation from the Consumer Price Index. Expectations are low as the economy maintains a large amount of excess capacity and wage growth remains constrained.
Thursday: The Conference Board releases its latest index of leading indicators. The index jumped 1% in September for its sixth consecutive gain. Analysts believe the string can continue and expect an increase of 0.4% for October.
Friday: A quiet session. Philadelphia Fed President Charles Plosser speaks in Singapore.
[Editor's Note: New Money Morning contributor Jon Markman is a veteran portfolio manager, commentator and author. He is currently the editor of two investment-research services, Strategic Advantage and Trader's Advantage. For information on obtaining a two-week free trial to the daily commentary of the Strategic Advantage, please click here.
Markman, an accomplished author, will have his fourth book debut in the middle of December. That book is an annotated edition of the 1923 book, "Reminiscences of a Stock Operator," an investment classic that most experts rate as one of the top business books of all time. For more information on the book, which is due to debut in early January, please click here.]
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