As I indicated in class today, I am posting the assignment that is due next Thursday (10/21). I prefer that you work in groups of two for this (I will consider groups of three with permission), but if you must work alone, please feel free to do so.
Over the weekend, try to use the material on flexible exchange rates we covered today to allow you to see the basis for several important trends, such as the recent decline in the US$ index.
Thursday, October 14, 2010
Wednesday, October 13, 2010
Golden Cross in the Dow-Jones Industrial Average
Something fairly rare has occurred in the Dow-Jones Industrial Average (DJIA) over the past few days: the 50-day moving average crossed above the 200-day moving average. This is referred to as a "Golden Cross." The chart below shows this (click to enlarge):
To many, this signifies a major buy signal for the stock market. Indeed, if you look at history, when this occurs, generally the market does fairly well for the next several months. Is that likely to be the case this time?
Over the past few years, the stock market has allowed patterns such as this to emerge. But, instead of potential investors being patient and waiting for further confirmation before entering the market or expanding their positions, they have all too often jumped in enthusiastically. What has the market done? It has caused the pattern to either reverse of be eliminated, stranding those poor (now literally) souls who impatiently dove into the market and committed their funds.
This happened about a year ago, when a head and shoulders pattern formed in the S&P 500. Before waiting for confirmation (price must fall below the "neckline"), it seems that just about everyone jumped in to short the market or obtain options that work the same way (puts). When the pattern failed to materialize, many were caught on the wrong side of the market (short the market). In a panic, there was an attempt at a mass reversal of direction, leading to a major rally for several months!
Let's get back to the chart. Yes, there has been a Golden Cross. BUT, note that the DJIA is in slightly overbought territory (i.e., the RSI > 70) AND at its current level, the market is not far from a resistance level. Put this all together and it is not clear that the Golden Cross will be sustained in the short-term. If resistance holds, those who have recently jumped into the market will not be happy.
Now let's shift gears and inject economics into this. In addition to the technical analysis I just covered to evaluate whether the DJIA is likely to go above resistance, use economic theory:
For the DJIA to break above resistance, it is necessary for profit expectations to be elevated above their current levels. QE2 (possible upcoming quantitative easing) has already been priced in. So, if that fails to materialize, stock prices will fall and much of this last leg up will likely be lost. Earnings results are beginning to be reported. If those are very good, better than expected, resistance may well be broken, as long as two things occur. First, top line (revenue) growth has to be emerging with greater regularity than it has in the past. Second, earnings guidance (what they expect to occur in future quarters) cannot be disappointing.
Then there is the election. The stock market will very likely react positively to the expected increase in the number of Republicans in the House and Senate. But I expect this to only be a short-term rally. Gridlock will occur, as governing will more closely resemble the WWE than what we studied in Civics class. Historically, gridlock favors bonds over stocks. Beyond this, the desire to move toward smaller budget deficits will hinder economic momentum over the short-term.
So, at this point, it will be interesting to see how all of this plays out. I do expect a short-term rally after the election, before the market returns to fundamentals as next year begins. While it is quite possible that the Golden Cross will hold for a few months, I expect this to be a shorter period of positive upward momentum that prior crosses have produced.
Over the past few years, the stock market has allowed patterns such as this to emerge. But, instead of potential investors being patient and waiting for further confirmation before entering the market or expanding their positions, they have all too often jumped in enthusiastically. What has the market done? It has caused the pattern to either reverse of be eliminated, stranding those poor (now literally) souls who impatiently dove into the market and committed their funds.
This happened about a year ago, when a head and shoulders pattern formed in the S&P 500. Before waiting for confirmation (price must fall below the "neckline"), it seems that just about everyone jumped in to short the market or obtain options that work the same way (puts). When the pattern failed to materialize, many were caught on the wrong side of the market (short the market). In a panic, there was an attempt at a mass reversal of direction, leading to a major rally for several months!
Let's get back to the chart. Yes, there has been a Golden Cross. BUT, note that the DJIA is in slightly overbought territory (i.e., the RSI > 70) AND at its current level, the market is not far from a resistance level. Put this all together and it is not clear that the Golden Cross will be sustained in the short-term. If resistance holds, those who have recently jumped into the market will not be happy.
Now let's shift gears and inject economics into this. In addition to the technical analysis I just covered to evaluate whether the DJIA is likely to go above resistance, use economic theory:
DJIA = f(short-term interest rates, profit expectations)
(this was covered in the most recent set of notes). Short-term rates, related to asset substitution, are likely to fall a bit more, but they are already very low. So, don't expect much change from this component. Focus instead on profit expectations.
For the DJIA to break above resistance, it is necessary for profit expectations to be elevated above their current levels. QE2 (possible upcoming quantitative easing) has already been priced in. So, if that fails to materialize, stock prices will fall and much of this last leg up will likely be lost. Earnings results are beginning to be reported. If those are very good, better than expected, resistance may well be broken, as long as two things occur. First, top line (revenue) growth has to be emerging with greater regularity than it has in the past. Second, earnings guidance (what they expect to occur in future quarters) cannot be disappointing.
Then there is the election. The stock market will very likely react positively to the expected increase in the number of Republicans in the House and Senate. But I expect this to only be a short-term rally. Gridlock will occur, as governing will more closely resemble the WWE than what we studied in Civics class. Historically, gridlock favors bonds over stocks. Beyond this, the desire to move toward smaller budget deficits will hinder economic momentum over the short-term.
So, at this point, it will be interesting to see how all of this plays out. I do expect a short-term rally after the election, before the market returns to fundamentals as next year begins. While it is quite possible that the Golden Cross will hold for a few months, I expect this to be a shorter period of positive upward momentum that prior crosses have produced.
Wednesday, October 6, 2010
Now that the Recession is Over, What's Next?
Now that the US recession has officially been declared as being over, the most obvious and pressing question is where we go from here?
As there are confusions about what a recession or recovery actually means (see the previous post), there are just as many confusions concerning whether we are actually in a recovery or a recession. I have provided a chart that will help to illustrate this point (click the chart to enlarge it).
I think it is safe to say that generally, most people refuse to believe the pronouncements of economists concerning when an economy is in the very early stages of either recession or recovery. Consider early recession in the chart. Note that the economy is not very far from its peak in economic activity. So, when economic data are released, the numbers are still very good in a historical context. In fact, unless you focus on what economists refer to as leading economic indicators, the numbers will show an economy that is still climbing the activity "hill" (i.e., to the left of the peak), making it even more difficult to assess what is actually taking place. Perhaps the best example of this is the one measure the general population focuses on most -- the unemployment rate. This is a lagging indicator, meaning its level at present reflects what happened in months past. Remember: a recession is NOT defined as a level of diminished economic activity. As the National Bureau of Economic Research (the "dating" body for economic cycles) points out, it is instead a period of diminishing activity. This highlights the distinction between levels and rates of change that I discussed in the previous post.
Right now, nationally at least, we find ourselves in the early stages of a recovery. Once again, look at the chart above. In the early stages of a recovery, an economy is close to the "bottom" of economic activity. The numbers that are released are therefore not going to be very good, and after a recession period, often discouraging. Of course, if you focus on lagging indicators, you will almost certainly conclude that we are still in a recession.
At this point, I need to reiterate that contrary to popular "wisdom," being in a recovery does not necessarily require a return to "normal" times and historical averages (or above) of economic variables. It might. But generally it takes some time to get back to "typical" levels. The next chart will help to explain this.
As this chart should illustrate, not all recoveries are alike. Each path reflects how rapidly economic activity will be rising in the future. Historically, when there is a very deep national recession like the one we just had, the economy rebounds quickly. This leads to a "V" shaped recovery (the green line). It doesn't take all that long to return to "normal" levels of economic activity. In that situation, a recovery feels like a recovery.
But recovery paths are different since not all recessions are the same. Global recessions occur over longer periods and are generally more damaging than more "typical" recessions. When there is a global recession with major financial problems, as the one we just had, the pace of recovery tends to be slow and it takes a longer time to return to "normal" levels of economic activity (the red line). Consider that at present, individuals are spending less, saving, and paying down debt. Banks have lowered leverage. All of this is very positive in the medium to longer term, but it extracts a cost on the rate of economic growth in the short term. Add to this the fact that banks aren't lending as much as they might have in previous recoveries, and you get what Mohammed El-Erian of Pimco refers to as "The New Normal" (click here for a video of El-Erian explaining this concept). He and I are somewhat concerned with the possibility of deflation in the near-term as well.
So, where does all of this leave us? What are you to think? Hopefully you are now more aware of the basics of what is really going on, what an early recovery means, and the possible paths the US economy might take. THE question is which path will be the one our economy follows. Let me be very honest about this: economists, including me, don't really know the answer to this, in spite of all our forecasts and predictions. In this context, let me state one of my favorite sayings: CERTAINTY IS AN ILLUSION. Any forecast, no matter who makes it, is essentially a scenario. It assumes what the areas are that will be the most important over the forecast period, how each of those areas will actually change, and the interactions between and among them. Obviously, there are numerous sources of potential error.
In a period of such uncertainty, where things seldom appear to be what they actually are, many persons are all too willing to step forward with their "solutions." While these might sound good, or appeal to the increasingly subjective notion of "common sense," they too are based on scenarios. So, they might be right. Or, they might be wrong. Let me recommend that you critique any or all of these within the context of one of my favorite sayings: "Complex problems have simple, easy to understand, wrong answers."
Let me finish by acknowledging that at this point you are no doubt wondering where I stand on the future path of economic growth. I will outline this in the coming days (it's time for me to get to class). Before doing that, I need to apply the information in these last two posts to what is occurring in Rhode Island. Stay tuned!
As there are confusions about what a recession or recovery actually means (see the previous post), there are just as many confusions concerning whether we are actually in a recovery or a recession. I have provided a chart that will help to illustrate this point (click the chart to enlarge it).
Right now, nationally at least, we find ourselves in the early stages of a recovery. Once again, look at the chart above. In the early stages of a recovery, an economy is close to the "bottom" of economic activity. The numbers that are released are therefore not going to be very good, and after a recession period, often discouraging. Of course, if you focus on lagging indicators, you will almost certainly conclude that we are still in a recession.
At this point, I need to reiterate that contrary to popular "wisdom," being in a recovery does not necessarily require a return to "normal" times and historical averages (or above) of economic variables. It might. But generally it takes some time to get back to "typical" levels. The next chart will help to explain this.
As this chart should illustrate, not all recoveries are alike. Each path reflects how rapidly economic activity will be rising in the future. Historically, when there is a very deep national recession like the one we just had, the economy rebounds quickly. This leads to a "V" shaped recovery (the green line). It doesn't take all that long to return to "normal" levels of economic activity. In that situation, a recovery feels like a recovery.
But recovery paths are different since not all recessions are the same. Global recessions occur over longer periods and are generally more damaging than more "typical" recessions. When there is a global recession with major financial problems, as the one we just had, the pace of recovery tends to be slow and it takes a longer time to return to "normal" levels of economic activity (the red line). Consider that at present, individuals are spending less, saving, and paying down debt. Banks have lowered leverage. All of this is very positive in the medium to longer term, but it extracts a cost on the rate of economic growth in the short term. Add to this the fact that banks aren't lending as much as they might have in previous recoveries, and you get what Mohammed El-Erian of Pimco refers to as "The New Normal" (click here for a video of El-Erian explaining this concept). He and I are somewhat concerned with the possibility of deflation in the near-term as well.
So, where does all of this leave us? What are you to think? Hopefully you are now more aware of the basics of what is really going on, what an early recovery means, and the possible paths the US economy might take. THE question is which path will be the one our economy follows. Let me be very honest about this: economists, including me, don't really know the answer to this, in spite of all our forecasts and predictions. In this context, let me state one of my favorite sayings: CERTAINTY IS AN ILLUSION. Any forecast, no matter who makes it, is essentially a scenario. It assumes what the areas are that will be the most important over the forecast period, how each of those areas will actually change, and the interactions between and among them. Obviously, there are numerous sources of potential error.
In a period of such uncertainty, where things seldom appear to be what they actually are, many persons are all too willing to step forward with their "solutions." While these might sound good, or appeal to the increasingly subjective notion of "common sense," they too are based on scenarios. So, they might be right. Or, they might be wrong. Let me recommend that you critique any or all of these within the context of one of my favorite sayings: "Complex problems have simple, easy to understand, wrong answers."
Let me finish by acknowledging that at this point you are no doubt wondering where I stand on the future path of economic growth. I will outline this in the coming days (it's time for me to get to class). Before doing that, I need to apply the information in these last two posts to what is occurring in Rhode Island. Stay tuned!
Subscribe to:
Posts (Atom)