Fed Aggressively Cuts Rates

The Fed lowered interest rates today but farther than many (included myself) had expected. Recall, I had anticipated the combination of a 25 basis point fed funds rate cut and a 50 basis point discount rate cut. Along with this, I expected a statement that indicated further rate cuts would be forthcoming as needed.

Recall there are currently two problems facing us -- a slowing economy, which the fed funds rate impacts, and a liquidity/credit crunch crisis that the discount rate addresses. And, there is the question of how much the US economy will slow in upcoming months. Nobody knows this for sure (no matter what they pretend). And, the two "dangerous ingredients," the slowing economy and credit crisis might possibly combine and become very "explosive," meaning cause a more severe slowdown and/or recession. Apparently, it is this potentially explosive combination that the Fed reacted to. And, given the lags in monetary policy changes (6-9 months), the Fed HAD TO BE PROACTIVE. Remember, Ben Bernanke has not been the Fed Chair for very long, so he still has to establish his "Fed Cred," or credibility. And, all the press play for former Chair Greenspan's book probably influenced the magnitude of the move somewhat (this Fed can't allow itself to possibly be "behind the curve" of this slowdown.

The result TODAY: the stock market got what it hoped for, so there was a major increase, +335 points for the Dow Jones, a full +70 points for the NASDAQ, and +43 points for the S&P 500. Shorter duration interest rates fell, a very healthy sign (we will discuss this in the next week it has to do with the yield curve) for future growth prospects. And, the exchange rate picture was mixed: the US dollar rose against the Japanese Yen, but fell against both the Euro and British Pound.

The chart shows Cyclicals ($CYC) for the past three months (click to enlarge). Note how, over this period, the 50-day moving average was originally support (until late July), then became resistance. Today, after the Fed's rate change, there was a very large increase. Note how tall today's bar is and that the close was at the day's high. More importantly, today's close broke above the 50-day moving average. Also, look at the RSI(9) above the cyclicals. It has recently moved into the bullish range, above 50. Finally, the price relative, comparing cyclicals to the stock market (in terms of the S&P 500) has turned up recently. Part of today's large increase was the result of "short covering," where persons had sold shares of various stocks betting that their prices would decline. When the news came out, they hurried to buy back the stocks (covering their shorts). This added demand was an important contributor to today's large run up in prices.

What about tomorrow? Now that the markets got what they wanted, there will no doubt be further deliberation and possibly second guessing of the Fed's decision. Was the large rate cut a sign that the Fed thinks things are actually worse then they have led us to believe up until now? Will today's breakout be sustained, or will something else come to the forefront, making today a "one day wonder," or in technical terms, a failed breakout. Keep following cyclicals through the rest of this week into next week.

Bearish Divergence As A Leading Indicator of Price Change

Cyclical stocks ($CYC) move in the same direction as actual or expected economic growth. As a market, this is itself a leading indicator. And, its changes contain real-time information on market expectations concerning growth.

As you know, yesterday (9/21), two indicators were released that caused markets to change sentiment -- reflecting the belief that the economy would weaken farther and possibly faster than was previously expected. On yesterday's blog post, I detailed how this affected the 10-year bond rate. That rate fell again today (to 4.6%). With the expectation of slower growth, cyclicals should also weaken. And they did.

In the handouts on technical analysis, I detailed what is called a bearish divergence: price action moving higher but the RSI not experiencing higher highs. This is a leading indicator of a downward move in price in the near term. Note this is not 100% accurate, but it has a fairly good track record.

I have included a graph of cyclical stocks where such a bearish divergence is evident (and marked). Click on the chart to enlarge it.


Based on this bearish divergence, one should have expected some decline in cyclicals, and thus the perception of a weakening economy gaining traction. THIS DOESN'T MEAN THE ACTUAL ECONOMY WILL NECESSARILY WEAKEN -- JUST THAT THE EXPECTATION OF THE MARKET IS THAT IT WILL WEAKEN.

To earn extra credit, get the chart of cyclicals and using weekly data for the past two years, annotate the chart, drawing lines and adding comments. Determine if a bearish divergence occurred. Also, draw the support line for weekly data and a possible support line for the Relative Strength indicator. This will be accepted no later than the beginning of class on Monday. No pencil or pen lines will count.

The next test is to see if the support line (indicated in the graph) is broken next week. Note that cyclicals have been underperforming the overall market (based on a declining Relative Strength (below the graph) since early May. It is also possible to draw a support line for the Relative Strength indicator.

Is the Market Headed Higher?

We discussed technical analysis a bit in class today along with sector rotations. When the economy is slowing, you will observe a rotation from sectors that do well with a strong economy (like cyclicals ($CYC) and discretionary spending (XLY)) toward more defensive sectors like consumer staples (XLP), telecommunications (IYZ), and public utilities (XLU).

A good article dealing with this by Michael Kahn of Barron's discusses this. It provides more practice as you learn the material from the handouts today. He points to relative strength as an indicator (recall this is a symbol or index divided by the overal S&P 500). When the relative strength graph is upward sloping, that market is outpeforming the overall stock market. For XLP, that has been the case since mid April.

Finally, note how you can apply lines to other measures such as advancing issues versus declines, or as Kahn's article shows, advance volume vs. decliner volume.