Does This Rally Have Legs?

Friday, after a horrible employment report, the market actually rose significantly. Is the market discounting that the worst is now behind us? Or, did the terrible jobs report signal the necessity of both bailing out the "Big 3" automakers and that President-Elect Obama will have to provide an extremely large stimulus package? I think it is far more the latter. Here is a ShortView by John Authers of the Financial Times discussing the current state of the markets.

How far will the market go? In the short-term, you should always check to see where resistance is. In the chart below of the Dow-Jones average (click to enlarge), note the market ended the day just at its 50-day moving average. More importantly, it is instructive to check the Fibonacci Retracement tool I discussed in class just before Thanksgiving. This is included in the graph.

To add a Fibonacci Retracement, go to the Annotation screen (click below the image to get this). When the Java window appears, click on the Fibonacci Tool as shown in the upper portion of the graph.

Holding the left mouse key down, drag the mouse sideways and down:
(1) From the most recent significant high, to
(2) The most recent low. Once there, release the mouse key.

Note how the most likely place for a resistance point, the 38.2% retracement (the first line) is essentially where the market is now approaching. Is it likely that the Dow-Jones will reach this? Check the RSI. It is above 50 (indicating the beginning of a possible uptrend) and it is not close to being overbought. So the potential is clearly there. Also, check to see if there are any major economic statistics this week that if bad could derail this uptrend. There is nothing on the horizon like the employment report of last Friday. So, it is reasonable for the market to move past its 50-day moving average and test the 38.2% retracement at 9,164.

There may well be a "Santa Claus" rally as this year comes to an end, as the bailout (part 1) and promise of an extensive stimulus package will act like the "rumor" in the old saying buy on the rumor, sell on the news. So, early next year, there may well be some kind of correction. But, the relevant question is from what level will this correction occur? We'll have to wait until next semester.

Is the Bottom Here?

Yesterday (Thursday, 11/13) after class the markets tested their October lows. The response by the market was substantial -- SUPPORT HELD!! When the Dow-Jones Industrial Average (DJIA) broke below the 8,000 mark, a great deal of buying occurred (amazing how many persons are now technical analysts!!!), pushing the price up over 500 points for the day.

What we witnessed yesterday, was a technical formation -- a key reversal day, which technically speaking, is a reversal pattern. In the context of a downtrend (it's safe to call our situation that), here's what a key reversal day entails:
(1) the market opens below the prior day's close;
(2) prices that day go below the low for the previous day;
(3) that day's high is above the prior day's high; and
(4) the close for that day is higher than the high of the prior day.

The daily chart below shows this (click to enlarge). Importantly, the key reversal day occurred with very high volume (conviction by buyers).

The media took this as the bottom being here, attributing the turn to President Bush's speech. Sadly, both hypotheses are wrong. Although the turnaround occurred as President Bush was speaking, the substance of his speech had been known for several hours, so his speech was a correlation but not causation. Actually, what we saw was a "major league" oversold bounce which then brought about a great deal of short covering.

How can we try to decide if yesterday was "the" bottom? Look at the weekly chart, which is given below (click to enlarge). Note the triangle formation from late September to now. On a weekly basis, the rally yesterday (and all of this week's price action) has failed to challenge the upper resistance line. While the low of yesterday (also the low for the week) did entail a breakdown from the lower support line, as of the time I am writing this, the value of the DJIA snuck back above support. Also, volume is not particularly large this week.

How will the week close? ALWAYS pay attention to Friday's close (and the weekly bar). It is highly likely that this week will not be a key reversal week. That would require a weekly high above last week's high of around 9,500, etc. As a rule: WEEKLY SIGNALS ARE MORE SIGNIFICANT THAN DAILY SIGNALS. Obviously, monthly signals trump both weekly and daily signals as well. So, we need further data to confirm whether (and when) a weekly key reversal will occur.

How might we try to answer that question? Economic theory -- specifically intermediate macroeconomics. What a coincidence, that's the subject of our course! The reversal will require better-than-expected news on different parts of the global economy that imply the worst of the global recession is now able to be visualized. As stock markets are leading economic indicators, remember the stock market will turn up before the economy does. How much before the economy turns cannot be known in advance. Don't pay attention to specific values such as 6 months. Start with the key drivers of stock prices: interest rates and profit expectations, and forecast what they will likely do in the next 3-12 months. Here's a video that attempts to address the question. Remember to critique this and anything else in the media.

Friday's Tumble

The stock market tumbled on Friday. The ultimate decline, 312 points, was a blessing. How? Before trading began here, markets in Asia and Europe had fallen sharply. Stock index futures for the Dow-Jones, S&P, and NASDAQ all had trading halted, as they reached limit down. Those futures were signaling an open in the US with the Dow-Jones falling as much as 1,000 points! Prior to opening, the word "crash" was being used by many (almost all, actually) market observers. I also viewed the potential for labeling the entire bear market as a crash had expectations occurred.

While the markets did drop sharply at the open, they began to recover. At times during the day, the market had moved to only "small" declines in the context of what has been happening routinely now for weeks.


The chart (click to enlarge) shows technical information about Friday, using 10-minute bars. The first thing to note is where support and resistance were. Resistance from late Thursday held all through Friday, not a very bullish sign, even though the market didn't end up at its daily low (there was a failed breakout at the end of Thursday). Look at the last bar of the day: a large bar (big range in last 10 minutes), but the close was far below the open for that time interval, also bearish going into Monday.

It is also important to consider that support held on Friday, making the overall news mixed. There was a double bottom, a reversal pattern, which signaled the rally that started around 2:00. During that time, the RSI remained above 50, signaling that an uptrend was occurring. That only changed at the close.

What were the economic factors surrounding Friday? First, there were large sell-offs in Asia and Europe. GDP for England was negative for the first time in about 15 years. That became a confirmation signal to markets that a global recession was either already in progress, or very likely. In the US, home sales actually improved. Of course, whether this is the beginning of a sustainable uptrend is a different matter. That accounted for part of the upward momentum at mid-day. Finally, one of the more important factors was the collapse of the yen carry trade. Review this on the online notes and don't be surprised if it pops up on the exam this Tuesday. For an excellent video clip concerning this, click here. As investors cashed in their overseas investments, they paid their yen loans, since the primary risk from the carry trade is the yen appreciating relative to the US $. Clearly, that had been happening all week. As I write this, the dollar-yen exchange rate is below 95 yen/$.

To determine how markets will do this week, check out the week's economic schedule. On Thursday, we get the first read on third quarter GDP in the US. IF, as many of us suspect, this will come in negative or very small, the global recession scenario will be reinforced, causing heightened market weakness, in spite of whatever market momentum might occur on Monday through Wednesday. Stay tuned!

Worst Week Ever?

This past week was a very trying one for the stock market, as all of you know. To see how bad things have become, notice that even the financial "experts," whose ridiculous recommendations have led so many to live in mortal fear of their 401(k) statements, are suddenly humbled. Gone (for now at least) is their truly outdated advice to "buy and hold," "dollar cost average," and based on forward price-earnings ratios, conclude that the market is very "cheap." Their only refuge is the assertion that when the market does bottom, it will probably rise by as much as 30 percent. Given the inherent conflict of interest these persons bring to the media, they make money from stock transactions, they are still trying to drum up business, but doing it in a more subtle way. Here is a video clip summarizing the past week.

This is where the power of technical analysis comes in. Asset prices are leading indicators of fundamental information. And, in times like this, where future earnings, etc. are incredibly uncertain, you can use the real-time information provided by markets to guide you.

How should we view Friday's market activity? Support at 8,000 (going back several years) for the Dow-Jones ($INDU) held. More importantly, while the market fell sharply at the open it then recovered quickly for a wild ride. The following chart from StockCharts.com will help you see this (click on it to enlarge). This shows the last two weeks of market data for the Dow-Jones.

First, look at the bar from eight days ago. It looks like a cross. In candlestick analysis, this is referred to as a "doji," which signifies indecisiveness - the bulls and bears fought a battle that nobody won. Note how short the bar is -- the gap between high and low was very small. Both features point to the possibility of a momentum reversal. Now go to the next day. Still a short bar, but the market closed near the low of the day, and close was below open. Not good for the bulls! The next day is even worse for the bulls: close at the day's low (near very short-term support) and an upward tail (undefended territory).

Now let's focus on the last two days, after apparent support (around 10,300) began to become a distant memory. The bars got much higher, so the daily battle of bulls and bears was intensifying. For Thursday, close was at the day's low. Ugh! For Friday, there was a large sell-off at open that probably produced much "panic" selling, so the day's low was within the first hour of trading. Then the market pulled up noticeably -- even though it was still down from the previous day. It went positive at several points, so the high was above the open, and by 3:30, the market was up by around 330. There was selling toward the close, so there was undefended high territory and the day's close was down 128 points.

Most people will focus on the fact that the market was down again, this time by 128 points. YOU should focus on the facts that: (1) the close and open were fairly close; and (2) a large lower tail emerged on Friday. Lower tails suggest the possibility of a bottom, or weakening of downward momentum. Consistent with this, the RSI(9) is also in very oversold territory.

So, my interpretation is that we are possibly very close to a temporary bottom, as support at 8,000 held, the RSI indicates oversold conditions, and a large lower tail emerged on the most recent daily bar. A few negative notes from the credit market: the 1-month t-bill rate remains below 0.10%; and while the overnight LIBOR rate fell sharply on Friday, the one and three-month rates remain elevated. NEVER OVERLOOK THE CREDIT MARKET!

How can we further decide whether this bottom will hold? How about economic theory? What a coincidence, that's what ECN 327 is all about! What determines stock prices? Interest rates (asset substitution, etc. that we covered in class) and most importantly expected future profits. So, looking forward, you need a forecast of the overall economic picture -- both national and international. But, for extra credit (due at the beginning of class on Tuesday), bring in two graphs, one with daily data, with annotations, showing support and resistance, the other repeating this for weekly data going back as far as possible.

This week should be a very important one for the future of this stock market downturn. Will the G-7 meetings produce tangible results? If not, will the market sell-off further? Will credit markets start to loosen and begin more normal lending again? Follow the bars each day and interpret them for what they convey. Practice like this will help you further understand charting and the information it provides.

Friday, October 3: Employment and Vote

This morning, the US Bureau of Labor Statistics released its September employment report. True to expectations, payroll employment fell by 159,000 relative to August. There were some revisions to earlier months, but these were very small (actually positive). The unemployment rate remained unchanged at 6.1% (I had expected this to rise), and average hourly earnings rose by 0.2%. Read this article about the report.

What reaction did markets have to such a disappointing report? The opposite of that expected. Stock market futures improved substantially. And, with this "bad news," interest rates rose, as did the US dollar. Perhaps the only expected result was the movement out of industrials, which are cyclically sensitive. What happened?

"Other things" were not even close to being equal. The weak employment report was perceived as increasing the likelihood of the passage of the rescue plan later today. Furthermore, credit crisis effects weren't even reflected in this report, so employment reports in future months should be even more disappointing. Thus, markets are also building in the presumption of Fed rate cuts, possibly today if the legislation fails to pass.

What about industrials? These are pro-cyclical, so with a slowing economy, you should expect these to decline. But, industrial companies also tend to rely substantially on externally generated funds. So, in light of the current and ongoing financial difficulties, even if the rescue legislation passes, there are questions about how far down industrials might fall in coming months. Where did the money exiting industrials go (rotate) to? Large banks, who have the money, even if they don't necessarily want to lend it. Graph XLI on Stockcharts.com and observe its behavior over the last few days and contrast that with today.

Let me reiterate that I continue to believe the Fed must lower interest rates. Remember, the Fed has a target of 2%, but the fed funds rate is a market rate that isn't always at its target. So, go back to the graph we did in class with real money demand falling due to a slowing economy and the Fed having a target of 2%. Were they to have kept the fed funds rate at 2%, the money supply would have been falling. But, all the injections of liquidity over the past few weeks have made the actual fed funds rate much lower than the 2% target. So, if the Fed decides to keep its existing 2% target and enforce it, they would have to undertake major withdrawals of liquidity, which would further exacerbate the current national recession (I continue to believe the US has been in a recession since January) and global weakness.

Finally, even if the rescue legislation plan passes (and I expect it will), DO NOT expect equity markets to go straight up from here. There is still a national recession, Europe and Asia are weakening, and global weakness will continue moving forward. And, last Monday when it was presumed the legislation would pass the first time around, the market was down about 3% even before the vote. There is an old saying in the stock market: Buy on the rumor, sell on the news. So, "the news" will be passage of the legislation. And, lots of money is waiting to sell any rally. So, don't be surprised if the market is down, maybe by several hundred points, for the day. And, if the legislation is passed, the anti-shorting ban will have a time table for expiration of a few days. What will happen when this is removed?

As I write this post (10am on Friday), the Dow Jones is up 136, NASDAQ is up 44, and the S&P 500 is 23 points higher. The 10-year bond is up 3 bp to 3.67%.

August Employment Report

On Friday, the government reported another decline in monthly (payroll) employment. This time the decline was 84,000. Weakness was greater than this number appeared to show, since prior months saw employment revised lower (ex: June went from -51,000 to -100,000, the first six-digit decrease since the recent declines began). Along with this the unemployment rate rose by a greater-than-expected amount, from 5.7% in July to 6.1% in August, its highest level in over four years.

As we haven't yet started with our topical coverage yet, I will refer you to an article dealing with this labor market report. Also, read the relevant chapter for this in the course text The Atlas of Economic Indicators. Finally, let me point out two things for you keep in mind as the semester progresses:

#1: When studying new data for an economic indicator, ALWAYS LOOK AT REVISIONS TO PRIOR PERIODS BEFORE EVALUATING THE CHANGE FOR THE CURRENT PERIOD (this puts the current change it into the correct context); and
#2: The overwhelming majority of media coverage from this report centered on the unemployment rate, which as I indicated on Thursday, IS A LAGGING INDICATOR.

I will leave it to you to figure out whether the media is actually basing its assessments of future economic activity on this lagging indicator.

An Economic Indicator is Born

This past Friday, there was a great deal made of the fact that for the first time ever, the number of customers visiting Starbucks declined. This had a very negative effect on Starbucks' stock (SBUX) and, more interestingly, the entire stock market reacted negatively to this news. Why would Starbucks' stock drag down the entire stock market?

The answer to this lies in assessing the overall strength of the US economy. Starbucks coffee is more expensive than its primary competitors nationally, Dunkin Donuts and McDonalds (it recently made a dramatic upgrade in the quality of its coffee). And, coffee at Starbucks is more expensive than both of these competitors. Furthermore, an important input for retailers selling prepared coffee is milk (and cream), the price of which has risen sharply of late, hurting its profitability.

So, the interpretation of the Starbucks situation Friday was that: (1) it is yet another company being hurt by rising costs; and (2) the deterioration in discretionary income resulting from higher food and energy prices has now spread to Starbucks, signalling the broadening of overall demand weakness. Thus, a new economic indicator was born on Friday: STARBUCKS AS AN INDICATOR OF DISCRETIONARY SPENDING.

How accurate is Starbucks as an indicator of discretionary spending and hence as a leading economic indicator? Has it been a very good indicator for quite a while and we didn't realize this until last Friday? For extra credit (due at the beginning of class tomorrow, 11/19), graph Starbucks stock price (SBUX) as a line graph in the same graph as consumer discretionary stocks (XLY). To do this, below the main graph under Indicators select Price. Enter the symbol XLY . Under POSITION, select BEHIND PRICE. Then make this a line as well. Add any annotations you think will illustrate your beliefs about the relationship between these two variables. Those annotations will serve as your discussion. Copy this graph and paste it into a Word document and bring it to class Monday.

Here is the link for an article written about Friday's events. Read it and critique it (you should begin doing this routinely).

Useful Links

It is very useful to have a blog post that provides URL's for reference information dealing with writing research papers in general. Here are several sources for you to consider:

A Step by Step List for Writing a Research Paper

Another Step by Step List (pardon the source's name!!). Click on each step of the process on the right of the page. Pay special attention to the section on Gathering Data.

A General Guide for Writing Research Papers . Look at Chapter 1 on outlines (as you page down). This is very relevant for next Friday's work due.


Here's a start for you. READ THROUGH EACH OF THESE. Bring any questions you have to me or other faculty members in our department.

After "The" Employment Report

As you know from class, the September employment change was essentially in line with expectations. Payroll employment for the prior two months (July and August) was also revised significantly higher. Most notably, the original employment change for August, a 4,000 decline, was erased. The revised August employment number is an increase of 89,000. Along with this, the unemployment rate rose slightly to 4.7%, and average hourly earnings rose by a greater-than-expected 0.4%.

Hopefully, you took the time to perform the practice exercise in advance of this report. The markets viewed this as a strong employment report. The perceived (key word!) likelihood of a recession dropped noticeably as the result of today's data.

- The stock market liked the report a great deal. It was not too high as to preclude further Fed rate cuts, but not so low that it might have indicated we were in the early stages of a recession. Read a story about this.
- The bond market didn't like this at all -- both significant employment gains and the "hotter" than expected wage gain raised the inflation flag. Here is a story about this. Examine the yield curve to see how the bond market ultimately reacted. Clearly, the yield curve got steeper, indicating the expectation of stronger upcoming growth and inflation.
- The oddity today was the foreign exchange market. Normally, we would assume that the greater perceived economic growth and higher interest rates would both strengthen the US Dollar. However, by day's end, the dollar had weakened further. Read about this. It might have been profit taking by currency traders and the overall perception that the direction for the US dollar is still down. Where is the bounce (support)?

Following what I did in yesterday's posting, I revisited the Market Carpet at StockCharts.com. This time, I looked at the most recent 10 days (not the entire time since the Fed rate cut). The "carpet" below is what pertains (click to enlarge):
Now look at the sectors that have performed the best over the period of this carpet, the last 10 days. All (no exceptions) are cyclically sensitive sectors (look at the bottom right). The leader is Financials. This sector had taken a beating after the financial worries in August. But, with recent data showing that the commercial paper market is improving and possibly stabilizing, there was some "make-up" momentum. Generally, however, it is desirable to see both the Financial and Consumer Discretionary sectors outperforming other sectors.
So, over the past 10 days, the equity market has signaled expectations for an improving level of economic activity. None of these sectors would have performed so well had there been substantial recession concerns. For extra credit (due at the beginning of class on Wednesday), replicate this market carpet (look at yesterday's post for how to do this) but for the 14 days since the last rate cut. Print out the carpet and bring it to class.

Finally, look at the sectors that underperformed: Utilities; Health Care; and Consumer Staples. All of these are defensive sectors, that outperform when recession worries accelerate, but underperform when recession fears abate, as has been the case recently.

Sector Performance Before "The" Employment Report

Tomorrow we get the September employment report. This will be a market mover, but not in the traditional way. The stock market wants the Fed to keep cutting. So, if the employment gain is very good, the Fed will be less likely to cut at its next meeting, causing a market sell off. The same is true for a very bad report. Yes, the Fed would likely cut again, but this would signal the possibility that we might already be in the early stages of a recession, so the souring of profit expectations would overpower the effects of lower expected interest rates. Remember:

Stock prices = f(expected profit, interest rates)

So, when both factors change, the effect of one may well offset the other. That is the nature of forecasting! The ultimate change in stock prices will ultimately be determined by the changes in each factor and how sensitive stock prices are to those factors when their changes are that large (or small). This is a non-linearity -- the impact of each factor depends on its own level and how the other changes.

The next thing to look at is which sectors have performed well since the Fed rate cut in September. To do this, go to StockCharts.com. On the left side, click on Market Carpet. Under the heading Available Carpets, select S&P Sectors Carpet. You should see the image below (click to enlarge):

Step #1: Stretch the number of days bar on the bottom right (indicated in red typing on image). Move this to 13 days. NOTE: you can change both start and end date by dragging on either or both ends of this.

Step #2: When step #1 is completed (the days are correct), click on the button on the top left (indicated by the red typing in image). This will give a more aggregate overview, listing the sectors that have done best and worst over the time period you chose.


The result should be the next image (click to enlarge): NOTE THE PERCENT CHANGES IN EACH SECTOR (Highlighted in a reddish tint on bottom right).

There is a mixed picture since the Fed cut rates. The leading sectors are Materials, Technology, and Financials -- this signifies that the rate cuts have up to now apparently stimulated sectors related to growth. But Health Care, a defensive sector has done fairly well, while Consumer Discretionary, which we would have expected to be among the best performers is one of the slower performers (it was the only declining sector).

Note that on the left side of this Java Applet the sectors and their percent changes are noted over this period (which was summarized on the bottom left). If you double click on one of the gray headings you get a breakdown of that sector and the bottom right list shifts to the best and worst performers in that group.

Try double clicking on Consumer Discretionary. Let's see who has been holding this back, making its growth less than expected. Look at the bottom 5. What has been slowing this sector down to less than expected? How does this information alter you view (if at all) about growth prospects.

Tomorrow "the" report on employment is released at 8:30. I encourage you to see how the above results change. In general, when a major release occurs, read about it in the Carnes and Slifer text (Atlas of Economic Indicators), and check out the sector patterns to discern any rotations. What do these rotations indicate about growth expectations?

Finally, it is important to keep in mind that all of this note has pertained to the stock market only. To see how the bond market is viewing the world, look at the yield curve and how it has changed (go to Bloomberg.com for this or go to the Links for this blog under my picture). Has it steepened or flattened (or possible inverted)? Finally, check out the dollar's exchange rate with other countries and its index ($USD). What does the world think about how this report has altered growth prospects here? You can also check out www.dailyfx.com for exchange rate information.

This weekend I will post a follow-up note after the employment report has been released.