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:

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.

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!

ECN 327 Syllabus

I have posted the online lecture notes on the bond market. Please download them and bring them to our next class.

The US Recession is Officially Over

Today, the group officially responsible for applying dates to national business cycle turning points (i.e., recessions and recoveries), the National Bureau of Economic Research (NBER), declared that the most recent recession ended in June of 2009. Read their full statement.

Just as most people didn't realize we were in recession for quite some time after the most recent recession began, many didn't realize that we have now been in an economic recovery for over a year. There are several reasons for this.

First, a (national) recession is not defined the way most people think it is. Apparently almost everyone believes that a recession occurs when the US economy experiences at least two consecutive quarters where real (inflation-adjusted) GDP declines. This definition is predicated entirely on the behavior of a single variable -- national output, which would be declining for at least six consecutive months. Were this the definition, it would be very easy to "date" recessions: count to two after checking GDP releases, looking for negative growth rates. Second, the NBER does not do things this way, nor do they restrict their analysis exclusively to quarterly data. Read the Q&A about the way they define recessions and recoveries. In this, the NBER states a very important point: a recession isn't defined as being a period of low activity, but a time period of continually declining economic activity. Extending this to recoveries, these don't necessarily indicate a return to "normal" times. Instead, they reflect continually improving economic activity in a number of areas.

What is the actual definition the NBER uses to define a recession? According to the NBER, a recession is defined in the following way:

"The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."

So, from this, what we can infer is that as we are now about a year into a national economic recovery, economic activity in a number of areas is improving (on average). THIS DOES NOT MEAN WE HAVE RETURNED TO "TRADITIONAL" LEVELS OF THESE VARIABLES. That could take months or even years, especially as our economy is in a period where persons are saving and paying down debt, and bank lending is not as great as we would like to see it.

Confusion surrounding the dates of recessions and recoveries is the manifestation of a very basic observation I will make: persons instinctively focus on the levels of economic variables; economists extend this focus on levels to rates of change as well. So, the rate of economic growth is just that -- a rate of growth and thus a measure of rate of change. Actually, economists often go farther, as we are now concerned about whether the rate of economic growth will be slowing. This means economists are now focusing on rates of change (are we slowing?) in the rate of change (the rate of economic growth). You will often hear this referred to as the "second derivative" of economic activity. Clearly, economists think and speak a different language than do most people, often defying "intuition."

Welcome Back!

Welcome to the Fall 2010 semester.

This blog will have postings throughout the semester -- my way of communicating important information to you when we are not meeting as a class. Check in on the days after class meets, especially on weekends.

The past few years have been dominated by a severe financial crisis and a global recession. The recession was so severe (believed to be the worst since the Depression) that it took on a name: "The Great Recession." This semester, growth remains a major concern, as there is considerable debate about whether or not the national economic recovery will falter, moving us to a "double dip recession." Whether or not this occurs, credit market weakness (ongoing credit problems and further after-effects of sub-prime mortgages) continues too be important, as is the behavior of future price change (are we closer to inflation or deflation?). The Fed can no longer lower the fed funds rate, as it is currently at (or near) 0. What do they do if things weaken? We will discuss this.

By semester's end, you will come to understand that all of the factors we will be discussing throughout this semester are interrelated. And, as the semester unfolds, you will observe the collective actions of the world's central banks, and whether their prior assessments prove to be correct.

For now, read all of Stikki Stock Charts for next Thursday and visit the web site: StockCharts.com. On the online syllabus I have added introductory material that will assist you in using that web site (we will be referring to it all semester).

If you have any questions throughout the semester, don't hesitate to e-mail me (llardaro@uri.edu) and/or stop by my office, Chafee 804. DO NOT LEAVE PHONE MESSAGES!!

Finally, if during the semester, you want to research the entire set of blog posts on a specific topic, click on its label beyond a particular post. The result will be a view of all of the posts that include that word as a label.

Potential Exam Questions for ECN 334

I have gone through the questions submitted for potential inclusion on the final exam. Here are the questions I will choose from (there will be at least one and possibly two selected).

1. Outline the impact of tougher financial regulation on the stock market.

2. Last year, the Fed decided not to pursue inflation as its primary target. Outline the actions the Fed would have taken had its target been inflation and the consequences of those actions at the present time.

3. How will the stock and bond markets react to the debt crisis in Europe, specifically in Greece?

4. Discuss the effect of bond prices on interest rates based on Yield to Maturity. In doing so, indicate in detail other factors that determine how bond prices or the bond market would react if one of these factors were to suddenly change.

5. Using the material from this course, outline why the US will have a slow and long recovery from the financial crisis of 2007, focusing on businesses and consumers.

6. What are some of the risks of unregulated derivative trading by investment banks? Be sure to explain what a derivative is and teh specific dangers they pose to the economy if unregulated.

7. Explain how the federal funds rate is an important indicator for the stock market.

 When you take the final exam on Friday, MAKE SURE THAT EACH OF YOUR RESPONSES ANSWERS THE SPECIFIC QUESTION IT IS ADDRESSED TO. I strongly suggest that before you hand in your exam, read each question again then make sure that your response is to the specific question posed and not just a series of statements that might be correct overall but that don't really answer the question.

Potential Exam Questions for ECN 335X

I have gone through the questions submitted for potential inclusion on the final exam. Here are the questions I will choose from (there will be at least one and possibly two selected).


1. Outline the underlying basis of the relationship between bond and commodity prices. Give an example of how this relationship can change based on occurrences in the other two intermarkets that would contradict this "traditional" relationship.

2. Explain the effects of a weakening US Dollar in an intermarket context.

3. Can the stock market and commodities move in opposite directions? Explain the basis of your answer.

When you take the final exam tomorrow, MAKE SURE THAT EACH OF YOUR RESPONSES ANSWERS THE SPECIFIC QUESTION IT IS ADDRESSED TO. I strongly suggest that before you hand in your exam, read each question again then make sure that your response is to the specific question posed and not just a series of statements that might be correct overall but that don't really answer the question.

Final Paper Citations

The forecast paper for ECN 335 that is due Friday MUST include correctly formatted footnotes and bibliographies. You should get into the habit of doing this for every paper you write. In order to make this process a bit less daunting for you, I have located an easy-to-use link that illustrates the appropriate footnote and corresponding bibliographic entries for various types of sources you might reference. I have chosen the Chicago style for this.

Finally, all of you need to avoid using incorrect words that unfortunately have the effect of making your writing and/or you appear to be "dumb" to persons who don't know you. I am referring to the confusion between "effect" and "affect," and "to" versus "too." I have a handout for you detailing this. If you confuse these words in your papers, you will be penalized a +/- on your paper grade.

What are Interest Rates Telling Us?

As we outlined in class yesterday, interest rates and the bond market have a great deal of predictive ability concerning future levels of economic activity. The simple yet very powerful model of interest rates you should use is:

interest rate = f(expected inflation, economic growth, monetary policy)

As I noted, inflation expectations and growth expectations are not necessarily independent of each other, so the time frame you are considering becomes relevant to seeing which matters more. You can use the TIP:TLT ratio in StockCharts.com as one proxy for expected inflation, while a preferable way is to calculate (and track through time) the TIPS spread (= nominal interest rate - TIP rate with same maturity). This is available daily (in real time) from Bloomberg.com. Here is a link to the web page to use for this. As of today (4/21/10), the 10-year US Treasury bond has a rate of 3.79%, while the 10-year Inflation Indexed Security (TIP) has a rate of 1.43%. So:

TIPS SPREAD = 3.79% - 1.43% = 2.36%

Historical data on this is available from the Federal Reserve Economic Data (FRED).

If you want to find a proxy for the level of economic activity and income, you can use consumer cyclicals ($CYC) in Stockcharts.com. Where is support for this? Resistance? Are there any leading indicators from technical analysis that can be of help in the short-term (ex: bullish or bearish divergences based on the RSI)? 

So, you should use the interest rate model above whenever you need to explain interest rate changes or to make interest rate forecasts. To do this, you will need to generate a forecast for each explanatory factor. Possibly, over the time period of your forecast, a factor that usually matters will not matter much. Or possibly, a factor that normally doesn't matter much will be influential. Remember: NOBODY KNOWS THE FUTURE (except CNBC, of course).

For those of you who have taken ECN 327 with me, you can expand the basic interest rate model substantially. Using general macroeconomic models such as the IS-LM and AD-AS, you can identify a fairly large set of factors that determine either economic growth (Ye in those models) or inflation (changes in Pe in the AD-AS model). Basically, those factors are the "other things" of the relevant curves.

Looking at a chart (click to enlarge) of the 10-year rate ($TNX), resistance at 4% becomes readily apparent (note: you must divide the number on the right axis by 10 to get the interest rate). Short-term support is at roughly 3.5%. Why has resistance held over the one-year period covered by this graph? Rates fell twice from 4% (a double top, by the way). What causes interest rates to decline? To answer this question, use the interest rate model.

Rates decline for some combination of declining expected inflation, less expected future growth, or monetary easing. Obviously, we can rule out monetary easing. That leaves us with declines in expected growth and inflation.

Will the 10-year re-test resistance or support? Again, use the interest rate model to answer this question. Anyone doing their forecast on interest rates will have to do this.

Read the relevant chapters in John Murphy's Intermarket Analysis to further help you with an understanding of this topic.

Financial Sector Plunges on Goldman News

On Friday, news about the SEC bringing charges against Goldman Sachs and one of its VP's for fraud charges shook the markets. According to the SEC, Goldman created Collateralized Debt Obligations (CDOs), a collection of parts of mortgage backed bonds, which were destined to fail, then sold them to entities without fully disclosing the facts concerning how these were constructed (toxic) and that a major hedge fund (of Paulson) was betting against them. Here is a link to a story about this. And, in an amazing intermarket application of all of this, there is a potential basis to associate the difficulties with Goldman Sachs with future gold prices. Here is a story about this.

Technical analysis of the ETF for financials (XLF) shows how significant Friday's events were. The chart (click to enlarge) shows how the sharp decline in price on Friday broke a very steep trendline, while still preserving (for now at least) the overall uptrend (based on RSI >= 40). This decline did not lack conviction (sorry for the pun), as it was based on extremely high volume.

Based on Fibonacci Analysis, the next potential support for XLF occurs at the 38.2% retracement  level with a price of $15.77 (Friday's close was $16.36). On the chart, note that the 50% retracement occurs at a prior high (from early January of this year) of $15.35. At this point, a 50% retracement can not be ruled out, as more news will no doubt emerge next week, much of which will involve negatives for Goldman Sachs and (potentially) other similar firms as well. Also, markets tend to overreact in the short-term to such momentous news events.

The question now becomes how financials react and whether this trend for XLF is broken convincingly. For extra credit due at the beginning of class next Tuesday, create a PerfChart of the S&P sectors (as I did in class on Thursday) with a time period that starts at the beginning of April this year. Based on this, which sector has led this "leg" of the rally? What does the chart above signify about any potential changes in what the PerfChart shows? Should the defensive sectors see money flowing in as the result of Friday's news? Paste the PerfChart and brief answers to these questions in a Word document.

One way to assess how financials will do in the near term is to perform technical analysis on the overall stock market. Prior to Friday, the S&P 500 was very overbought, as the RSI(9) was well above 70. After Friday, the RSI fell to below 70, so it is no longer overbought. I also recommend that you look at the economic "numbers" that will be coming out this week. Other than the Leading Economic Indicators on Monday, the only major number with market moving potential is Durable Goods, which is released next Friday morning. So, for much of this week, the market overall and financials in particular will be driven by further news concerning the SEC's case against Goldman Sachs.