NASDAQ Support at the 50-Day Moving Average

The market has now been in correction mode for a few days now. Focusing on the NASDAQ, as of last Friday, the RSI was in overbought territory and a Doji appeared. Since then, the NASDAQ has been lower. But it is important to see that sometimes a "psychological level" can provide either support or resistance. In the present case, the 50-day moving average has become support for this NASDAQ's pullback, as the chart shows (click to enlarge).

Note how changes occurred right at the (rising) 50-day moving average. While the RSI remains below 50, the traditional value above which a bullish trend is viewed to be in place, it does still remain above 40 -- a level that can be viewed as support during an uptrend.

Does the uptrend remain in tact? Remember that an uptrend means higher highs and higher lows. At the present time, the recent lows remain above the low from the end of January, so the uptrend is still in force. Also, note the increase in the RSI over the past few days. This too provides some reason for optimism.

The fate of oil production and shipping in the Middle East will ultimately determine whether the present support level holds. However, the February employment number will be released on Friday morning (8:30am). This will be pivotal. A very bad number then absent weather influences, will very likely cause support to be broken -- for now.

Tuesday, 2/8

Based on all the recent weather problems, we haven't been able to meet much since the course started. So, for tomorrow's class, make sure you bring the notes on Supply and Demand. Also, review this topic in your principles textbook, as we will be using this throughout the entire semester. You need to be very strong on this topic.

Friday, the employment report for January was released. It was perhaps the most bizarre report I can remember in quite some time. The "headline number" (+36,000) was far below expectations and appeared to be disappointing, yet in spite of this, the unemployment rate dropped all the way to 9 percent! Here is a link to this report on Econoday. You should also read about this in a more typical news story (this link is for MarketWatch). Essentially, weather played some indeterminate effect in the January jobs report. That report is the payroll employment report, which counts the number of jobs available (i.e., non-farm payroll). But, as last Friday showed all to vividly, there is another survey, the Household Survey, from which the unemployment rate is derived. The number of persons working, resident employment (weather doesn't affect the number in this survey), didn't show such weakness, rising by 117,000.

From what little we have had the opportunity to discuss in class up to this point, a weak employment report should (other things being equal) bring about lower interest rates. Yet that didn't occur, as persons looked below the "headline number" and found signs of strength (and weather-related reasons to look beyond this). Here is a story about the changes in interest rates that occurred. Try to follow this as much as possible at this point.

So, the overriding pattern in major "numbers" at this point in the semester continues to be the need to look beyond "headline numbers" and look at a release in a broader and more meaningful context. Fortunately, with all the snow days, you have lots of time to do this!

Welcome Back!

Welcome to the Spring 2011 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 still considerable debate about whether or not the national economic recovery will falter. Whether or not this occurs, housing market weakness continues to be important, as are the financial problems in the Euro zone and with individual US states. There remains the question, albeit less pressing, as to whether we might still be flirting with deflation. The Fed can no longer lower the fed funds rate, as it is currently at (or near) 0, but will they continue with Quantitative Easing, attempting to hold longer-duration interest rates down?

By semester's end, you will come to understand that all of the factors we will be discussing throughout this semester are interrelated, and how the key four markets we will be focusing on interact. 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 download the online notes for the technical analysis handouts I have written. If you get a chance, 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.

ECN 327 Final Paper

The forecast paper for ECN 327 that is due next Thursday 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.

Finally, those papers are due at the beginning of class next Thursday. I have no intention of negotiating dates I will receive these. As stated in the syllabus, you can still hand in a paper after class Thursday until the beginning of our exam, but with a grade reduced by one letter grade.

Third Quarter 2010 GDP Revision

The revision to third quarter 2010 GDP was released last week. The original estimate, 2.0%, was revised up to 2.5%, a more "respectable" number than the original. In the first release of each quarter's GDP number, inventories, exports, and imports are all approximated. Subsequent months will use available data to eliminate the "educated guesses" contained in the first estimate. That was the case for today's release. Here is a story discussing the GDP release.

As the official GDP releases represent somewhat "stale" data, we can approximate what they will entail using real-time data from asset markets, which has been a central theme of my classes. To do this, go to StockCharts.com and on the middle right select the PerfChart (this stands for Performance Chart) that deals with the sectors of the S&P 500. To save you time and effort, here is the link.

PROCEDURE:
First, choose a bar chart at the bottom left (second button from the left). Then, move the slider (bottom right) to cover the exact time period you desire. Here, I have used the third quarter of 2010.

ANALYSIS:
Observe which sectors have performed better than the S&P 500 index (i.e., outperformed the overall market). This occurs when the S&P 500 button at the top left of the chart is selected.

For the third quarter of 2010, clearly the most cyclically sensitive sectors outperformed the market, with the exception of Financials. Overall, this is a reflection of the growth that occurred during that quarter. Had the defensive sectors (i.e., Consumer Staples, Health Care, and Utilities) outperformed, this would have signaled a potentially weakening economy.

Can this analysis be used to help predict the GDP report before it is actually released? The answer is yes. Asset markets, one of which is the stock market, are leading indicators, which means they tend to move in advance of changes in other parts of the economy. So, current changes in leading economic indicators tend to signal future changes we can expect to observe in the overall economy.

What is the stock market (and its sectors) telling us about the fourth quarter rate of economic growth? The second chart (click to enlarge) shows market performance since October 1. Other than Energy and Consumer Discretionary stocks (which themselves are cyclical), the remainder of cyclical indicators are performing less well than they did in the third quarter. The apparent message is that economic growth in the fourth quarter will be slower than it was in Q3, or spotty at best in comparison.

There are two things that should be noted. First, there is no indication that economic growth will become negative in Q4. Second, the slowing of economic growth these sectors seem to be indicting also affects the defensive sectors, so they are more negative than they were in Q3. The greater under performance utilities may also reflect an expectation of somewhat higher interest rates in the near term (i.e., (public) utilities like electric companies tend to pay high dividends which become less attractive when interest rates are expected to rise). Part of this no doubt reflects ongoing worries about the US housing market and the economic stability and solvency of several European countries as well (Ireland, Portugal, Spain, Italy, and Greece, sometimes referred to as the PIIGS, using their first letters). Will economic weakness in Europe weaken the recent momentum the US has been experiencing? The market apparently believe that this is likely.

Let me suggest that you continue to follow the sectors as we move farther into the fourth quarter and see what the market is suggesting. We won't get the initial Q4 GDP data until late in January, so this should be informative in advance of the formal data in January (that will be stale at that point).

The 50-Day Moving Average as Support

In the last post, I addressed how the Dow-Jones Industrial Average (DJIA) failed at resistance. In cases where the DJIA is expected to fall from that level, how far can it be expected to decline? To translate this into technical analysis terms, where is the next support level? In the most recent situation, that support was at the 50-day moving average. The chart below shows this (click to enlarge).

Notice how the market moved all the way down to the 50-day moving average then "bounced" off this newly found support level. As of the time this post is being written the Dow is moving once again toward the prior resistance level.

Had the market fallen below its support at the 50-day moving average, where would it likely have fallen? Again, where are the next support levels? We should view the 50-day moving average as support level #1 (S1). Below that, the next support (S2) occurs around 10,900, then 10,700 is S3 (both of these are derived from horizontal support lines. After S3 comes the 200-day moving average at 10,600. Note, though, that the DJIA moved above support here when it was not yet overbought (the RSI never fell below 30). So, it is quite possible that we will be testing resistance once again. As I have stated in earlier posts, to determine whether resistance is likely to hold, it is necessary to evaluate what would drive profit expectations to higher levels so that resistance would be broken? Again, check the economic calendar for the upcoming week or two.

Let me finish this post by showing another way to determine likely levels of support should the market fall in coming days. This is illustrated using Fibonacci Analysis. In StockCharts.com, when you choose "Annotation," there is an icon to do this. Go from the most recent low to the recent high. The result is illustrated below (click to enlarge).

To add Fibonacci Analysis, click on the button highlighted in the upper portion of the above chart, then drag your mouse from the low value to the high (hold the mouse button until you reach the final level).

According to Fibonacci Analysis, the first likely level of support from an uptrend "retraces" 38.2% of that uptrend (this is called a Fibonacci Retracement). If that level of support fails, the next likely support occurs at 50% retracement. Finally, the last support level is at 61.8% retracement. If the market falls below 61.8% retracement, it is fairly likely that the prior low will be tested. Consult the RSI to assist you in deciding (in real time) if this is likely to occur.

Dow Jones Fails at Resistance

The Dow Jones Industrial Average (DJIA) recently tested then failed at resistance (of 11,258). There were signs in advance that this might happen. First, the index was very overbought, as the RSI (for nine periods) was far above the typical overbought reading of 70. Second, there was an intermarket relationship at work -- the US dollar found support. For quite some time now, the stock market and the US dollar have moved in opposite directions (the result of the dollar carry trade). The chart below (click to enlarge) shows this recent price action in the DJIA. The line below the DJIA chart is that of the US Dollar Index. Note how it turned up at support just as the DJIA failed at resistance.

Where will the market go from here? Translating this to technical analysis, where is the next support level? From the chart, the next support occurs at 11,100. The second (next) support level after that is at 10,900.

There is another element in this situation that needs to be examined, however. While the overall market has recently pulled back, does this mean the uptrend has now ended? The definition of an uptrend is not, as might sometimes be thought, continual increases in price. Instead, an uptrend is a series of higher highs and higher lows in price. At present, the DJIA is still in an uptrend. There is another way to help determine this. Using the RSI, an uptrend exists as long as RSI(9) > 40. While typically, a bullish signal is an RSI at or above 50, many persons (including myself) use support for a trend at the RSI of 40. In other words, as long as the RSI(9) remains at or above 40, view the uptrend in the DJIA will still be in tact.

So, will the uptrend remain in tact? Remember that in general, stock prices depend on interest rates and profit expectations. The primary driver at present is profit expectations. So, the question shifts to how profit expectations will behave in the near term. To answer this, it is necessary to consider monetary policy and QE2, whether US fiscal policy will shift to being contractionary, what other central banks are doing and will do, and how much strength other economies will be able to sustain. A critical factor in this is the strength of the Chinese economy. This is obviously related to whether China will further tighten its credit. A possible slowing of Chinese growth was behind today's (Friday) pullback.

To end this post, look at profits, the difference between revenues and costs. As the US dollar has been weakening, which has pushed commodity prices higher, this will raise production costs, working against future profits. What about revenues? If the economy begins to grow more rapidly and consumer spending continues to strengthen, then revenues may well continue to move in the right direction. But will this be enough to offset the effects of commodity-based cost increases? This is the question that everyone will be attempting to answer in the coming weeks.

Macro Assignment

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.

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!