Oct. 22, 2010, 7:01 a.m. EDT
Stock market controlled by a visible hand
Commentary: Familiar face in the driver’s seat — for now
By Michael Sincere and Pascal Willain
BOCA RATON, Fla. (MarketWatch) — Many investors are confused because the stock market nowadays doesn’t appear to reflect the real economy. It makes you wonder who, if anyone, is controlling this market.
The answer: The Fed is in control — at least for now.
The market is reacting to the Fed’s monetary easing, keeping interest rates to near zero (since December 2008) and organizing the outright purchase of securities, commonly referred to as quantitative easing . The Fed has hinted that it is prepared to lower interest rates even further.
Fed’s bond buying won’t help
Whatever the Federal Reserve does to lower interest rates further won’t help the U.S. economy, according to First Pacific Advisors fund manager Tom Atteberry, who says that’ll just weaken the dollar and hurt savers. Deborah Levine reports.
As a result, the U.S. dollar has fallen in anticipation of the monetary easing. As the dollar systematically falls, many institutional investors took this opportunity to buy equities, another reason why the market is trending up. (MARKET:SPX)
Gold has also soared. In fact, gold zoomed so much even proponents wonder when the 10-year gold bull market will end. The falling dollar certainly helps propel the gold higher. For now, some traders are waiting for a flash blast before making a final exit out of gold. (CONSOLIDATED:GLD) (COMMODITIES:GCZ10)
Inflation or deflation
Meanwhile, many people are wondering if inflation or deflation is more likely. At the moment, it’s possible that both scenarios will occur together.
The downward pressure on real estate prices, the millions of houses in foreclosure, and lower prices on some goods and services support the deflation scenario. On the other hand, the Fed believes it needs to continue easing to keep the U.S. competitive and completely pull the economy out of a stubborn recession. The cost of easing, many economists have noted, means an increase in the cost of oil, food, and basic materials. This is the inflation scenario.
The Fed has stated it doesn’t believe that inflation is a problem now. In fact, Federal Reserve chairman Ben Bernanke recently said that inflation levels are too low. In our opinion, although inflation is not a problem now, it could be a huge concern in the future.
Also, if the currency war between major central banks continues, commodities will surge higher, boosting worldwide inflation. China will buy whatever commodities it can with its huge pile of U.S. dollars that are losing purchasing power.
Using technical analysis to determine who is in control
As traders, we determine who is in control of the market by comparing prices to trendlines or moving averages. In particular, we monitor whether prices are close to the top or bottom of a trend or moving average.
In addition to using traditional market indicators, we also use a sophisticated tool called VWAP (Volume Weighted Average Price) to determine whether buyers or sellers are in control. VWAP is the average price paid by investors for the duration of the analysis period. If the current average price is above VWAP, investors are making a profit, and buyers are in control. If below VWAP, investors are losing money, and sellers are in control.
This tug-of-war between buyers and sellers crossed a line on September 1st when price pierced through the descending VWAP line. Since that time, buyers have been in control, and the trend is still in their favor.
Using the VIX as a contrarian indicator
Another indicator we look at is the VIX, which helps us to determine when investors get too complacent. When the VIX drops below 20, this is a signal investors are getting too complacent. At this writing, the VIX is at 19.79. If the VIX drops further, the chances of a major market reversal increase. (MARKET:VIX)
One method we use is to compare the VIX to the market price. Using charting software, in this example we simply divide the S&P 500 by the VIX. This gives us another view of investor confidence.
We use these technical tools to help determine when the market has reached extreme levels so we can be prepared for a reversal when it comes. We’ll also look at market indicators such as sentiment surveys (Investors Intelligence and the AAII Sentiment Survey) for more clues that investors are getting overly exuberant.
In addition, excellent earnings reports by market leaders such as Google and Apple may propel investor confidence to extreme levels. From a contrarian viewpoint, this could be the catalyst for a market reversal.
Because of all of the reasons mentioned above, and with the help of the Fed, the market appears poised to move higher in the near term.
Nevertheless, it is way too early to signal the danger is over. There are enough red flags that should raise enormous concerns. For example, one story we’re watching closely is the “foreclosuremess,” a black swan event that could tank the market if the problem spreads.
Because the Fed appears to be in control, many investors are hoping for the best. For experienced traders who have been through this before, the “Don’t fight the Fed” battle cry feels like déjà vu all over again.
Michael Sincere (www.michaelsincere.com) is the author of All About Market Indicators (McGraw-Hill, 2010) and Understanding Options (McGraw-Hill, 2006). Pascal Willain is the author of Value in Time: Better Trading through Effective Volume (Wiley Trading, 2008) and owner of the website, http://www.effectivevolume.com.