There Goes Another False Fed Rally

By Dr. Duru written for One-Twenty

July 14, 2006

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What indeed was the big deal? When the market rallied sharply after the last Fed rate hike, I warned that " a week or two, you will wonder what all the excitement was about in the first place." Sure enough, here we sit two weeks later, and the evidence of the market's "mistake" is splattered in red all over the financial pages. See TraderMike for a review of the tremendous technical damage done to the markets this week. I will summarize by the following salient points:

  1. On July 10, the Nasdaq completely returned all of the gains from the last "Fed day" and on the 12th, it went below the low of that wonderful Fed relief rally. Incredibly, the Nasdaq is right back at those 9/11 post-rally highs that we have seen so many times over the past 5 years. Back in June was able to pull off 2 or 3 picture perfect bounces off those levels. The fourth time was not a charm.
  2. The S&P 500 was less gradual. After hanging between the 50 and 200DMAs for what seemed an eternity, two quick and vicious days of selling have put that index well below the prices of the last Fed day.
  3. And, finally, the Dow also gave it up on two days of hard selling.
Take note that the Nasdaq was leading the way toward lower prices as it so often does. The Nasdaq is full of technology stocks. Technology companies need a robust and growing economy to do well. Listen to what the market is really telling us: faith is rapidly dissipating in the Fed's ability to manage it's way to a "soft landing." Cyclical industrial stocks have been hanging in there pretty well. Some, like Cummins Engine (CMI) rallied sharply from the June lows to make new all-time highs. But technology is cyclical as well. If the economy cannot support robust tech earnings, the rest of the growth sectors in the economy are likely to stubmble too.

I point to increasing oil prices as the growing threat to combine an economic slowdown with higher prices. Most people do not seem to take stagflation seriously because they immediately think back to the troubles of the 1970s. Who says that things have to get as bad as that for stagflation to exist? All we need is a slow economy that gets bogged down with high interest rates and high oil prices driving up the price of everything because of supply problems. Now, I have heard things like 70% (or 80%?) of core inflation comes from labor costs (Nightly Business Report this week). In a related fashion I keep hearing that energy and other commodities are not as large a part of the economy as in the past. I certainly argued earlier that if the Fed is finally getting worried about inflation, then the time is near for us not to worry about it. So, I am a bit torn on a final conclusion. Regardless, if all these arguments hold water, commodities will continue to soar because the economy can continue paying up, the Fed will keep raising rates to calm those prices down, and the economy will continue to get beaten down. At some point, something has to break....and before then we might see stagflation.

Now, having said all that, I am not encouraging one to rush to get on the negative bear bandwagon now. The time to be skeptical was when the market was having its nonsense rally for no good reason except for false Fed hopes. Now, the pendulum feels like it has swung to the other side. Much of the negative news pushing the market's hot buttons involve the kind of geo-political events that typically prove to have no lasting effect on the economy. Eventually, the market could begin hoping for "good news" from the Fed again, even as it dreads what awaits in the notoriously weak early Fall months. Another interesting tidbit of news is that the 10-year Treasury note is incredibly all the way back down to 5.07% as some folks flee to "safety." This level is Well below the current target federal funds rate of5.25%. Sure it means the yield curve is inverted (two-year note at 5.1%) and continues to signal economic weakness ahead, but the inversion also means the market is betting against an inflation threat. Maybe, just maybe, the market has been clobbered enough such that bad news during earnings season suddenly becomes good news (bad economic news feeds the hope that the Fed must stop raising rates). Given we are back in (technical) bear market territory in the S&P and Nasdaq, we would not be wise in trying to pick bottoms. The market will certainly get plenty of additional excuses to sell-off in the next few months, and the likely positive catalysts are few and far between. I am just saying that in this market, you must keep your mind on what could happen to get the market moving opposite of the latest trend.

Be careful out there!

DrDuru, 2006