'on the edge'
Apr 21, 2004
Below is an extract from
a commentary posted at www.speculative-investor.com on 18th April
A short-term bottom was probably put in place in the stock market
at the end of last week and the market will probably rebound
sufficiently over the next 2-3 weeks to take the S&P 500
Index to a new high for the year. However, we currently have
something akin to a "Pascal's Wager" situation in that
the positive consequences of betting on a short-term bullish
outcome and being right are far less than the negative consequences
of betting on a short-term bullish outcome and being wrong. In
other words, although the market will PROBABLY move several percentage
points higher in the short-term the alternative is that the rebound
high from the March low is already in place and a major decline
is in its early stages. This is why we have just added a second
position in USPIX (a leveraged inverse index fund) to the Stocks
List. Our plan is to add another bearish speculation to the List
(a third position in USPIX or, perhaps, some put options) if
the market rallies over the next few weeks and negative divergences
The bond market stabilised during the second half of last week
and this had the predictable effect of causing a sharp rebound
in the NYSE Advance-Decline Line (due to the large number of
interest-rate sensitive stocks on the NYSE) and modest strength
in the senior stock indices. However, the price action during
the second half of last week was not at all bullish and, as illustrated
by the below charts, has left the market 'on the edge'.
Below is a chart of our old favourite -- the NDX/Dow ratio. NDX/Dow
is a measure of the willingness of market participants to take-on
risk. This ratio has not only tended to trend with the overall
market over the past few years, it has also led the market at
important turning points.
Note that NDX/Dow peaked in January, bottomed in March, and was
in the process of rebounding prior to a sharp drop during the
second half of last week. It is still comfortably above its March
low, but continuing weakness in this ratio in the short-term
would be evidence that a major decline is either already underway
or about to begin.
We'll now take a look at the
SOX/NDX ratio. This ratio provides similar information to the
NDX/Dow ratio in that the semiconductor stocks (represented by
the SOX) have greater valuation risk than the average large-cap
tech stock (represented by the NDX). Therefore, when the SOX/NDX
ratio is moving higher it is evidence that market participants
are prepared to throw caution to the wind. A general willingness
to ignore valuation risk is, in turn, critical if a dramatically
over-valued market is going to move even higher.
Note that SOX/NDX turned down at the beginning of December and
after rebounding for a couple of weeks has just dropped back
to near its recent low. Further weakness from this point in the
semiconductor stocks relative to the NDX would be a significant
negative for the overall market.
Next, below are charts of two
of the leading semiconductor stocks: Applied Materials (AMAT)
and Intel (INTC). Both stocks ended last week near important
support, so either they are about to rally or the rebound from
the March bottom is over.
Lastly, the below chart of
Alcoa (AA), the world's largest aluminium producer, has just
tested support at 32.50 for the third time this year. A close
below 32.50 would create a technical target of around $26, a
level at which we would probably be buyers of the stock.
As mentioned above under "Overview,"
we think the odds favour support holding and the market rallying
in the short-term. However, the situation is dicey to say the
Alfred Broaddus, President of the Richmond Federal Reserve Bank,
said last Friday that he was not "unduly concerned"
inflation would suddenly surge, saying there was still a lot
of slack in the economy. He also said: "It now looks like
the recovery, while not galloping away, is finally gaining more
momentum," and "The outlook is relatively bright."
The constant attempts by the Fed to assure us that everything
is fine on the inflation front would be comedic if the situation
weren't so fraught with danger. What we have is a massive US
inflation problem with US policy-makers trying to 'fix' the problem
by simultaneously creating a) more inflation and b) a smoke screen
to conceal the effects of inflation. This is going to end very
badly, but the goal is clearly to postpone the end for as long
as possible in the hope that the problem will either miraculously
right itself or, at worst, become the responsibility of a future
set of policy-makers.
One of the ways of creating the aforementioned smoke screen has
been to talk up the prospects of deflation from time to time
or, to be more politically correct, to talk about the risk of
an "unwelcome drop in inflation." What they always
fail to mention, though, is that a drop in inflation can never
be unwelcome unless there is already an inflation problem. This
is because real economic growth and inflation are NEGATIVELY
correlated, but a lengthy period of high inflation effectively
puts in place a set of conditions whereby the short-term outlook
will be brighter if the inflation can be continued. Brighter,
that is, until the bond market wakes up to what is happening
and begins to push interest rates sharply higher. At this time
the political cost of allowing the inflation problem to build
becomes greater than the short-term cost of doing something to
Right now we appear to be at the point where the bond market
is beginning to awaken to the inflation problem, but we are still
probably some distance from the point where policy-makers feel
pressured to take aggressive action to curb the problem.
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