The market’s been due for a correction for more than just a couple of days. Nevertheless, the S&P 500 has gone 38 days without a single day loss of 1%.
This is the classic “caught between a rock and a hard place” scenario, where you’re doomed if you do (buy stocks) and doomed if you don’t. No doubt stocks (NYSEArca: VTI) are due for a correction, but with every Tom, Dick and Harry (including myself) watching, the correction pot may need more time before coming to a boil.
This article will explain the reasons behind this relentless rally, when and where it might stop and how to trade safely in this tricky environment.
2011 Deja Vu – The Rally Explained
Today parallels the late 2010/early 2011 QE2 (or POMO) rally: Good news, bad news, high trading volume, low trading volume, bullish seasonality, bearish seasonality all doesn’t matter. Stocks are seemingly on a one-way track.
The November 2010 ETF Profit Strategy Newsletter examined the effect of POMO on stocks and shared the following results: “Looking a month after POMO buys, the S&P was up 78% of the time. The larger the POMO buys, the better the S&P’s performance. Certain POMO transactions resulted in positive S&P performance 89% of the time.”
QE2 was like fertilizer for stocks as banks (NYSEArca: KBE) and financial institutions (NYSEArca: XLF) flooded the stock market (NYSEArca: TWM) with cash. But QE2 stopped on June 30, 2011 and the Fed hasn’t officially unleashed QE3, yet. However, a covert two-prong QE3 has already been in place for months.
1) On November 30, 2011, the Federal Reserve revived its “temporary U.S. dollar liquidity swap agreement.” This agreement allows various central banks (including the ECB) to borrow funds from the Fed. In the fall of 2008, the Fed had more than $600 billion of currency swaps on its books. Unfortunately, I don’t know the current swap balance.
2) On December 21, 2011, the European Central Bank (ECB) allowed 523 banks from across Europe to borrow euro489 billion ($650 billion) at 1% for up to 3 years. The process is called longer-term financial operations (LTRO). This was the first of at least two LTROs (more about the second tranche in a moment).
Although I did not expect the S&P to rally 38 days without as much as a 1% correction, it’s no surprise that this kind of liquidity is pushing up stocks east and west of the Atlantic. The October 11, 2011 ETF Profit Strategy update foretold that: “This rally from the 1,075 low is a miniature version of the March 2009 – May 2011 rally.”
How High can Stocks Fly?
Philosophically, the sky is the limit. Technically, the Dow Jones (DJI: ^DJI), S&P (SNP: ^GSPC) and Nasdaq Composite (Nasdaq: ^IXIC) are butting up against key resistance levels right about now (the chart below shows the S&P’s resistance, which is further explained below).
Obviously those resistance levels are no secret because even the Associate Press and Reuters refer to them:
AP: “Dow flirts with 13,000 again but can’t make it”
Reuters: “S&P fails to break key level”
The media’s take on the indexes latest rendezvous with their respective resistance levels suggests that the market will (at least briefly) move above resistance (just to proof main street media wrong).
Rather than pinpointing one specific resistance level right now, it’s better to refer of a resistance cluster. The S&P is dancing with the very Fibonacci resistance and parallel channel resistance that halted its May 2011 ascent.
The April 3, 2011 and subsequent issues of the ETF Profit Strategy Newsletter referred to this resistance range and warned that: “The 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions.”
The initial reversal – the S&P dropped nearly 300 points – was of historic proportions, but the September 23, 2011 ETF Profit Strategy Newsletter prepared subscribers for a strong rally: “From its May high at 1,370 to its eventual low, the S&P will likely have lost about 300 points (22%). This kind of move validates a counter trend rally, that once underway, will probably re-inspire a certain degree of confidence into the market before it runs out of steam” (the provided target was S&P 1,275 – 1,300).
Even though the Fed’s currency swap and the ECB’s LTRO cash infusion make last May’s reversal seem less historic, with the VIX (Chicago Options: ^VIX) below 17, now’s not the time to become blindly complacent.
How to Trade this Market
Europe’s LTRO I provided euro489 billion in loans to banks, equivalent to about 5% of the eurozone’s GDP and the largest amount provided in a single ECB liquidity operation.
Analysts expect LTRO II – slated for February 29 – to provide euro400 – euro500 billion of new loans. Betting against this kind of cash infusion without seeing a clear technical breakdown in the capital markets isn’t prudent.
The question is if LTRO will push (and keep) stocks above their respective resistance levels? If it does, how high can stocks rally? If it doesn’t, how much down side potential is there for stocks?
At this stage in the game, there’s enough conflicting data that allows Wall Street and its gurus to paint bullish, bearish, short-term bearish and long-term bullish (or whatever agenda there is, there’s data for it).
My long-term view is still bearish, but it doesn’t make sense to be dogmatic in a market like this. The market is the ultimate authority and it tends to do whatever creates the most fools.
Now is the time to either stay on the sidelines or rely on a flexible trading/investing strategy that makes money in either direction with a very limited amount of risk.
The latest ETF Profit Strategy Newsletter introduces this low-risk strategy along with a straight forward, to the point short, mid and long-term forecast.