There are four primary reasons risk assets can move higher than most can rationally comprehend:
- The Fed will take action.
- Open-ended QE could mean unbounded money printing.
- Spain and Italy have avoided the worst case scenario.
- The charts don't lie.
Dual Mandate Says Fed Will Act
As we noted on July 7, according to the 1977 amendment to the Federal Reserve Act, the Fed has a dual mandate to keep inflation in check and produce "maximum employment". The Fed now has six months of weak job creation numbers in hand. Last month, the economy created just 96,000 jobs. The prior month was revised to a still low 141,000 jobs. To bring down the unemployment rate, the economy needs to create at least 250,000 jobs per month. As shown via the vertical bars below, the reports from the last six months are nowhere near 250,000, giving the Fed more cover to announce a third round of quantitative easing (QE3).
Open-Ended QE
On Thursday, the European Central Bank (ECB) announced a game changing bond-buying program. Not to be outdone, the Fed may have its own game changer in the form of open-ended QE (quantitative easing). According to an August 26 Reuters story:
"Some officials have said any new bond buying, or quantitative easing, could be open-ended, meaning it would not be bound by a fixed amount or time frame."
QE-friendly assets are clearly showing the market expects the Fed to move soon. The Metals & Mining ETF (XME) was up 4.79% Friday afternoon on well-above average volume. Other signals given Friday by the market that QE3 is coming: copper (JJC) up 4.05%, silver (SLV) up 3.07%, gold (GLD) up 2.25%, and gold mining stocks (GDX) up 2.75%. We own all four based partly on Germany's bailout-friendly shift in early July.
Spain and Italy: Nightmare Averted
The market's biggest fear for the past 2.5 years has been the possibility of Spain or Italy needing a full-blown bailout similar to Greece. A full bailout involves losing access to the bond market. The ECB's bond buying plan ensures Spain and Italy will remain active participants in the credit markets. Is this a long-term solution? No, but it should be enough to allow risk assets to stage a significant rally. It stands to reason that if the market's biggest concern has been addressed in some meaningful way, risk assets can surprise on the upside.
If you didn't catch Germany's shift in early July, the ECB clearly telegraphed this week's announcement in late July. On July 30, Bloomberg reported:
European Central Bank President Mario Draghi has gone on the offensive as he seeks a game changer in the battle against the sovereign debt crisis... Draghi's proposal involves Europe's rescue fund buying government bonds on the primary market, buttressed by ECB purchases on the secondary market to ensure transmission of its record-low interest rates, two central bank officials said July 27 on condition of anonymity. Further ECB rate cuts and long- term loans to banks are also up for discussion, one of the officials said.
The Charts Don't Lie
The bullish set-ups we outlined on August 10 remain in place and could push the stock market higher than most can comprehend. If you go back over the last four months and find managers that have been in line with the market, you can bet the vast majority of them pay attention to the market rather than talking heads. The video below shows numerous "last time this happened stocks went up" set-ups in the stock, bond, and commodity markets. Demark exhaustion counts tell us Italian stocks (EWI) are attractive from a risk-reward perspective. DeMark charts and indicators are proprietary tools from Market Studies LLC.
Monitoring the charts and following central banks have allowed us to participate in gains in oil stocks (OIH), oil (DBO), silver (SLV), gold (GLD), gold stocks (GDX), Spain (EWP), Italy (EWI), and the Euro Stoxx 50 (FEZ). Since the fundamental backdrop remains weak, and recent gains have been largely fueled by anticipated actions from central banks, we will maintain maximum flexibility and an open mind about future outcomes. We remained confident enough this week to add the Oil & Gas Exploration ETF (XOP) and Metals and Mining (XME) to our already central bank friendly allocations.
If the economy is too weak for stocks to push higher, ask yourself:
"How did the economy look in March of 2009 when stocks bottomed?"
The answer is "not good". Central banks take action when the economy is noticeably weak. When central banks take action, stocks and commodities tend to go up. Central banks took action in early 2009. They are taking action again. See a pattern?
