Tuesday, May 17, 2016

stock market upsdate

As you can see in the top three charts the US stock market has completely retraced virtually all of its drop from the November 2015 top to the February 2016 low. These three trend indicators are all well above their 200 day moving averages while the NYSE advance-decline line has reached a new high point for the 2009-16 bull market, certainly a bullish configuration.

As you know ever since the 2009 bear market low points I have taken the bull markets in the US, Europe, and Japan to be a manifestation of quantitative easing polices which have been implemented by the US Federal Reserve, and later by the Bank of Japan and then by the European Central Bank. These QE policies affect the domestic and world economy principally by alterning expectations in the business community about the likely growth path of nominal gross domestic product. For these policies to work people must be confident that indeed the central banks will do "all that it takes" to get nominal GDP back on the desired growth path. If they are convinced of this then one has essentially a self-fulfilling prophecy because businesses will then invest and hire antipating growing demand for their products.

But expecations about the future can be fickle and if the central bank's determination to do "all that it takes" is called into question for any reason the positive effects of QE policies will be lost. Stock market averages are good barometers of the state of business expecations so I like to monitor their behavior to see if central bankers are maintaining their credibility.

The US Federal reserve so far has passed this test. The eventual end to its QE policies was announced by Bernanke in May of 2013. But since then the US stock averages have risen more than 25%. and have held onto these gains. This shows that the Fed has succeeded in moving the US economy onto a self-sustaining path of nominal GDP growth.

The situation in Europe and Japan is not so hopeful.

In the fall of 2014 the European central bank announced its own QE policy and not only has it remained in place but it has been expanded since then. But as the chart of the Euro Stoxx 600 index shows European stock market prices have dropped 30% from their 2015 highs and are now back where they were when European QE was undertaken. I think this reflects a general lack of confidence among world investors that the ECB can free itself from the political constraints (imposed principally by Germany) which limit the aggressiveness of its QE policies. People doubt that the ECB indeed will be able to do "all that it takes" to get European nominal gross domestic product to grow rapidly enough to ease debt burdens and lower unemployment. These doubts have also resulted in 10% appreciation of the Euro currency over the past year.

The situation in Japan is better but it is clear from the 30% drop in the Nikkei over the past year that confidence in the Bank of Japan's QE policies (implemented late in 2012) is faltering. Moroever the Yen has appreciated about 15% against the dollar as well, another sign of a lack of confidence.

Both the Stoxx 600 and the Nikkei have so far retraced only about 38% of their bull market advances. This shows technical strength in both markets and offers the prospect of a resumption of the bull market and a recovery in confidence. But a break of the 2016 low points in these averages would be very bearish and probably mean that the QE policies in Europe and Japan have failed and/or will be abandoned.

It is certainly possible that a serious further drop in European and Japanese stock prices will take US stock prices down with them. But at this moment I'd say that the US market is showing quite a lot of strength. For example, not only has the S&P 500 stayed well above 1580, the 38% retracement point for the entire 2009-15 bull market, but it is also still visibly above the 38% retracement point for the February-April 2016 rally. This is a sign of a heathy bull market. Another sign of strength appears in the 5 day moving average of the CBOT equity put-call numbers. This indicator is near its January-February 2016 high points and in the upper reaches of its 5 year range, thus showing a lot of bearish trader sentiment which is likely to support a further substantial advance in prices.

I expect the US market to continue its upward path unless and until stock prices in Europe and Japan drop substantially from current levels. Failing such a drop I think a rally to 2500 in the S&P 500 index in likely over the next 18 months.

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