October 2011 Stock Market Outlook

During the Federal Reserve’s Open Market Committee meeting on September 21, the Fed pulled yet another rabbit out of its hat of monetary tricks. From what increasingly appears to be an empty hat, Fed Chairman Ben Bernanke pulled out a $400-billion plan to buy long-term treasuries while selling short-term bills and notes held by the Fed. The expected net result will be to narrow the yield spreads between long and short maturities of U.S. treasuries.

The plan, quickly dubbed by commentators as the “Twist,” will further flatten the yield curve; something the market itself has already started doing in recent months. The historical correlation of the slope of the yield curve to the stock market shows that flat yield curves have been bearish for stocks, while steep curves have been bullish for stocks.

To put it another way, the larger the difference between yields on long-term and short-term maturities of T-bills, the better the long-term outlook for the stock market, and vice versa.

The 30-year chart of the yield difference between 10-year and two-year U.S. treasuries demonstrates the above historical correlation. Regrettably, in the brave new world of perpetual zero interest rates on short-term treasuries and record-low yields on long-term treasury maturities, numerous time-tested fundamental and monetary indicators have lost some of their accuracy and relevance.

The Fed’s September 21 announcement (about buying long-term treasuries to bring down long-term interest rates) has completely failed to perk up the moribund stock market, already dazed from the long-running Greek tragicomedy, the global economic slowdown, a dysfunctional Washington, and the usual flood of economic data and expert opinions.

Lacking the necessary smarts to make much sense from this information overload, I need to rely on technical and sentiment data to come up with “educated market guesses.” My last guess—that the S&P 500 would mimic the downside breakout of a head-and-shoulders formation on the chart of 10-year treasury yield—has turned out to be on the money.

The breakout quickly brought the S&P 500 to the downside target of 1,140-1,150. Over the subsequent eight weeks the S&P 500 has traded within 10% of the range just noted. Now the big question, the million-dollar question, is: what will be the resolution of this narrow trading range?

A textbook resolution to the trading range, the first scenario, would see the S&P 500 rally towards the neckline of its H&S top to a level of 1,230. Nine percent above where the popular stock market index sits today,

But considering its slope, any textbook rebound should run out of steam in the 1,260-1,270 range, and be followed by a re-testing of the August 2011 low of 1,101. My guess is that the test will fail and the S&P 500 decline will meet the 20% rule-of-thumb definition of a bear market. This is something indices such as the Dow Jones Transports, the Russell 2000, the NYSE and Canadian TSX Composites have already met.

New 2011 lows by the S&P 500 would confirm the new lows already hit by the NYSE Common Stock AD Line and the NYSE Upside/Downside Line. To put a positive spin on such bearish musings, on numerous past occasions (i.e. 1987, 1990, 1998, 2002) the market bottomed out during the month of October.

My conclusion: October will not be a pleasant month for the stock market this year. But it could also mark a new temporary bottom for stocks prices, from which they will likely bounce.