The Technical Picture
Investors have been hoping for the longest time that the Fed’s comments will contain some hint that the two-year tightening in the U.S. monetary policy may be coming to an end. Following 17 quarter-point increases in the federal fund rates, from 1% to the current 5.25%, the anticipation of the end of the two-year upswing in interest rates is quite rational. What is less rational are the huge one-day rallies which, so far, have turned out to be only wishful analysis of the Fed’s comments on the state of the U.S. economy.
In May 2006, after the first of four recent daily spikes in stock prices on April 18, accompanied by a Daily Upside/Down Side volume ratio of more than nine, I had commented on the fallacy of assuming that the end of interest hikes is bullish for the stock market. I quoted a study by Birinyi Associates showing that during the last nine monetary tightening cycles the market lost an average of 7% from the time the Fed stopped raising interest rates until the time it made the first cut. Only on two occasions, the most notable was the 1995 occasion, did the market gain during these “periods in limbo.” It may just be a case of being careful what you wish for.
In fact, one does not have to go back far in history to find an example where the end to the tightening cycle proved to be far from beneficial to the financial well-being of investors. Only six years ago, the end of the preceding tightening cycle came on July 2000. It was just as the stocks were completing what Saddam Hussein might have called the mother of all market tops, to describe the subsequent two-year collapse of nearly 50% in the S&P 500 and 78% in the NASDAQ Composite.
Weakness in equities after the Fed was done with cooling down an over-heated economy is not just another example of investors selling on good news. The Fed has a tendency to overshoot on the upside when interest rates are rising. As it is next to impossible to attain perfection in such a complex endeavor as fine-tuning the U.S. economy, the Fed would rather risk a recession than runaway inflation circa 1970s and the early 1980s. The history of the boom-and bust economic cycles gives the Fed more confidence in reviving a sputtering economy than fighting double-digit inflation.
From the preceding it appears that until the Fed starts to cut interest rates, buying in the hopes that the Fed is done raising interest rates is premature. Intriguingly enough, a technical argument can be made from the recent four short-lived one day explosive rallies for higher stock prices in the next 12 months.
Back in mid-1980 Martin Zweig, a prominent analyst credited with rules such as “Do not fight the Fed” and “Do no fight the Tape,” noted that a daily Upside/Downside Volume Ratio (Up/Dn Ratio) greater than 9 is extremely bullish, though not infallible. Analyzing the 1960 to 1985 period, he discovered that when two daily ratios of 9 or higher occurred within a three-month period stock prices were always substantially higher six and 12 months later. The average gains for 12 buy signals in that period were 14% and 20.7%, respectively.
A cursory examination of the trading of the last 10 years, to a large degree, confirms Martin Zweig’s findings. Since 1996, there were eight trading days with the Up/Dn Ratio of 9 or higher. With the exception of the badly failed signal of March 16/2000, all other occurrences were followed by higher prices within 12 months. The most profitable buy signals for the S&P 500 were: Sept. 8, 1998 at 1023.4 — gaining 38% in 10 months. July 28, 2002 at 898.9 — gaining 13% in 11 months. March 17, 2003 at 866.4 — gaining 34% in 12 months. Aug.16, 2004 at 1091.2 — gaining 14% in 12 months.
The recent four daily readings of more than 9, starting with the April 18, 2006 Up/Dn Ratio of 9.7, included the most bullish Up/Dn Ratio ever of 22.5 on June 15, 2006. My guess is that this unusual cluster of very high Up/Dn Ratios can be to a large degree credited to the proliferation of trigger happy trading of hedge funds.
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