Before the article begins I would like to thank all of those who leave comments and questions, and I again want to encourage everyone to do so. Please don’t worry if your opinion is different than mine, because an honest debate is a learning experience.
I think you’re really going to like this article because I’m going to tell you exactly what to look for in determining how high equities markets will go and best of all, you’re going to be able to do this very simply with just a minimum amount of homework.
The question of how high the markets can go is an important one for currency traders because the dollar will trend lower as stocks and commodities trend higher. The dollar index, which is made up of a basket of currencies (euro 57.6% yen 13.6% pound 11.9% Canadian dollar 9.1% Swedish krona 4.2% and the Swiss franc 3.6%) was on 87.52 the day the S&P bottomed, 12.68% higher than Friday’s close.
You won’t need extensive knowledge of how the Federal Reserve System works or a broad based understanding of economics in order to do this. You also won’t need to spend endless hours scanning the financial press for articles and information.
Of course, if you’re an economics geek like me, than understanding how all things economic works is something you enjoy finding out about. Certainly, we’re living through historic events, ones which will be studied extensively for many years to come. So I think it’s a great idea if you do have an interest and a desire to learn more but my point is that if you don’t, you still can do very well in the months ahead.
Ok, here we go. Let me start with an analogy.
Pretend you’re in a hospital emergency room watching the doctors working frantically on a patient. They’re yelling out instructions with terminology you don’t understand while they’re using medications and technologies which are a complete mystery to you. Here’s my question:
Do you need a degree in medicine in order to know that this patient has something seriously wrong with them? Of course not. Well, the same thing goes for the economy and therefore, the overall markets.
In this case, the economy is the seriously ill patient, the Federal Reserve is the doctor, and the tools the Fed uses (interest rate adjustments and emergency lending facilities) are the medications and technology that’s being applied.
Now, I made a very good call back in the summer of 2007 when I advised people I knew to get out of the stock market, but all I needed to do was to recognize that the doctors (the Fed) were going to be using their emergency measures (interest rate cuts), which meant that there had to be something very wrong with the patient (the economy).
As simplistic as this may sound, that’s really it; since there had to have been something seriously wrong in the economy for the Fed to cut interest rates, that’s all the warning I needed to get out of stocks.
Where Are We Now
At this time, all of the Fed’s technology and medications have been applied to the patient so what’s happening now in the markets is that investors are buying into the idea that all this care is going to heal the patient. What’s also helping to support this idea is that the Fed acted quickly (once they did begin) and with overwhelming force. Even better, what’s actually happened is that there’s been a globally coordinated monetary and fiscal policy that’s been applied.
So, what am I looking for as conformation that the patient is well on the way to recovery? Simple. Let’s go back to our emergency room analogy.
As the patient improves over time, the doctors are going to gradually withdraw the technologies and medications they needed to use when the patient was in an emergency situation. Well, the same thing applies to the economy; the Fed is not going to begin withdrawing its emergency lending facilities and even begin to think about raising interest rates until it believes the economy is well on the way to recovery.
Now, do you need an education in medicine in order to know that if a patient needs less treatment it means they are getting better? Of course not. And you also don’t need an extensive knowledge of how the Fed’s emergency tools work-all you need to be aware of is that these emergency measures are being withdrawn in order to gain the appreciation that the economy is improving (which policymakers aren’t now but eventually will be doing).
Always keep in mind that the Fed applied its medicine when it believed the economy was sick and that it will begin to withdraw its medicine when it believes the economy is healthy enough to survive without it.
At some point in the future, and that time might be a year or more from now, investors are going to be looking to hear from the Central Bank that its emergency lending programs are being wound down or that the Fed is letting those programs which are scheduled to end do so of their own accord.
Conversely, if the Fed sees a continuous need to have these programs functioning (or if they see a need to expand them) that to me would be a sign that perhaps the patient is not doing as well as hoped. I would take that as another sign to get out of the market and get back into the dollar or Treasuries.
For now, the patient does seem to be recovering although I don’t expect to see a full recovery for quite some time. There definitely is a risk of relapse primarily because banks are still not extending credit under normal conditions and because lending is unlikely to return to normal levels any time soon.