U.S. Stock Market: Is It Headed Higher or Lower?

Analysis

 @JosephLazzaro
on August 11 2011 8:28 AM
At Issue: U.S. and Global Stock Markets
The wild recent ride exhibited by U.S. and global stock markets continued Wednesday, with the latest concern being France's banking sector. Traders and analysts say choppy market conditions are likely to continue until investors can sort out which debt/loan concerns are real, and which are not. REUTERS

Wall Street notched another wild day Wednesday, with the Dow Jones Industrial Average (DJIA) plunging 520 points to 10,720 and traders say the volatile conditions are likely to continue for a while.

Wednesday's plunge was primarily triggered by chatter that a major French bank was insolvent, and if that's the case, the financial crisis will have entered its third phase, after the Lehman Bros. collapse, and the European sovereign debt issue.

No credible, substantive evidence emerged Wednesday concerning the France concern, but that did not prevent hedge funds and other short-term players from hitting the "sell" button.

Short-Term Traders Exit Market

Why are so many short-term investors bailing on stocks? Keep in mind that many have done quite well -- racking-up impressive capital gains during the 2008-2011 period -- hence any substantive sign of bearishness or enduring economic weakness encourages them to lock-in 30 percent of 40 percent capital gains (and larger) etc.

Wednesday's selling also can be attributed in part to other short-term players, specifically the "bond vigilantes," who appear to have turned their attention now to France on the aforementioned bank insolvency chatter, after hitting the bonds of Greece, Ireland, and Italy earlier in the financial crisis.

Economist Ed Yardeni, who now runs Yardeni Research Inc. of Great Neck, N.Y., coined the term 'bond vigilante' in the 1980s to describe the institutional investor practice of selling bonds and shorting bonds of governments when they see unsustainable fiscal policies and/or other actions by governments or companies that the institutional investors believe will lower the value of the bonds issued.

Two Views of Market

With the above as a backdrop, what's ahead for the Dow and the markets? Here are the arguments:

The bears continue to argue that absent adequate, sustained, month job growth of at least 150,000 to 200,000 new jobs per month, the economy will continue to grow at, at best, a tepid rate, weighing on both corporate revenue growth and earnings growth. Hence, the bears see a Dow falling to 10,000, and possible to 8,700 to 8,800.

Conversely, the bulls argue that the Fed's commitment to low interest rates through mid-2013 will telegraph to companies that borrowing rates remain conducive to expanding operations, and when combined with modest median income growth by consumers, should be enough to enable the U.S. economy to progress to a self-sustaining expansion -- Fed Chairman Ben Bernanke's goal.

Technical Indicators: Mostly Bearish

From a technical analysis standpoint, the bears still hold the edge: the Dow is below the key 50-day moving average at 12,157 and also is below the 200-day moving average at 11,991 -- an even tougher average to break. Further, there's also a lack of buying pressure - another bearish factor.

However, the bulls can claim one technical indicator improvement: the relative strength index (RSI), which is now at 26.6. Readings below 30 indicate the market is oversold, hence two or three data points of good news could help the Dow form a bottom.

What's more, if the bulls can hold support at/near 10,700 to 10,800 it could serve as a base for new rally, hence it goes without saying that Thursday's and Friday's sessions are key days for the Dow.

Market/Economic Analysis: Economists, and market analysts are now trying to detect patterns in the Dow's recent moves that parallel previous bearish periods, but there aren't enough data points to incontrovertibly claim that the current period mirrors 1987, 2008, or 1929, etc.

What's the best tack for typical investors at this stage? If you can tolerate the risk associated with own stocks, dollar-cost-average with quality companies. Another words, look for companies with demonstrated business models in establish markets and buy in stages. With an S&P 500 P/E ratio of about 10, many companies are "on sale" -- i.e. they're selling at a low price. Again the key is having the ability to wait-out soft market conditions. This is not a stock market for rookies or squeamish investors.

More broadly, as noted, look for choppy, volatile trading to continue, until institutional investors can reach a consensus concerning whether the Fed's new, two-year low-interest-rate stance will provide enough stimulus to rev-up U.S. GDP growth.

 

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