S&P 500 Bear Market Now Confirmed

When the Standard & Poor's (S&P) 500 (SPX) blasted through 1,096.46 this morning, a bear market in the index was confirmed by my definition.

Because I have been an editor/writer almost all my life, it is my conceit that words -- and the meanings of words -- are more important to me than they are to most equity-market operators.

I therefore have strict definitions of stock-market terms such as Consolidation, Correction, Bear Market, and Bull Market in the current context of the S&P 500, as follows:

Consolidation: Bringing into play the SPX cyclical high level of 1,370.58 on May 2, I believe the index entered a consolidation phase when it moved below 1,302.05 on June 3.

Correction: Employing the same cyclical high level, I think the S&P 500 entered a correction phase when it moved below 1,233.52 on Aug. 4.

Bear Market: Using the same cyclical high level, I believe the birth of the index's new bear market was confirmed when it moved below 1,096.46 today.

Bull Market: Likewise, I think the death of the SPX's old bull market was confirmed when it moved below the same value today.

Given this confirmed change in character, I consider one of my main tasks as an equity-market operator centers on the identification of likely areas of support and resistance -- not only for individual issues but also for major stock-market indices.

In doing so, I conduct analyses of the U.S. economy on the one hand and analyses of the fundamental, sentimental, and technical conditions of the U.S. markets on the other hand.

Day in and day out, I count my study of Fibonacci retracements (FRs) across multiple time frames as surprisingly helpful. I employ the term surprisingly because if Fibs are proven to have any prognostic value in the equity market, then I personally would attribute the phenomenon to self-fulfilling prophecy more than to anything else.

Even so, I appreciate the insights provided by my study of cyclical FR levels of the S&P 500 -- and other indices -- especially since the market-volatility storm began to rage in earnest on Aug. 4. And the following chart focusing on the SPX shows why:



Looking backward, I note there were 42 trading days between Aug. 4 and Oct. 3, inclusive. The S&P 500's closing level on 35 days (83.33%) fell in the range from FR1 (1,204.49) to FR2 (1,103.73). The SPX closed above FR1 on five days (11.90%), at FR1 on one day (2.38%), and below FR2 on one day (2.38%). As a guide to support and resistance, the cyclical Fibs appear to have done yeoman work to this point in the market-volatility storm.

Looking forward, I suspect it is more likely than not the S&P 500 will visit the area of FR3 (1,018.69), sooner or later.

Methodological Note:

I calculated my FR levels employing the 666.79 intraday value recorded March 6, 2009, as the relevant cyclical trough and the 1,370.58 intraday value recorded May 2 of this year as the relevant cyclical peak. Below are my FR levels and their corresponding percentages:
FR1: 23.60%
FR2: 38.20%
FR3: 50.00%
FR4: 61.80%
FR5: 78.60%
FR6: 100.00%
FR7: 123.60%
FR8: 138.20%
FR9: 150.00%
FR10: 161.80%

'Operation Twist I' and SPX Behavior

A half-century ago, the U.S. Department of the Treasury and Federal Reserve conducted "Operation Twist I" under economic conditions described well by Titan Alon and Eric Swanson last April 25 in their "Operation Twist and the Effect of Large-Scale Asset Purchases," which I mentioned in "Go, Chubby, Go: Let's Twist Again!" this week.

Yesterday, the Federal Open Market Committee (FOMC) announced "Operation Twist II" under economic conditions described well in an many places virtually every day, including this very blog (e.g., "GDP Slide Signals Recession. Soon.").

There are similarities and differences in the U.S. economic conditions existing during the two periods. One obvious similarity centers on the status of the business cycle, meaning the above-referenced R-word was or is on almost everybody's lips in both cases. One obvious difference centers on the country's debt as a percentage of gross domestic product, which was not too bad in 1961 but is not too good in 2011.

Given this mishmash, it may or may not be helpful to examine the market performance of the Standard & Poor's (S&P) 500 (SPX) in the wake of the launch of "Operation Twist I" on Feb. 2, 1961. But I did it, anyway.

With a common baseline of Feb. 1, 1961, the four charts below show the S&P 500's behavior during the following one-month, three-month, six-month, and one-year periods, respectively:









Source: Risky Business Charts Based on Yahoo! Finance Adjusted Closing-Price Data

If past is prologue, then the recent equity-market crash may be comparatively short-lived. After all, the Fed will be driving financial-market participants out of the long end and into the short end of the U.S. Treasury yield curve, as well as higher-risk assets.

If past is not prologue, then the recent stock-market crash may be relatively long-lived. Clearly, aggregate demand is lacking in the U.S., and nearly all available evidence indicates this circumstance is other than either a local or a temporary phenomenon.

You pays your money, and you takes your chances.

'Twist' Tops the Ops at the FOMC

In a well-choreographed move, the Federal Open Market Committee (FOMC) OK'd today by a 7-3 vote a new cover of "Operation Twist." The original version was discussed in "Go, Chubby, Go: Let's Twist Again!" on Monday.

According to the FOMC statement belatedly released at the conclusion of its two-day meeting: "[T]he committee decided today to extend the average maturity of its holdings of securities. The committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of [six] years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of [three] years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate."

The FOMC also noted: "To help support conditions in mortgage markets, the committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the committee will maintain its existing policy of rolling over maturing Treasury securities at auction."

All things considered, I believe this plan may have a limited effect on the U.S. economy, but I think its potential impact on the yield curve may constitute a headwind in terms of the profitability of certain financial institutions (e.g., banks).

You Say To-may-to, I Say To-mah-to

In "GDP Slide Signals Recession. Soon." on Sunday, I indicated my fact-based opinion is that the U.S. economy either has shifted or is shifting to contraction from expansion.

One key factor in the forming of this opinion is the anemic 1.55% change in real gross domestic product (GDP) recorded during the most recently reported four-quarter period (i.e., between the third quarter of last year and the second quarter of this year.).

Support for this notion can be found in Forecasting Recessions Using Stall Speeds, a Federal Reserve Board staff working paper authored by Jeremy J. Nalewaik that was published last April 14.

According to Nalewaik: "This paper presents evidence that the economic stall speed concept has some empirical content, and can be moderately useful in forecasting recessions. Specifically, output tends to transition to a slow-growth phase at the end of expansions before falling into a recession."

Of course, the Washington-based economist adds, "[M]odels using output growth alone produce a considerable number of false positive recession signals, [so] adding the slope of the yield curve, the percent change in housing starts, and the change in the unemployment rate to the model reduces false positives and improves recession forecasting."

Meanwhile, Nalewaik contends, "GDI [gross domestic income] provides a better measure of output growth than GDP, its better-known counterpart, and in our work here, while stall phases are evident in GDP, they are more plainly visible in GDI."

Harrumph.

Go, Chubby, Go: Let's Twist Again!

With the Federal Open Market Committee (FOMC) attempting to save the U.S. economy from itself once again at a two-day meeting this week, it appears a new cover of "Operation Twist" may be atop the playlist of at least some of the committee's members.

The Federal Reserve conducted the original Operation Twist a half-century ago under circumstances Titan Alon and Eric Swanson describe well in their "Operation Twist and the Effect of Large-Scale Asset Purchases," which appeared in the FRBSF [Federal Reserve Bank of San Francisco] Economic Letter last April 25:

"John F. Kennedy was elected president in November 1960 and inaugurated on January 20, 1961. The U.S. economy had been in recession for several months, so the incoming Administration and the Federal Reserve wanted to lower interest rates to stimulate the weak economy.

"However, Europe was not in a recession at the time and European interest rates were higher than those in the United States. Under the Bretton Woods fixed exchange rate system then in effect, this interest rate differential led cross-currency arbitrageurs to convert U.S. dollars to gold and invest the proceeds in higher-yielding European assets. The result was an outflow of gold from the United States to Europe amounting to several billion dollars per year, a very large quantity that was a source of extreme concern to the Administration and the Federal Reserve.

"The Kennedy Administration’s proposed solution to this dilemma was to try to lower longer-term interest rates while keeping short-term interest rates unchanged -- an initiative now known as 'Operation Twist' in homage to the dance craze then sweeping the nation.

"The idea was that business investment and housing demand were primarily determined by longer-term interest rates, while cross-currency arbitrage was primarily determined by short-term interest rate differentials across countries. Policymakers reasoned that, if longer-term interest rates could be lowered without affecting short-term yields, the weak U.S. economy could be stimulated without worsening the outflow of gold."

Hmm. In the anticipated remake of Operation Twist, the Fed is expected to first sell shorter-term U.S. Treasury securities already on its books and then employ the proceeds to buy longer-term U.S. Treasury securities, with little or no effect on the bottom line of its overall balance sheet. Meanwhile, the cross-border flow of gold seems to be a nonissue this time around, given President Richard Nixon's closing of the gold window in 1971, which ended the convertibility between the precious metal and U.S. dollars. Hmm.

In the words of one of my favorite financial-market observers after the FOMC's announcement last Nov. 3 that it would be monetizing an additional $600 billion in U.S. debt by purchasing an assortment of U.S. Treasury securities, "I believe this plan may have a limited impact on the U.S. economy."

Because of the inviolable Risky Business Law of Unintended Consequences, however, this apparent new program could boost prices in certain financial-asset classes, such as commodities. (As I once noted elsewhere, one effect of this unbreakable law appears to be that every time I slip-'n'-slide my way into the shower of the RB Executive Washroom, the telephone rings. Given my unique blend of astigmatism and myopia, this could one day lead to a pretty humorous obituary.)

Operation Twist: Those oldies but goodies remind me of you* . . .



*Props to Little Caesar & the Romans