A journey into Bernanke's thinking

First, a disclaimer: I confess to total ignorance when it comes to Mr. Bernanke's thinking; what follows is pure speculation. Now that's out of the way, let me give it a try. Here goes:

The way I understand it, the most important thing for Bernanke is not inflation but the health of the economy. Put another way, fighting inflation is the Fed's number one priority, as long as the economy is healthy. The key to a healthy economy is, has been for many years and will continue to be the consumer and more precisely the consumer's sense of his or her personal wealth. That particular sense has been somewhat damaged by the fact that house prices stopped going up then started coming down in what appears to be a slow motion train wreck type of action. Now, if the stock market also crashes durably, then the consumer will very likely cut down on consumption and tank the economy. That could happen even if the stock market does not go down and stay down. But it is sure to happen if we enter a prolonged bear market. Most people have a large percentage of their wealth locked in their home and a large percentage of their savings and pension plans in stocks. It figures that if both house values and the stock market go down in unison, consumption will have to take a backseat.

Therefore, one thing Bernanke cannot let happen at this point would be a severe and durable stock market dislocation. He will use "all the tools at his disposal" to prevent just such an event.
Any notion that the Fed is not watching the stock market these days would seem to be very naive. I believe they are watching very closely and are ready to intervene, as they have on August 17th. (By the way, I also happen to believe they leaked their coming rate cut at around noon and major support the day before August 16th, which brought the market back from the brink of disaster, but then again I also tend to believe most conspiracy theories.)

However, preventing a market crash is not the same thing as engineering a rally. The market could stay within a large range where we don't make new lows because of the Fed's actions (or perceived actions) but we don't make new highs because every time we're about to, people come to their senses and send the market back down.

Just my take on things.

The big question

Isn't the first chart a thing of beauty (click to enlarge)? We'll get to that in a moment.

First, the big question:
Is the current rally corrective and once it is over, we're headed back down OR

the "meltdown" was corrective, it is now over and we're slowly but surely going up again with new highs down the road?

Obviously, nobody knows at this point. Anybody who forcefully declares one way or the other is nothing but a blowhard. But it always helps to establish some sort of "zone of no return" beyond which the question becomes moot. It goes without saying that a point of no return would be if the Dow makes new all-time highs above 14,000 (or conversely new intermediate lows below 12,500). But even before that, Fibonacci aficionados would tell you that if a move is retraced more than 76.4%, than it is very likely not corrective. As you can see on the second chart above (click to enlarge), that would give us a Dow level of 13,670 which is very close to the level (13,695) reached on 8/8 right before the nasty last part of the "meltdown" episode and above which we break the pattern of lower lows and lower highs characteristic of a downtrend.

So to sum it and round it up, if the Dow Jones Industrial Average breaks above 13,700 decisively (on a daily close basis and on above average volume, say), then we could safely (as much as anything can be safe in this field) assume that the previous downtrend was just a correction, the long-term uptrend has resumed and that we will be above 14,000 before long.

One ETF/market for which the big question has been resoundingly answered, as you can see in the first chart, is FXI ,the ETF for the Chinese stock market. A new all-time high was established on Friday .....and it's off to the races, giving the lie to any silly talk of bear market.

I couldn't resist mentioning this informational gem, courtesy of Robert L. Rodriguez, CFA.
It appears that, while investors, regulators and analysts have been (sheepishly) relying on credit ratings, the very credit agencies issuing these ratings have not had the utmost confidence in them. Case in point: every S&P credit rating report had the following disclaimer:
"Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision."

Will this (lame) disclaimer get them off the hook as the main sacrificial lamb in the current disaster? I think not.

The same source points out that Warren Buffet, in Berkshire Hathaway's latest annual report, wrote, in what could become a classic Wall Street saying:

"Be fearful when others are greedy, and be greedy when others are fearful."
Amen to that.

And now, for a change, a non-technical (read fundamental) entry

According to a Societe Generale research note, "financial shocks that occurred alongside strong corporate profitability [which is presumably the case now] were ultimately worked out without any major spillover effects into the real economy".
"The recent market turbulence is a confidence problem, not a fundamental problem. The distinction is important for the Fed and the markets. The economy is not yet in a position where companies need to restructure. Profit margins are strong and will encourage companies to invest and hire. Tighter credit is a modest negative for growth and will impair some businesses, but most generate sufficient cash flow to finance their investment plans.
The ultimate impact on the economy depends on how quickly the financial crisis is resolved. The key for the Fed is restoring confidence."
"If the Fed is ultimately pushed to cut rates, they would take on the risk that inflation runs away from them, a-la-1998. This could require a quick reversal once the situation is normalized."

I think the key here is "how quickly the financial crisis is resolved".
As bleak as the situation looked mid-day Thursday, look how fast things turned around. And for all the pronouncements that the Big Bear Market is upon us, who's to say that, come September, business as usual slowly starts taking over and this crazy summer becomes just a bad memory.
I am not saying that's what's in store for the market and I don't see it in the charts yet, but should it come to pass, the situation would fit right in with the analysis above.

Intuition still relevant in trading after all

As if any sane person (quants and stats arbitrageurs not included) ever doubted it, intuition does after all have its place among the tools traders can use to make money and more importantly to avoid catastrophic losses. This just in from Dow Jones News:

"Perhaps this is time to adopt a more qualitative approach," Citigroup says in a note titled "Quants Turn Toxic." Firm says "Maybe good old-fashioned human intuition does have something to add in the portfolio construction process." In putting together a simple hedge fund model to assess the current quant predicament, Citi sees things as more a hedge-fund problem than quant issue. Its analysis "emphasizes the vulnerability of hedge funds to the vicious circle of redemptions and margin calls. This can create significant dislocations in markets, as they are forced to precipitously reduce positions."

On a more general note, maybe the blogosphere was a bit unfair to Jim Cramer. For all the total craziness of his "meltdown" two weeks ago ("It's Armageddon out there", "They have no idea", "Call someone", "Bill Poole is shameful, he is shameful", etc....), he wasn't so far off the mark. Two weeks later, the Fed does get the idea that it's just maybe time to do something to avert Armageddon.
Now, will they succeed or are they too late, that's another question, to be answered on your quote monitors over the next few weeks.

It looks like, contrary to what I alluded to in my previous post, the VIX will not break its previous high of 45 reached in 1998 (taking into account the fact that the VIX as we know it did not exist during the 1987 crash when it would have fetched something north of 150). But we did get mighty close. And it's not over....yet. The weekly RSI is not anywhere near giving an all-clear signal. It's still in extreme overbought territory.

This Bloomberg article in the form of a letter from the Hedge Fund guy is an absolute must-read for anyone who wants to have an in-depth understanding of everything that's been going on in the financial markets of late. Peerless.
Excerpt 1: "Currently, all of the portfolios we manage are undergoing a rigorous screening known as ``crossing our fingers and praying that we don't have to try and find a bid in the market.'' This is supplemented by a cross-market statistical analysis originally developed by the U.S. military called ``don't ask, don't tell.'' This ``unmarking-to-unmarket'' procedure has been the benchmark for the hedge-fund industry for the past, ooh, 72 hours."
Excerpt 2: "We are pleased to report that, contrary to what current market prices might suggest, all of our top-rated securities remain absolutely AAA. Provided, that is, the future performance of the underlying collateral is identical to its history. Otherwise, the rating companies say our investments are likely to be reclassified as ``toast.'' "

How high can the VIX go?

(Click to enlarge)

This is the weekly chart of the VIX (the CBOE Volatility Index) dating back to its inception in 1990. It's interesting to note that the 14-day RSI is as high as it's ever been in the past 17 years. It's currently at 75.24, higher than during the 2 previous credit crunch-type situations in 1997 and 1998, higher than in September 2001, higher than during the summer 0f 2002 when it became clear the war in Iraq was inevitable.
How high did the VIX go on those occasions? 38 in 1997, 45 in 1998, 43 in 2001 and 44 in 2002.
Where are we now? Above 26, as high as we've been since these current "troubles" started.
I think there's a very real chance we revisit those dizzying heights of old. And once there, what's to stop the VIX from making history? Its RSI is already in uncharted territory after all.
No matter what happens, though, and if history is any guide (and if it weren't, there would be no technical analysis), a major buying opportunity will present itself when the RSI turns back down and crosses back below 70.

S C A R I E R ?

Last week I had an entry titled S C A R Y, thus this entry's title. None too original.

But instead of adding to the generalized bearishness out there following an all-around horrendous Friday meltdown (and I'm not talking about Cramer's), I will just point out the fact, lost amidst all the fear and loathing, that two things did NOT happen yesterday:

1) The VIX did NOT make a new high, and

2) the Dow did NOT make a new low

as can be seen in the two daily charts above (click to enlarge).

I could have shown myriads of nightmarish-looking charts but those are easy to find anywhere in the financial blogosphere. Tim Knight's blog, for example, is full of them. Instead, I chose to show you the two rare ones that do NOT depict an all but certain death of a bull.

I thought this very interesting, courtesy of Thomas Ingoglia, paraphrasing noted technician Gary Anderson:

"A market bottom usually has the weakest bouncing the hardest." "However AFTER THE BOTTOM, relatively strong stocks need to be strong. when we get stronger stocks getting weaker while weaker stocks are getting stronger, traders are being defensive and unsure of themselves. It is a much better sign when traders are putting all their money in leaders that have already made runs. It says that they feel the market is strong and safe"