To QE3 or Not to QE3? How to Predict Fed Response, and the IT Market Update

Let’s get one thing straight:  I can’t always predict the market with 100% accuracy.  I do a reasonably good job most of the time, but sometimes I miss by a little, and sometimes I miss by more.  I publish these updates pretty much daily, and it’s just not humanly possible to get every day right. 

However, there is one arena in which I currently maintain a 100% perfect track record -- and that's in predicting whether more QE will be coming from a given Fed meeting (we have another one coming up this week).  In this arena, I have taken on pundits who have a myriad of more “official qualifications” than I do, and yet I’ve consistently out-predicted them.  These days, not surprisingly, hardly an hour goes by when I’m not hounded by various world-class economists begging me to reveal my secrets, frequently at gunpoint.  Frankly, the burden has become a bit tedious, so I’ve decided to finally capitulate and reveal my QE-Predicting Secrets to the world -- in a format so simple that even an economist can follow it.  I am referring, of course, to a flowchart (below):

As we can see from this incredibly-serious and perhaps overly-detailed flowchart, my theory (which has served me well thus far) is that this Fed is solely reactionary to what’s going on in the market – despite all the Fed jawboning about other factors and benefits of QE, such as the “benefit” of higher gas and food prices for all Americans.

However, there is an extenuating factor not outlined in this chart... and it’s one which I’ve not had to face before, so I’m not certain how it will impact things.  That factor is the upcoming Presidential election.  This is probably the last real chance Bernanke will have to launch QE3 prior to the upcoming election, because launching it later in the year would almost certainly draw fire for appearing too politically motivated.  So, while I’ve been quite confident in my prior “no QE3” predictions (going back to when QE2 ended), in this particular instance, I’m not 100% sure.  I have no “past performance” precedent to draw from that encompasses all the current factors.  I feel perhaps 65% certainty and tend to think they probably won’t launch QE3 now, because the market’s still levitating -- though it has taken a bit of damage in recent months.  I further postulate that if they don’t launch QE3 now, they probably won’t launch it for the remainder of the year. 

That said, if there is any significant central bank action, it should be viewed with great trepidation by bears.  While I suspect the intermediate trend has changed to down, I am also basing this on a “natural” market free of central bank intervention (I know: keep dreaming).  If the Fed or EU launches something in the near future, any developing down-trend will almost certainly get reversed by their liquidity -- and the central banks have recently publicly reaffirmed their blood-pact to support the markets at any and all costs, so it will be interesting to see how the market responds to this psychological booster shot.

Short-term Market Outlook

Prior to last week’s trading range, the market performed almost exactly as anticipated going back to early May when I warned that SPX was headed into the low-1300's to mid-1200’s.  More recently, on June 5, I warned that bears should be very cautious, that a strong snap-back rally was waiting in the wings, and that trade above 1298 would be bullish.  Then, in the next update, I published a target of 1336 +/-, which the market effectively hit and reversed from (at least temporarily) -- unfortunately, particularly during corrections, sometimes I can only see a short way down the road.  At these times, I simply have to watch how the market responds to key zones before I can get a feel for what may be next. 

Long-time readers (and traders) will recognize this pattern: the market gets hazy, then it gets clear… then it gets hazy again, then it gets clear again.  This is why two important keys to successful trading are patience and discipline.  Right now, we’re still in the “hazy” zone.  Accordingly, I have outlined some short-term signals to watch which will aid in bringing clarity to the picture.  At this stage, barring an immediate market reversal, it seems fairly reasonable to assume that last week's wave iv count is probably off the table.  We'll see what Monday brings. 

In any case, hopefully the numerous breakouts I warned to watch as bullish signals (dashed blue trendline and upper green channel line) allowed bears who were holding shorts taken near the 1336 target to escape at break-even, or with a small profit.

The chart annotations below discuss some clues to watch.  At this point, it's probably ill-advised to get overly bearish until:

1.  The lower blue trendline connecting the troughs at 1310 and 1320 is broken.

2.  The lower red trend channel connecting the troughs at 1266 and 1310 is broken.

The short-term trend is up until those trendlines are broken.  One can always take stabs when targets are hit, but one should remain nimble in a hazy market like this.

Intermediate Market Outlook

Presently, I remain in favor of the view that the trend has changed at intermediate degree, and that the market has begun a new long-term downtrend.  There are a couple things which could cause me to doubt that view:

1.  Sustained trade and closes north of 1370-1375 SPX.
2.  A new QE program.

The chart below outlines some of the immediate challenges faced by the S&P 500 (SPX).

Keep in mind that if this is wave (ii) (in other words, if the market doesn't reverse back down pretty much immediately), then its job is to turn the majority bullish again.  This means it could last as long as a couple more weeks, while it blows up bears repeatedly and convinces the masses that the prior decline was just a correction to an ongoing bull market.  This is what I was warning about on June 5, when I wrote:

I do believe bears need to remember that a strong snap-back rally is expected for wave (ii) after the current decline bottoms (assuming it hasn't already). This is worth remembering, because one does not want to short the entire way up during wave (ii) and potentially give back the lion's share of one's profits.

Hopefully, readers heeded that warning (along with the warning that trade over 1298 was bullish, in the same article) and closed shorts at 1298, and then waited until the 1336 target was hit before attempting new shorts.  Those shorts should, of course, have been closed when warning levels were violated, or at the very latest, when 1336 was broken to the upside.  If you're a bear whose heeded those signs, then you have certainly protected profits well during this rally.

The next chart I'd like to share is the Nasdaq Composite (COMPQ), mainly to simply show its present approach to one key overhead resistance level.  It will be interesting to see if the bulls can sustain trade above that key breakout zone.

Finally, long-time readers know I think it's important to track indices other than those tracked by the mainstream media.  One of my favorites is the NYSE Composite (NYA), which is a very broad representation of the total NYSE market.  The NYA is also approaching a confluence of overhead resistance, shown by the falling red trendline and falling blue channel. 

I have also noted the potential of a large head and shoulders top in formation.  It's important to realize that unless and until the neckline is broken, this is only a potential.  Patterns such as head and shoulders require confirmation by a decisive break of the neckline -- but it always pays to be aware of them early.

In conclusion, I remain skeptical of this rally from an intermediate-term perspective, but the current short-term uptrend should probably be given the benefit of the doubt until proven otherwise.  The potential does exist for an immediate reversal, but barring that, we should probably assume we are facing a higher degree wave (ii) rally -- the first target for which is 1348.  Over the intermediate term, there are some levels which could shift me to a more bullish stance, but it appears the bulls have their work cut out for them. Trade safe.

Reprinted by permission; Copyright 2012, Minyanville Media Inc.