The Real Taper Problem

My last article was a tongue-in-cheek look at the lighter side of how to handle the "tapir" of Quantitative Easing; this article will be a bit more on the serious side.

Scientists tell us that the highest number the average human can comprehend, without counting or guessing, is (are you ready?):  4.  When we get to 5, people can figure it quickly by counting, but most of us don't instinctively comprehend numbers larger than 4.  To quickly validate this research, imagine the last time you stopped at a restaurant for an impromptu dinner with a group of family or friends.  Most likely, when the host asked, "How many in your party?" you had to run a quick count in your head, even though it may have only been eight or nine people.  When it's just you and your significant other plus one other couple, you automatically know the party size is 4; but when there are kids and grandparents and aunts and uncles, we have to count.

My point is, when we start dealing with the types of numbers we deal with in finance, the quantities become incomprehensible to us.  To my knowledge, scientists haven't drawn an exact line as to where numbers reach the point of being completely unfathomable, but I think we can draw our own rational conclusions with a bit of mental experimenting.

Consider that on an unusually clear night, there are "only" a few thousand stars actually visible to the naked eye -- yet to the human mind, their numbers seem infinite.  Weigh that visualization of "a few thousand" against a number such as two trillion.  We quickly find we can't wrap our heads around it and mental tricks fall short.  Try it:   A million is a thousand thousand, so: let's start with something we can visualize, like the night sky.  To reach a million, simply multiply the number of stars in the entire night sky by a factor of three hundred or so.  Theoretically, that gets us to a million, but our minds are already cheating and we end up visualizing something akin to "a whole bunch."  To get to one trillion, we have to visualize a million million -- so we have to multiply a number we can't visualize by another number we can't visualize (and then we have to double the sum!)  Our minds don't even really try, and all they can come up with is: "Wow, a whole bunch more!"

I would argue that when it comes to the huge figures we're dealing with in programs like Quantitative Easing (and things like the national debt), we just flat out have no clue what the numbers mean.  The numbers are so big, in fact, that we can't even understand how big they actually are (if that makes sense).

So, with all that said, the Fed now holds over $2 trillion in Treasuries.  Fed holdings of mortgage-backed securities now total over $1.3 trillion, as seen on the chart below:

 

Since 2009, the Fed's total holdings (of both) have increased by about $2.8 trillion -- roughly a factor of six.  Do those numbers find any traction in your head, beyond, "Wow, that's a lot of money"?  Because they don't in mine.  The main thing my mind does is look at the graph and pretend those were numbers I could understand in personal or business finance, and then it comes up with:  "That doesn't look healthy."

The present upwards trend simply cannot continue infinitely in a linear fashion, because the Fed does not have the ability to take on an infinite balance sheet.  So, from that simple fact, we know the present moment is fleeting and cannot continue.  That presents problem one: what happens when the Fed stops expanding its balance sheet?  Problem two is how does the Fed backtrack and shrink its balance sheet in order to engineer a 'soft landing' at some point?  Can they?  Many would argue that the Fed is now trapped by its own machinations. 

The Fed has become a bit like DeBeers is with diamonds: they can control prices as long as they can absorb and regulate the supply.  The advantage DeBeers has is that diamond production is much, much slower than Treasury production.  And unlike the Fed, DeBeers "only" has several billion dollars worth of diamonds in its vaults -- yet if by some chance they were forced to liquidate the entire vault tomorrow, diamond prices would drop like a rock (pun intended).  The Fed faces a similar dilemma.

Further, just like DeBeers, if the Fed were to abandon the business of purchasing new supply, prices would fall because a huge source of demand suddenly disappeared.  On Friday we saw how Bernanke handles the dreaded Tapir (it's handled just like everything else: feed it money) -- but the real question is: how does the Fed handle the taper of QE?

I don't think there are any easy answers.  

Chart-wise, there isn't much to add to Friday's update: presently the decline works as a passable ABC, but a bit more downside will begin to give it an impulsive appearance -- and as I noted Friday, there are enough waves in place for the upwards move to be complete.  Theoretically, support lies in the 1695-1705 zone, and bulls could start to run into more serious problems if the market sustains trade beneath that zone.

It's getting hard not to notice that the pattern, presently at least, appears to be a bearish rising wedge (it could also pass for a Three Drives to a Top pattern).  The normal expectations of a wedge are for the market to return to the point at which it began; in this case the mid-to-high 1500's.

The Philadelphia Bank Index (BKX) continues to look weak, and may be the canary in the coal mine here.  Long-time readers know I believe that trouble for BKX equates to trouble for the broad market, and BKX still looks like it wants new lows.

In conclusion, I continue to feel that downside risk outweighs upside risk at this moment.  Bulls could do a few things to change that -- for example, a breakout in BKX would go a long way toward causing me to rethink my position.  Barring that, I remain unconvinced that the present rally has staying power; and the market hasn't shown me anything recently to change that view.  Trade safe.    

Bernanke Claims Investors Misunderstood "Tapir Talk"

The big news since last update is, of course, the surprise announcement from Bernanke that there will be no taper of the QE program.  This announcement came after months of "taper-talk" -- and burned investors who bet the market would decline as it was weaned off the Fed's bottle.  On Thursday, critics blasted Bernanke for his lack of clear communication.  Chris Low at FTN Financial was quoted as saying: "Despite Bernanke's effort yesterday in the press conference to paint the FOMC decision as entirely consistent with earlier communication from the FOMC, it was not...  the Fed's communications credibility is shredded."

My sources have provided us with an exclusive photo that helps explain the miscommunication.  The problem stemmed from the fact that the words "taper" and "tapir" are pronounced the same, but have entirely different meanings.  Bernanke communicated perfectly -- it was we who misunderstood. 

Taper means: diminish or reduce or cause to diminish or reduce in thickness toward one end.

Tapir means: a nocturnal hoofed mammal with a stout body, sturdy limbs, and a short flexible proboscis, native to the forests of tropical America and Malaysia. 

When Bernanke talked about how to handle the Tapir, anxious bears simply heard what they wanted to hear ("taper").  After seeing this photo, I have to disagree with Chris Low -- the Fed's communication credibility is, in fact, wholly intact.   

If it weren't for the discovery of this honest miscommunication, one might have started thinking the Fed was actually trying to bait bears with all its taper-talk.  Luckily there's no need to start any blindly speculative and completely unfounded conspiracy theories, since we now know that simply wasn't the case.

Where does all this leave the market?  Well, we're into territory where bears will need to make a stand fairly quickly.  If this wave begins to appear that it's subdividing into a larger five wave form, we'll have to start giving serious weight to my big picture bullish count from February and its long-term target in the 2100's. It's worth mentioning that the fourth waves we've had to date have been somewhat pathetic -- typically we'd have expected a bit more downwards movement than we've had each time, and a couple have caught me looking (to borrow a baseball term).  Welcome to the Fed's humbling New Normal, I suppose.  

The hourly chart shows more detail.  Frankly, it looks likely that there will be at least a bit more upside, but there are enough waves in place to count the last rally as complete.

The Philadelphia Bank Index (BKX) continues to look uninspired, and is still keeping me from jumping on the "rah rah, we're going to the moon" bandwagon.  A breakout over the key 65 zone could change all that, though. 

In conclusion, the intermediate term will hinge on how the market behaves in the directly upcoming sessions.  If the rally is a straightforward five-wave form, then it should be nearing completion.  If it instead subdivides, the market will be off to the races again and headed for the 1800's.  We'll have to see how the structure develops over the next few sessions.  Trade safe.

A Closer Look at the Big Picture

At times like this, it's easy to get lost in the day-to-day market nuttiness, and I've found it's sometimes helpful to take a step back away from the one-minute charts and look at the big picture.  So today we'll start off with the old reliable NYSE Composite (NYA).  NYA is a great representation of the broad market, since it contains all the common stocks on the New York Stock Exchange -- and it often tells a different story than the big-cap indices like the Dow Jones (INDU) and S&P 500 (SPX).

It's very interesting to note that NYA has still not made a new all-time-high.  The chart below is a weekly chart, and the notes contain most of my thoughts.  Just glancing at the chart, the main thing that jumps out is how quickly and effortlessly NYA plummeted back in 2008, versus how it has seemingly struggled to regain that ground.  This is especially noteworthy given the massive Fed money pumping that's occurred during the past five years.  The picture suggests that the fits-and-starts nature of the rally is caused by the fact that it's a correction to the last decline -- one of the ideas behind Elliott Wave analysis is that the market struggles when moving against the larger trend.

The Philadelphia Bank Index continues to lag.  So far, this isn't doing much to sell me on this rally as anything that will have legs for SPX.

Even if this rally is going to become an impulse and make a new all-time-high, it looks like it's very close to being a complete structure.  As I've noted previously, the main bullish hopes would lie in the idea that when this five-wave fractal completes, it will make up wave (i) of a still larger five-wave fractal.  Given NYA and BKX, I currently have to view that bullish option as lower probability.

In conclusion, I do not presently believe this is the start of a nosebleed rally -- to the contrary (while I think it's entirely possible SPX will push on to another high), I still believe the market is in a topping phase.  Trade safe. 

No Fed Chairman? Must be Bullish

Futures are indicating a big gap up come Monday morning, so it looks like the market could blow through my 1695-1700 target.  This market somewhat reminds me of the reverse of the 2008-2009 bear market.  In 2008-2009, the market would bounce for a little while and get bulls hoping the bottom was finally in -- then it would collapse again to new lows.  The market didn't form a long-term bottom until bulls had all but given up entirely.  I recall in March 2009, investor sentiment was over 70% bears.

We may need to see that shoe on the other foot now, and I wonder if we aren't awfully close to the point where bears capitulate.  The ongoing challenge of speculating as if we were working within a "normal" market framework is that we have continued Fed money pumping -- and as the saying goes, "You can't keep a good printing press down."

Speaking of, the big news over the weekend was the voluntary withdrawal of Larry Summers from consideration as next Fed Chairman.  Summers notified Obama on Sunday first via phone call, then sent a letter soon after (the title I really wanted to use today was: "Summers Falls as Winter Approaches").  In response to Summers' withdrawal, Obama issued the following press statement via teleprompter:

"Larry was a critical member of my team as we faced down the worst economic crisis since the Great Depression [APPEAR CONCERNED], and it was in no small part because of his expertise, wisdom, and leadership that we wrestled the economy back to growth [GESTURE WILDLY AND FORCEFULLY, AS IF WRESTLING] and made the kind of progress we are seeing today [PAUSE FOR LAUGHTER]."

Many are speculating that Federal Reserve Vice Chair Janet Yellen is now the front-runner for the Fed Chairman position, since, among other things, her qualifications include having a last name that sounds like "yelling."  Yelling is considered an important skill for a Fed Chairman, because it's the only way they can be heard above the constant roar of the printing press.  (And now that I've brought that segue full circle, I can move on in good conscience.)

Anyway, I'm wondering if this bull market will just keep running, until we reach the point where everyone reflexively buys every dip and bears have completely capitulated.  If it behaves as the inverse of 2009, then when the real top comes, everyone will naturally assume it's just another pause.

Technically, the bear count won't be invalidated until the S&P 500 (SPX) trades back above the all-time high.  The market has shown the 1710 area as resistance, and it's tough to get too bullish near resistance (or too bearish near support).  Keep in mind that the market often likes to run just a bit farther than a key level to grab stops before reversing, and my original (but since abandoned) preferred count target for SPX was the mid-1700's.  Certain indices like the NYSE Composite (NYA) have been suggesting that a fifth wave up was still needed -- I noted those signals weeks ago; in hindsight, I probably should have given them more weight than I did.

NYA "should" make a new high here; and it will be interesting to see how SPX behaves after the opening gap. 

SPX suggests similar.  If the rally is developing into a five-wave impulsive structure, it will need to unwind at least a couple more fourth and fifth wave sequences:

Even if 1710 is claimed, in the bigger picture, we aren't presently talking about a blow-out rally.  Bulls will have to keep their fingers crossed that the pending potential impulse wave is only wave 1 of the larger red v.

In conclusion, the bearish wave count may be reset this week, but presently that doesn't put the bears out of the running.  If 1710 is broken, then we'll have to see the form of the next decline to help anticipate if this wave is indeed going to mark all of red v and lead to a protracted decline, or if it's only going to mark wave 1 of red v.  And if mere mention of a protracted decline makes you feel hopelessly frustrated, then we may actually be getting close.  Trade safe.

Does Your Fundamental Bias Cost You Money?

"... a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware." -- John Maynard Keynes

"To combat depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection- a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end." -- Fredrich Hayek, 1933

I think many traders feel that Bernanke's printing press has given new meaning to the term "bull" market.  Bears are tired.  It's like every bear on the planet has been waiting for the "real" market to emerge since at least 2010.

Personally, I've been quite bullish at times (early October 2011, and late 2012/early 2013 were probably my most bullish moments), but this market has felt, for lack of a better term, "unnatural" to me for a long time.  But maybe that's just my fundamental bias.

I try my best to stick to what I see in the charts, but I am a fundamental bear at heart.  I've learned that one of the psychological hurdles that creates for me is this:

I can forgive myself when I'm bearish and end up wrong -- but I have a much harder time forgiving myself when I'm bullish and end up wrong. 

If I'm bullish and wrong, that error eats away at me in a different way.  There's a self-chastisement of "you know better!" because it offends my core sense of what I believe to be True (with a capital T) about the world in general.

I'm not sure if I can explain this in a way that makes sense, but I'll try: our beliefs represent what we stand for in this world.  And what we stand for in turn represents who we are, in a meaningful sense.  At least, it has meaning to us on a personal level.  Our beliefs generally represent the core foundations from which we build our enduring life principles -- so beliefs translate into action.  As a result, we all associate "who we are" with our beliefs to a greater or lesser extent, depending on the depth and strength of the belief.  This is why religion and politics are such heated forums -- people feel criticized on a deeply personal level when those beliefs are challenged.  They feel you are attacking not simply their ideology, but actually attacking them as individuals. 

Anyway, I think this human tendency is one of the challenges that makes it so incredibly hard to get away from our fundamental bias.  It's much easier to forgive ourselves when we err on the side of our fundamental bias, because that error is in line with our self-image -- it's "who we are" to some extent. And we can forgive ourselves for "being ourselves" (we do it all day long!).  Conversely, that same psychology causes us to criticize ourselves much more harshly when we err against our fundamental bias.  Which in turn causes us to make more errors toward the side of our bias.

It's worth examining.  We all have a fundamental bias -- and I suspect it costs every one of us money at times.

Moving on to the charts, the market has followed Wednesday's near-term projection quite well, and the market has now moved into "close enough" territory for the target zone:

The big picture is essentially unchanged since last month.  The alternate intermediate count sees the possibility that 1627 was it for the decline, and that the market is headed on to new highs.  I'm presently still inclined to favor the bears (but maybe that's just my bias speaking!).  There is both a bullish and bearish interpretation of the intermediate pattern -- the bull interpretation is called an “expanded flat,” and I discussed it at length last month.  

In conclusion, if this is indeed the wave ii/B rally the preferred count believes it is, then it should be nearing completion.  If the S&P 500 moves above 1709 instead, then bears have their wave count reset and we’ll have to start calculating new upside targets, beyond the current 1695-1700 zone.  Trade safe.