To no one’s surprise, the Federal Reserve this week announced its plan to “twist” interest rates. The primary focus of the move is to drive down long-term interest rates. Here is the statement the Fed released in announcing its program:“To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the 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 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 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.”

In general, one would think lower long-term interest rates are a good thing. However, it can be a bad thing for risk-averse investors such as retirees who depend on investment income. Lower long-term interest rates mean lower mortgage rates—good for those hoping to buy or refinance a home. But lower rates also means lower interest payout on certificates of deposit (CDs), long-term bonds, and other types of fixed return, low risk investments. That can be quite bad for anyone who depends on that type of income.

In fact, by driving down returns on low risk investment options, the Federal Reserve is forcing conservative investors to accept greater risk exposure. For example, imagine that 10 years ago, a couple at retirement determined they needed a 5% annual return on their portfolio to meet their income needs. At that time, the bulk of the investment portfolio could be put into long-term CDs and bonds with a 5% annual payout. Now the return on those CDs and bonds might be less than 2%. As a result, the couple is forced to choose investments with the possibility of higher returns but which also carry substantially higher risk.

There is quite a bit of disagreement among economists and politicians about whether or not the Federal Reserve’s actions will actually help the economy. In fact, three members of the Federal Reserve’s Open Market Committee voted against the latest Fed action plan because they feared it could lead to increased inflation pressures.

On the other hand, the Fed announced previously that it plans to keep its Federal Funds rate at or near zero through at least the middle of 2013 and it reiterated that commitment in the latest statement. It is unusual for the Fed to provide that kind of information for so far into the future. There are many economists and analysts who believe that the Fed is running out of options to stimulate the economy and the “twist” was one of the few it had yet to try. Many have attributed this week’s market slide to the possibility that many traders and investors are worried that there is little the government can do to stave off further economic catastrophe.

From a technical standpoint, major stock market indices have so far been able to hold above key support levels. But this week’s slide was surprisingly sharp and investors should be prepared to exit long positions if support is violated—that would be at 1,100 on the S&P 500, 10,600 on the DJIA and 2,350 on the NASDAQ.

Flint Stephens

With all of the economic doom and gloom reported lately, it might surprise some investors to learn that technical indicators for major stock indices have improved significantly over the past week. One of the leading sectors has been technology, which is often a good indicator of market strength and momentum.

The chart below shows a comparison of the NASDAQ and the DJIA over the past three months. Notice that over the past week, the NASDAQ made a much stronger move than the DJIA. The significance of this is that many of the companies whose stocks trade on the NASDAQ are aggressive, smaller companies. In comparison, the DJIA is made up of 30 large, solid, well-known companies. When money starts to shift from the blue chip Dow stocks to the small cap NASDAQ stocks, that can be a signal that Wall Street traders are feeling more comfortable about economic conditions.

The middle portion of the chart is a moving average convergence divergence (MACD) for the NDSDAQ. This indicator crossed over in late August and has been moving upward since then. It is approaching positive levels, which often indicates at least a few more weeks of improved market strength.

The bottom section of the chart shows a stochastic oscillator, which is used to identify the more-or-less random market cycles. The last cycle became overbought and rolled over near the end of August. Instead of completing a downward cycle to an oversold level, the oscillator turned positive again at mid-level. That often occurs when markets have upward strength and momentum. The stochastic oscillator is now at an overbought level again which would normally indicate downward market pressure. When markets have lots of positive momentum, however, the oscillator can sometimes remain at an overbought condition for weeks.

Of course, the financial markets have a well-deserved reputation for being unpredictable and any number of unforeseen events could derail this fragile market rally. But these indicators should at least provide hope to investors who are waiting for a more sustained market advance.

Flint Stephens

Continued high unemployment numbers are getting lots of the blame for recent market weakness. When GOP presidential candidates debated Wednesday, job creation was a major topic of discussion. Thursday unemployment was again the focus when the president spoke to a joint session of Congress. But a close look at the numbers raises questions about whether the high jobless rate is the cause of stock market weakness or merely a symptom.

Consider this, while no one disputes that the August 2011 rate of 9.1% was dismal, it is still considerably better than the 9.6% jobless rate in August 2010. Yet a year ago economic optimism was growing and stocks were beginning a strong intermediate-term rally that continued for seven months.

Friday morning after President Obama revealed his American Jobs Act, stocks opened sharply lower. It would be convenient to conclude that stocks fell because of disappointment about the plan. However, there is no way to make that cause-and-effect connection.

No one can dispute that high unemployment levels are a significant drag on the economy. A high jobless rate is a double whammy because the unemployed are not contributing as much to the tax base and they often rely on government assistance. But unemployment is likely not the major factor currently influencing the financial markets.

In the early 1990s I spent some time in Romania. It was shortly after the fall of Communism in Eastern Europe. Newly formed governments were not well organized and there was no government support system to help the struggling populaces. In the rural areas outside of Bucharest, everyone reverted to an agrarian lifestyle in order to survive. There was no fuel, so people resorted to fires and stoves to heat their small homes. Unfortunately, wood was almost non-existent. Through the years trees were cut down and no replacements were planted. As a result, the main product to burn for heat was leftover corncobs.

Under those circumstances, one could have theorized that the main problem was a lack of wood for stoves and that if the government would give wood to each family everything would be fine. Unfortunately, the government had no way to provide wood. Even if it had, that would have only provided a temporary solution for a single facet of complex and multifaceted problem.

The situation with unemployment and the financial markets is similar. While it is a horrible situation and it is a huge drag on the economy, it is only one of many factors affecting the stock market. Friday’s market decline was generally attributed to the resignation of a key official of the European Central Bank. It is somewhat ironic that the day after the president gives an address focused on tens of millions of jobless American workers a bigger market mover was news about a single person resigning from his job in Europe. Yet that also perfectly underscores the complexity of the financial markets and the current global economic morass.

There is no question that creating optimum conditions for job growth should be a government priority. But it would be a mistake for investors to focus on unemployment as the dominant factor driving the financial markets.
Flint Stephens

After the sharp downturn in stock prices early in August, it is not surprising that many investors are apprehensive at the beginning of September. After all, September has the worst trading record of any month and according to the web site worststockmarketcrashes.com, three of the 10 worst trading days in Wall Street history. Three others occurred in October so those two months have brought investors plenty of worry and stress through the years.

From a strictly emotional perspective, many investors, traders and advisers might want to move to cash at the end of every August and just hunker down before re-entering the markets in November in time for the traditional Santa Claus rally. But making trades based solely on emotion often proves costly. So before spending the next two months in hiding, it is probably a good idea to look at some technical indicators to get an overview of current market conditions.

Below is a chart of the S&P 500 index (SPX) over the past year. The most obvious feature of the chart is undoubtedly the red arrow I added to highlight the level where the index began 2011. The index is currently below that mark, meaning that so far performance has been negative this year. I’ll come back to that point later.

The next section of the chart shows a moving average convergence divergence (MACD). This indicator was at an oversold level in early August. It turned upward at the middle of the month. On the chart, the blue line represents the MACD. The brown line is a moving average of the MACD. Some traders use the point where the lines cross as buy or sell signals. In that case, this indicator gave a buy signal in mid-August. This indicator would appear to signal that there is a potential for additional advances by the S&P 500.

The next chart section is a stochastic oscillator. It is used to attempt to pinpoint random market cycles and identify overbought and oversold turning points. Like the MACD, this indicator was at an oversold level in mid-August and signaled that and upward move was likely. That proved to be the case. This indicator differs from the MACD because it is measures shorter cycles. Early this week it reached an overbought level, which normally signals that a few days of market weakness are likely. That has also been the case. Based on a typical cycle, we can expect another day or two of weakness and then this indicator will probably again be at an oversold level where the next upturn is likely.

Finally, the bottom portion of the chart is a relative strength indicator (RSI). This indicator measures momentum. When an investment climbs above the 50 level, then it has enough momentum to sustain an advance. This indicator reached the 50 mark last week and has since dropped slightly below that level. If it holds here and crosses back above 50 in the next few days, that would be a signal that a rally is underway.

These indicators tell a different story that that of many of the experts interviewed recently in the financial media who are forecasting a possible return to recession. Of course, there is no guarantee that just because these indicators seem to forecast a rise in stock prices that it will actually occur. I think of them much like the tools used by those who forecast the weather. Sometimes they prove to be very accurate and sometimes they miss the mark completely. Who would have imagined that some of the worst damage from Hurricane Irene would occur in Vermont?

Now let’s revisit that red arrow on the chart. More than the weather, man-made forces can manipulate the stock market. In the financial industry, advisers, managers, analysts, executives and others are often judged on calendar year performance. People who work in the financial industry want desperately to show a positive return at the end of the year because it directly impacts their compensation. In addition, others who can influence market performance also want to avoid a negative annual return. These include people like members of the Federal Reserve, the presidential administration and members of Congress. Trust me; all of these people are well aware that they have only four months to make certain that the S&P 500 Index and other major market indices end 2011 at a level higher than that marked by the red arrow. They will be doing everything in their power to make certain that occurs.

The negative factors working against the economy are well documented: high unemployment, continued problems with the real estate market, unsustainable government debt levels, and more. Whether or not stock can overcome all of the negatives and end the year at a higher level is something no one can know yet.

Flint Stephens

Wall Street and investors waited anxiously for days to hear Federal Reserve Chairman Ben Bernanke’s Friday comments about the economy. As many economists and analysts predicted, while the chairman addressed the problems of high unemployment and a weak economy, he did not indicate that the Federal Reserve will be talking any new action to shore up the ailing economy.

His remarks came after a Federal Reserve meeting at Jackson Hole, Wyoming. It was the same setting a year ago where he announced the Fed’s plan known as QE2 (the second round of quantitative easing).

In addition to Bernanke’s dismal assessment of the economy, there was other bad news for investors today. Today the U.S. Commerce Department made a downward revision of second quarter GDP growth. Instead of the 1.3% growth rate previously announced, the rate was actually just 1%, according to the release from the Commerce Department.

There was also disappointing news about consumer sentiment. The August reading for the University of Michigan’s Consumer Sentiment Index was 55.7, down from 63.7 the month before. That was lower than previous forecasts and the fourth lowest reading ever. The Consumer Sentiment Index is considered an important leading indicator because consumer spending accounts for two-third of U.S. economic activity.

Finally, hurricane Irene is churning toward the East Coast and is expected to make landfall this weekend. People up and down the eastern seaboard are taking precautions to reduce the potential damage once the storm hits.

In spite of all of this negative news, stocks were higher during Friday’s mid-day trading—a sign that the downward pressure of the past few weeks might be lessening.

Below is a candlestick chart of the S&P 500 (SPX) over the past three months. The body of each candlestick reflects the area between the open and closing price of a security. The wick illustrates the highest and lowest traded prices of the security during the time interval represented. If the security closed higher than it opened, the body is white or unfilled, with the opening price at the bottom of the body and the closing price at the top. On losing days, the body is red, with the opening price at the top and the closing price at the bottom.

Some things one might notice in looking at the chart are how the red (down) days have dominated over the past few weeks. Also, the size of the candlesticks has been considerably larger during that time, indicating that daily volatility has increased.

Obviously market risk remains very high right now. But today’s events provided plenty of reasons for another dramatic slide in stock prices. The fact that markets held up fairly well instead could be a sign that the recent market instability is finally blowing over.

Flint Stephens