There has been much discussion in the media about whether the U.S. Federal Reserve will raise the federal funds rate in September from its current near-zero level. Many analysts are afraid that a rate hike will intensify the market’s volatility. While a rate hike could lead to more volatility in the short term, in the long run, I think that a rate hike would help get the bull market back on track.
If the Fed believes that the economic recovery is still on, raising the fed funds rate would assure investors that, despite a slowdown in China and some other emerging markets, there is business as usual in the U.S. In the long run, this would help stabilize markets.
As long as the fed funds rate stays near zero, it reinforces a financial crisis mentality. It refuels the idea that we are just one step away from another recession. Thus, investors panic at every hint of a slowdown in the U.S. or elsewhere, which further spreads the crisis sentiment. The ongoing crisis mentality could be making businesses reluctant to hire as well.
If the Fed really thinks there is substantial risk of slipping into recession, then I suppose the low inflation rate is a justification to delay an interest rate hike. But if the Fed believes the recovery will continue, they really need to start raising rates now.
The U.S. stock market had a very sharp rally beginning on Wednesday. I am not quite ready to say that the correction is over. However, the midpoint of the range between the May 20 high and the August 24 low is about 16,800 on the Dow and 2000 on the S&P 500. If we can break above those levels with strength, I would say that a new uptrend has begun.
In my last update, I said that I was expecting a short-term rally, then a decline to a new low to end the correction. Even though there have been two huge rallies following the intraday low on Monday, I do not think they lasted long enough to suggest that a new low would be the ultimate bottom.
At Tuesday’s close, the S&P was sitting at Monday’s intraday low. The Dow might also have to retest its Monday low, but I think that we will soon get either a substantial countertrend rally, or else continued sideways movement within the trading range established over the past couple days.
Last weekend I said my target for a bottom was Dow 15500-16000. On Monday, the Dow broke the lower end of that range, hitting 15370. I think that before this correction ends, we will break below 15370, but not by a massive margin. The worst-case scenario I see right now would be a drop to 14500-14700 (the low end of the May-October 2013 trading range). The S&P 500 may need to return to its October 2014 low at 1820.
In the past week we had a sharp acceleration to the downside in the U.S. stock market. This acceleration, in my view, strongly suggests that there is more downside to go. Although it is tempting to be a contrarian and call a bottom as soon as the selling gets intense and the media has a surge in bearish articles, from my own experience watching the markets, the bottom usually does not come until you get a short term rally and then a decline to new lows with less downward velocity. My bottom target range continues to be 15500-16000 on the Dow. But the most important thing is not the price level reached but rather that the decline subdivides and stops accelerating.
Two problematic pieces of data have recently come out. One was the New York City Fed’s report that showed the largest contraction in New York State’s manufacturing activity since April 2009 (near the bottom of the recession). The data on the site linked above goes back to 2001, and there has only been one instance in which the indicator fell to its current level without a recession (April 2003).
But perhaps even more concerning is the Atlanta Fed’s Q3 GDP forecast of only 0.7%. Given that Q1 growth was only 0.6%, and Q2 was a mediocre 2.3%, a return to near-zero growth in Q3 could suggest that an economic contraction is on the horizon.
So, what does this mean for the stock market? I think it means that stocks will have to fall enough to discount a mild recession. Historically, that entails a 15-25% drop in the broad market. I do not know whether a recession will actually happen, but I think if it does happen, it would be relatively shallow for two reasons. The first is that, I don’t think there has been a bubble in the markets or the economy, and I say that as someone who has been bearish on stocks since March. The second reason is that inflation is low enough to allow the Fed to delay interest rate increases if necessary.
Since my last update on July 6, the U.S. stock market has performed very much as I expected. The only difference is that it took a little longer for the downside to accelerate, so the correction may terminate in September rather than this month. I expect the Dow to bottom out around 15300-15800.
To recap my intermediate-term rationale, I have three charts labeled below with links to sites where you can learn more about the corresponding patterns. Click on the charts for a clearer image.
Three Peaks and a Domed House
Ascending Middle Section:
Bull Market Elliott Wave Count:
Of all the major indices, I think the NASDAQ-100 (NDX) shows the clearest Elliott Wave pattern.
Lastly, I should mention that we are approaching the 28th anniversary of the 1987 crash. For some mysterious reason, there seems to be a phenomenon in which drops of 20+% are separated by roughly 28-year intervals. I previously discussed this here.
I’m back with another long term chart. This time, it’s a chart of Disney’s stock. On Tuesday, Disney reported earnings, and the stock fell sharply from an all-time high of $122.08 to a low of $104.24 on Thursday. CNBC has been abuzz with discussion about the stock’s fallout.
I think that Disney’s stock has further to go on the downside. I’ll give you an Elliott Wave perspective first, and then I’ll discuss the fundamentals and investor sentiment situation with Disney.
From a low in 2002, Disney had a Cycle degree wave up that lasted until 2007, and then a Cycle degree wave down into 2009. We are currently in a Cycle Wave 3 which, as usual, has been a huge wave. It has subdivided into three Primary waves, and I think the third wave topped out earlier this month. The high of 122 was nearly 1.618 times the percentage gain of the first wave, which is about the biggest kind of Wave 3 that you can get. I am looking for a Wave 4 decline that matches the Wave 2 decline on a percentage basis. That gives a bottom target around $75.
Not all individual stocks lend themselves to a traditional Elliott Wave analysis; some are too volatile to apply Elliott Wave guidelines beyond the basic principles common to technical analysis in general. However, Disney’s history is consistent with Elliott Wave theory thus far.
From an investor sentiment perspective, I think that the post-Frozen enthusiasm surrounding Disney and its stock constitutes a bullish crowd. Although I do not think that overall demand for Disney’s products is going to decline anytime soon, investors’ expectations for the company went too high, making the stock vulnerable to negative surprises such as the loss of cable subscribers described in the earnings report. I also have a feeling that the upcoming Star Wars movie in December is going to disappoint where sales are concerned, and that could set off the final leg of the stock’s correction.
Disney’s stock is currently trading at a forward P/E ratio of 19.21. That number would not be enough to make me bearish in and of itself; however, considering how far the stock has risen since 2011, the P/E ratio is high enough to suggest there is more downside to go.
P/E data: Yahoo Finance