15 March 2010 – Chart of the Week
Chart of the Week: Déjà Voodoo In The Stock Market
It’s happening again. Having collapsed 50% during the bear market, stocks have surged 50% to recover half those losses. However, while demonstrating that percentage changes are larger on the way down than the way up, stocks have been struggling lately at what traders call the 50% Fibonacci retracement.
Stocks collapsed by 50% in only two other bear market cycles since World War II: the early 1970s and the early 2000s. Remarkably, in both cases the subsequent bull market recoveries similarly struggled at the 50% retracement level. And in both cases, the eventual catalyst for the next leg up in stocks appears to have been the first hike by the Fed, in June 1975 and June 2004, respectively.
Generally, the Fed’s first hike is merely a shift from easy money rather than a signal of an outright tightening of rates. It marks the point at which the economy’s new expansion is becoming self-sustaining and the monetary stimulus can be withdrawn. Put another way, in those earlier episodes, stocks rallied initially on the prospects of a stronger economy; then, after a lull, they rallied again on the reality of a stronger economy, the same reality that induced the Fed to begin removing excess liquidity.
In this cycle, the strength of the economic data continues to build. Even with the winter blizzards in February, retail sales and industrial production were both strong. Moreover, a topping in the unemployment rate and a firming in capacity utilization suggest that the slack in the economy is finally being taken back up, a customary precondition even for an initial Fed hike.
While an inflation-fighting outright tightening of rates could be some time away (particularly given the new dovish appointments that appear imminent at the Fed), a modest reversal of easy money could begin relatively soon, although the timing is undoubtedly far more complex this time around than typical cycles. That said, the futures markets currently have a hike priced in by the fall, which could help set the stage for a strong rally in the second half of the year.
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