The Calm Before the Stock Market Storm

It was a relatively calm week as global stock markets for the most part flat-lined in the face of conflicting economic news and statements from the Federal Reserve.

The bulls and bears have largely been at a standoff since mid September, and while nobody can predict the future, I can tell you with some certainty that this stalemate will not continue.

In fact, the longer we remain in this sideways coiling process, the more powerful the breakout will eventually be, either up or down.

This coming week promises to add significant clarity to the future direction of the market and signal the end to the “calm before the stock market storm.”

Make no mistake, the storm is coming.

In the chart of the S&P 500 above we see a number of interesting items.

First off, notice the similarity of the patterns identified as #1 and #2. In July we can see the significant run up to the top circled in item #1, followed by a steep decline into late August, and it’s easy to notice the eerie similarity labeled item #2 with the run up in September to the top we’re currently in, followed by a dotted line indicating the next potential move down to the mid 1000 level or below on the index.

This move would be supported by RSI, labeled #3 and is currently overbought with this market condition confirmed by item #4, the Stochastic, also in overbought territory and looking much like its position in early August before the August decline that quickly dropped nearly 9% from the index’s value.

So it’s quite clear from a quick glance at just one chart that the next tradable move is most probably towards the down side.

The View from 35,000 Feet

The technical story is further confirmed by seasonality which points to October as the month most susceptible to steep declines and crashes while the fundamental picture is murkier.

And always present in today’s post crash world is the not so invisible hand of Dr. Bernanke and his colleagues in the equity and currency markets of the world.

Last week’s fundamental news was mixed with positive numbers coming from the Case/Shiller housing index showing a rise in home prices, a small improvement in the jobs outlook and improvements in the Chicago Purchasing Managers Index and the University of Michigan Consumer Sentiment Index.

On the negative side of the ledger we saw a conflicting drop in Consumer Confidence along with an ominous reading in the ISM report on Friday.

Just to take a closer look at the ISM report, it’s important to understand that it dropped to 54.4 from a previous reading of 56.3 and that readings above 50 indicated economic expansion. While seemingly not a huge decline, the internal components were significantly weaker with particular red lights flashing in the decline in new orders, a slowing of hiring and a significant rise in inventories, all of which precede a slowing economy and declining earnings.

Finally, and perhaps most importantly, the Federal Reserve has practically announced that they’re going to resume “quantitative easing” at the conclusion of their next meeting on November 3rd.

Chairman Bernanke, “Big Ben” as he is affectionately known in the blogosphere, telegraphed his intentions after their meeting on September 30th and this week William Dudley, the President of the New York Federal Reserve said, “Further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.”

It seems safe to say now that the only questions are, “how much,” “how” and “will it work?” The consensus answers are $500 billion most likely distributed in smaller tranches rather than in the “shock and awe” fashion of last year.

Regarding “will it work?” the answer is “most likely not.”

A much bigger round of easing last year obviously didn’t work or they wouldn’t be starting off on another round now; it didn’t work in Japan and it didn’t work for FDR during The Great Depression. It’s quite likely that much of “QE2” is already priced into the market and that we would see a short term pop in asset values followed by more of the grinding market action we’ve seen all year.

What It All Means

In three words, “more pain ahead.”

We unfortunately have a long road ahead as a country and as investors and try as they might, the best the powers that be can hope to do is kick the can down the road, as the old saying goes.

Herbert Hoover, “the father” of the Great Depression learned this lesson and our current leaders should listen to his voice of experience: “Economic depression cannot be cured by legislative action or executive pronouncement. Economic wounds must be healed by the action of the cells of the economic body – the producers and consumers themselves.”

We will heal but it’s going to take some time and much more pain.

Over the last few weeks we’ve been in the “calm before the storm.” The storm is about to hit and will either take us to higher ground and safety or into a vortex of volatility and asset destruction. Wall Street Sector Selector remains in the “red flag” mode, expecting stormy weather and lower prices ahead.

The Week Ahead

It’s very likely that this week will be pivotal with large scale economic reports on the horizon and the official start of Q3 earnings season.