The two issues we penned in May revolved around the vulnerability the equities market was finally showing. An oft quoted Wall Street axiom is ”the stock market climbs a wall of worry.” We cannot remember in the twenty plus years we have followed the market that there were so many things to angst about, and yet nothing seemed to faze the charging bull. North Korea attacking South Korea, a devastating earthquake, tsunami, and nuclear crisis in Japan, the apparent insolvencies of several European countries as well as our states and municipalities, nagging unemployment, Mideast unrest, $4+ a gallon gas, a non-existent real estate/construction recovery and other less than desirable data points were unable to distract the Dow from gaining 2,750 points from September 1st to May 1st.
The fundamental catalyst for the run appears to be growing corporate profits and the cash build up generated from them. Much of the profits were from strong gains in productivity combined with expense reductions, mostly in the form of layoffs. The earnings of the S&P are estimated to surpass the record made in 2006 of $87.72, with most estimates hovering near a $100. What could go wrong?
May was a challenging month for stocks, but the resiliency continued to be evident. The last four days brought another one of those rallies that had me thinking here we go again, as the major indices cut their losses. The S&P 500 lost just a shade over 1% for the month, no big deal. But the first four trading days of June has been a little different story as the S&P 500 has lost over 4% and key support levels have been sliced through like buttah. There is a legitimate concern for a deeper correction as much of the recent economic news might be hinting those earnings estimates might be a little too rosy.
This calls for the work of the Fed’s not so secret Plunge Protection Team. We are surprised that many investors are unaware of this entity and its interesting history. It was created in the aftermath of the 1987 Crash; you know when the Dow dropped over 20%…in a day! The Working Group on the Financial Markets was created by executive order by President Reagan. Members include the Treasury Secretary, Fed Chairman, and the Chairman’s of the SEC and Commodity Futures Trading Commission. The intent was to prevent and repair significant market dislocations.
It appeared the team earned their keep in 1998 when the hedge fund Long Term Capital threatened to bring down the bond market. The story goes that Alan Greenspan was able to convince several large banks to work together to avert a possible financial system meltdown. The strategy worked and we still remember the very scary correction bottoming on October 8th, and the dotcom bubble recommencing its epic run. Greenspan earned the moniker “Maestro” for his efforts, which was also the title of a revealing book written by Bob Woodward of “All The President’s Men” fame.
Many have postulated that the last dozen or so years the PPT has become a tool in the Fed’s arsenal to prop up the stock market at key times by purchasing index futures. The purported intent is to keep investor confidence high which should have a residual effect on consumer confidence. We first came to know of the PPT around the turn of the century and viewed this rumor with some skepticism.
We did start to notice often when the market appeared to be sitting on a precipice or just falling off it, a robust rally would begin and technical support levels would hold and even strengthen. It happened so often that we did a flip flop and become a conspiracist. As the last decade unfolded new reports of the PPT increased and the existence of the group became “sort of” well documented. Former Fed Governor said in the WSJ that it would be more effective to buy futures than flood the system with liquidity and potential spark inflation. We believe there is your smoking gun.
Our guess is that the next few weeks might bring the Invisible Hand of the PPT into the market and a prevention of too steep a correction. Just the fear of the PPT coming into the market can keep the short sellers nervous, off balance, and even out of the picture. We believe the team may actually use the short sellers to their benefit in the following manner; the market is sitting on an important support level and falls through, this will often have the short sellers increase their bets pushing the market down further, the PPT will let this unfold and then begin their purchases pushing the market back above the support level, forcing the shorts to extend the move when they cover, and this strengthens that support level. Hope you were able to follow that. It certainly is no fun being a short seller in that scenario.
The next key data points to focus on are second earnings results due to begin the second week of July. The recent weak economic numbers will probably have little impact on those releases, but the forward look to the third and fourth quarter might be impacted. Couple that with QE2 ending and the PPT may have their hands full this summer. QE3 may become a very hotly debated topic if it coincides with the debt ceiling drop dead date in August and the ramping of the 2012 campaigns.
We sure hope this grand strategy the policymakers are experimenting with has a productive outcome. It seems to me the more they fool with Mother Nature (Mother Market in this case) the more challenging the end result might become. If ever there was a time for bi-partisan leadership from our politicos, this is it (twittering your underwear does not count). Secondly let’s hope the growing middle classes of these developing countries around the globe become mini me American consumers and help us grow our way out of this predicament. It could happen?
Chart Spotlight
Below are two leading indices, the S&P 400 Mid Cap and the Russell 2000 small cap index. Both indices have been leaders of the rally the last two years and both made new all time highs earlier this year. As you can see the first week of June took both indices below key support levels as indicated by the green lines. Often times when support levels like this our broken they become resistance levels to attempted rallies. Several other sectors and indices have broken similar support levels intimating that a correction may last the entire summer. A similar pattern unfolded last year and as that 15%+ correction persisted QE2 was hatched. No dull moments here.
Did You Know
Summer Stock Market Data - The 3 summer months (June-July-August) have produced an average loss of 0.6% (total return) for the S&P 500 stock index over the last 21 years (1990-2010). The stock index was up +11.7% during the 3 summer months in 2009 but was down 3.2% during the summer of 2010. Through the end of May 2011, the S&P 500 was up +7.8% YTD on a total return basis. June is ranked 11th out of the 12 months in average performance for the S&P 500 since 1990. Only August (ranked 12th out of the 12 months) has a poorer average stock performance than June. The best “June-to-December” total return performance for the S&P 500 in the last decade (i.e., 2001-10) took place in 2009 when the stock index gained +22.8% over the final 7 months of the year. The worst “June-to-December” result took place in 2008 when a loss of 34.5% occurred (source: BTN Research).
Final Thought
“A fanatic is one who can't change his mind and won't change the subject” - Winston Churchill
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