This week saw the market test the bottom of its recently established 9869-11258 trading range.  The low end of this trading range was put in place during an extreme spike down in the US indices on 6 May 2010.  This time the support level (roughly equating to the 50-week moving average) was tested during more normal trading conditions and we closed the week above the support level.  This time around there was sufficient trading time around the support level to allow sensible long-term investors to buy additional stock.

The Dow probed its 9869 support level on 25 May 2010 and fell to 9774 intra-day.  Hence the low end of the trading range now becomes a band of support in the 9774-9869 region.  Only two possible outcomes now exist for the markets – either we will break down through this band of support or eventually the markets will rally to test the top end of the trading range, allowing sensible investors an opportunity to bank some profits and top-slice their holdings once more. 

This may sound a bit simplistic but really that is all there is to do once a market enters a trading range.  Options traders have plenty of fancy strategies to pursue regarding selling volatility and entering strangles based around the trading range levels but long-term investors following the Anatomy of a Secular Bear Market roadmap should simply wait for one of the two outcomes mentioned above.

It has only taken two weeks since the Dow put in a high around its 200-week moving average for the US stockmarkets to fall back to touch their 50-week moving averages.  Yesterday’s price action, with a 580-point Dow sell-off in the space of 4 minutes followed by a 580-point bounce-back in the following 8 minutes, printed its V-bottom 42 points below the Dow’s 9911 50-wma and scored a direct hit on the S&P’s 1066 50-wma.

Whatever the reason for the extreme spike down in the indices (fat finger error or otherwise – only the sellers who sold during the fall know the real reason for the 580-pt spike down), the price action formed a low point on the price charts at a valid support level.  Hence we now have a 9869-11258 trading range in place on the Dow.

Remember that the bigger picture (see Anatomy of a Secular Bear Market) called for a rally off the bottom followed by a deep pullback to create a trading range.  Now that we have a trading range established, we know for certain that eventually the market will test either the top or the bottom of this trading range.  These price points provide support and resistance levels for sensible long-term investors to rebalance their portfolios, buying additional stock at the bottom and taking profits at the top.

Eventually this trading range will be broken, but for now we have two clear levels to trade around until the range does get broken.  Although a 12% range feels a little narrow, it may well prove to be a surprisingly long time until this trading range gives way.

We have now reached a point in this recovery from the recession of 2007/9 where companies are enjoying very favourable trading conditions.

GDP growth has resumed and, whilst it may not keep going at the pace seen in the last quarter of 2009 (which was greatly helped by inventories being rebuilt), GDP looks set to continue growing slowly.  So the cake from which each business takes its slice of turnover is now growing again.

There is still plenty of spare capacity which can be used up to meet new orders before much needs to be spent on building (or buying) additional capacity.  We are seeing capex well below depreciation, which boosts companies’ cashflow.

There is plenty of slack in the jobs market (9.7% US unemployment rate) and employers will first look to increase workers’ weekly hours (which fell during the recession) before considering hiring new staff.  We are also seeing subdued pay rises which helps profits. 

After witnessing the banks’ collectively reduce credit lines and tighten their criteria for fresh lending, the companies’ collective response has been to pay down as much debt as possible through cashflow and/or rights issues.  Less interest paid also raises profits.

Whilst governments around the world may kid themselves that they are all going to export their way out of trouble, businesses are well aware that not every country in the world can rely on exports at the same time (someone has to run a trade deficit to buy all those exports).

Within their own countries, those businesses which survived the recession are benefiting from the demise of their competitors.  The survivors are enjoying a bigger share of a smaller cake and this helps to explain why sales taxes (e.g.VAT) are still down but corporate profits are nevertheless growing.

Given that central banks are going to keep interest rates at record lows until employment picks up markedly (whilst inflation remains absent), businesses are able to enjoy this prolonged sweet spot where they fill additional orders by using up their spare capacity and giving existing workers a few extra hours to create the additional output.

However this is all well and good but all of the above is already known and the rally since March 2009 has discounted these facts into current stockmarket prices.  Some job creation has started in the States, which is a further sign confirming economic recovery.  Eventually this will lead to a bear market in Treasury bonds in textbook fashion, and rising long-term rates will put downward pressure on the stockmarkets.  Now that the S&P has almost reached its 200-week moving average (having also retraced 61.8% of the entire 2007-09 bear market), it is time for the stockmarket to do a bit of sustained backing-and-filling.  The Dow has already reached its 200-week moving average (11,133) and these levels are not far off where markets closed on 12 Sep 2008, the eve of Lehman’s bankruptcy (1251/11421 for the S&P/Dow).  Remember that the bigger picture (see Anatomy of a Secular Bear Market) calls for a rally off the bottom and then a deep pullback which creates a trading range.  Since March 2009 we have been rallying off the bottom in search of the top of the trading range.  The 1224/11133 area on the S&P/Dow may well turn out to be the top of the new trading range.  Sensible long-term investors should look to top-slice their holdings and take some chips off the table, particularly in high-beta sectors such as banks, insurance & miners.

Given that low Base rates are here to stay for a long while yet, which assets will benefit most from the BoE’s low-rates-for-yonks policy (which is primarily directed at halting the recession and, as a consequence of growth, reducing unemployment)?

Normally government bonds sell-off (higher yields) when the market sniffs an economic recovery but with so much spare capacity in the economy to be worked through, Base rates will remain low until a recovery is well under way and unemployment has turned decisively lower.  In this environment short-dated government bonds should continue to do well, especially for those within 5 years of maturity.  Longer-dated yields may well go higher (especially once the BoE finishes spending its QE money) with the result that we may see a very steep yield curve sustained for quite some time.

Credit spreads on corporate bonds should carry on tightening, although there will come a limit when the absolute level of the coupon offered scares investors – lending money to a BBB-rated corporate at, say, 3% for 5 years will surely make investors think twice.  The margins currently enjoyed by banks will also serve to stop credit spreads from tightening too far as banks enjoy better protection on their loans (so logically the credit spread on corporate bonds ought to be greater than banks’ lending margins).  A steep yield curve also benefits banks greatly too.

Commodities follow a price path all of their own as they offer no yield, so they offer little attraction to income-seeking investors.

Which brings us to equities. Yields in excess of government bonds coupled with low Base rates until a recovery appears mean that equities could quite easily become over-valued against the current backdrop of macro policy.  Companies with big pension schemes may not join the party as the combination of tightening corporate credit spreads and bond yields being held down by QE buying will result in lower AA-bond yields (which are used as the discount rate with which pension scheme liabilities are calculated).  This will temporarily result in bigger pension scheme deficits which the market may well take fright at (again) for those companies affected (the usual suspects are British Airways, British Telecom, etc.), but the effect will subside once the BoE stops propping up the gilts market and long-dated gilts sell off (higher yields).

Once the supply of fresh equity from companies raising money to pay down debt and get their balance sheets into better shape has largely abated, the coast will be clear to bid up the price of equities.  Any type of a recovery (slow & protracted would be ideal) will result in companies growing their top-line sales revenues, whilst all the cost-cutting implemented since the credit crunch hit in summer 2007 means that lots of that top-line growth will translate into higher profits.  And high unemployment rates also mean that workers won’t be getting much of this profit growth.

The obvious risk to this all-out bullish view is that the economy double-dips badly and the hoped-for GDP growth never materialises.  Until that prospect (which looks very unlikely at the moment) seems much likelier to happen, it will not pay to be bearish on equities.  The Bank of England is too worried about spare capacity bearing down hard on inflation to care much, for the time being, about an asset bubble developing in equities.