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.

Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).