At their regularly scheduled meeting on Tuesday, September 16th the Federal Open Market Committee left their fed funds target rate unchanged at 2%, even though there were almost universal calls for a rate cut of 25 to as much as 50 basis points. The feeling on the trading floor was that it was almost a given that the Fed would address the Lehman Brothers Holdings bankruptcy and the American International Group concerns with additional accommodation. The fed funds contract, which is usually a very reliable indication of Fed policy changes, was not correct this time. Before the announcement, the fed funds contract was factoring in a very strong possibility that the fed would lower interest rates by 25 basis points. In fact, traders had priced in an 86 % chance that the central bank would cut the benchmark rate by a quarter percentage point to 1.75%. It appeared logical that another rate cut would be forthcoming since the Fed had lowered its target for their overnight lending rate seven times from September 2007 through April of 2008. Why not one more cut? The circumstances appeared to be much more deserving of a rate cut than they were at any of the other times that the Fed reduced interest rates in this current cycle of easier credit.
Not Enough Accommodation from the Federal Reserve
When the AIG bailout announcement was made prices initially advanced in the overnight trade. As part of this agreement the Fed agreed to make an $85 billion loan to AIG. In return the government would get a 79.9% equity ownership in the company. The initial gains on this news did not last. Renewed selling pressure developed later, as traders’ attention refocused on the U.S. housing situation, along with prospects of further weakness in the economy.
The next day prices quickly followed through on the downside when housing starts were reported to be 895,000, when 950,000 were expected and permits were 854,000, when 928,000 were anticipated. The starts number was the lowest level since January of 1991. The permits portion of the report was much weaker than the starts number and has much more predictive value because it is a better gauge of future home building activity. Our studies suggest that the housing market will not bottom until the second or third quarter of next year, at the earliest.
The lack of more accommodation from the Fed means that this period of economic weakness that we are currently experiencing will continue for a longer period of time than many analysts had expected. An interest rate reduction would have reduced the downturn in the economy by three to six months. That will not be the case now. Apparently the Fed thought the $70 billion that they recently injected into the system was sufficient to address the current round of banking problems. In addition to the injection of reserves to the U.S. banking system by the Fed, the European Central Bank added 70 billion euros ($100 billion) to their banking system, while the Bank of Japan added 2.5 trillion yen ($24 billion) and the Bank of England injected 20 billion pounds ($36 billion). It seems only logical that the Fed would follow through with additional accommodation with a fed funds rate cut of at least 25 basis points. Our analysis suggests that additional weakness in the economy will force the Fed to lower interest rates one or possibly two more times between the end of this year and the first quarter of next year. The next Federal Open Market Committee meeting is scheduled for October 29th.
Seasonals
History has shown that the third year of a presidential term is usually the best performing year for stock index futures. That proved to not to be the case last year. History has also shown that the second best performing year for stock index futures is the fourth year of a presidential term. At least for now, stock index futures are giving every indication that this seasonal tendency will not hold true for this year either. However, not all of the historical relationships that have been observed over the years are failing now. There is one historical indicator that is conforming to expectations. That indicator is the January indicator. It states that the price direction in January for stock index futures can predict the direction of the market for the balance of the year. Higher prices in the month of January imply further gains for the rest of the year, while just the opposite is likely when January is a down month. January was a down month and the rest of the year has not fared any better. Currently there is little to suggest that this rule of thumb will not work in 2008 as stock index futures flirt with new lows.
Technical and Fundamental Indicators
In the months ahead, stock index futures prices will continue to work lower based on current technical and fundamental analysis. Temporary late week gains were directly linked to a coordinated effort by six major central banks to add billions of dollars into the international financial system. This helped to reduce bank lending rates only marginally, however. The main participants were the U.S. Federal Reserve and the European Central Bank. The combined effort added over $180 billion. Other central banks participating in the coordinated effort were the Bank of England, the Bank of Japan, the Bank of Canada and the Swiss National Bank.
My technical analysis places a lot of weight on how stock index futures respond to various types of news. This brings us to one indicator that I have found to be very accurate for all markets and especially for stock index futures. This is the “opposite reaction to news” indicator. This signal may be a bit more subjective and less scientific than some indicators, but it works very well for short-term analysis and often when markets are making major highs or lows. The best example of this signal is how futures recently ignored the bullish influence of the massive amounts of liquidity that the major central banks added to the international banking system. When the news is bullish or bullish on balance and futures trade lower, it is likely that further selling pressure will develop. This is a sign that some bearish factors are present, but not yet apparent. For example, the fundamentals: 1) may be changing for the worse or; 2) possibly one or more large traders may be overextended on the wrong side or; 3) possibly there is little to buy under the market. Either way, it is a bearish indicator when futures perform worse than the news would suggest. History has shown that a strong U.S. dollar has a tendency to be a leading bullish indicator for stock index futures. However, the current strength in the U.S. dollar has not translated into stock index futures gains. This is a perfect example of this how a bullish influence has not been able to support stock index futures for very long, if at all. In addition, bearish news is tending to produce an overreaction on the downside. There appears to be no good reason to think that these bearish signals are likely to change any time soon.
Another technical indicator of great importance is how well futures follow through when chart buy or sell signals are generated. When chart buy signals do not follow through and sell signals tend to work well, we can conclude further price weakness may be in store for any given market. The few chart buy signals that we have seen on the charts recently have not worked, while the technical signs of weakness that have developed have been valid and pointed the way to further price weakness.
Strong U.S. Dollar - Strong Economy Myth
Some analysts are thinking that the current strength in the U.S. dollar is a sign of a turnaround in the economy. Our work suggests that this is not the case. The U.S. dollar strength is due to ideas that economic activity in Europe and Japan will slow more quickly than the economic activity in North America. Recently released economic reports showed that the European and Japanese economies contracted in the second quarter. This is the first time the European economy has shown negative growth since the euro currency was introduced in 1999. In the second quarter, Japan’s economy contracted by an annualized rate of 2.4%. A strong U.S. dollar along with a weaker international economy has to be construed as a very negative development for the U.S. export business outlook. U.S. corporate earnings are already under pressure. How well will they fare when the pillar of U.S. corporate strength, the export business, dries up? In addition, for over a month we have been hearing reports that analysts are revising lower their estimates for third and fourth quarter corporate earnings.
S&P 500 Futures - Monthly
Chart provided by APEX
Where are Futures Headed from Here?
The S&P 500 has fallen 25 % from their 2007 highs and is on the verge of posting its first yearly loss since 2002, after global banks registered more than $514 billion in credit losses and asset write downs. This is the worst credit market crisis since the U.S. housing slump of the 1930’s.
It appears as though all of the government bailouts and support packages are only having a temporary bullish impact on stock index futures. We can expect lower prices for stock index futures in the months ahead as the impact of the Fed’s various support packages fades and the longer term bearish fundamental influences are likely to remain. According to our fundamental and technical research, this bear market in the S&P 500, Dow Jones and NASDAQ futures will continue for the balance of this year and well into 2009.
Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. The views and opinions expressed in this letter are those of the author and do not reflect the views of ADM Investor Services, Inc. or its staff. The information provided is designed to assist in your analysis and evaluation of the futures and options markets. However, any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to ADMIS. Copyright © ADM Investor Services, Inc.
Alan Bush
alan.bush@archerfinancials.com
1.800.243.2649 ext 7911
