Indicators Rise to 71.0 Percent, Sentiment Bearish, Correction Over?

Our sentiment indicator - the number of bullish advisors is at 56.2, the highest number of bulls since April 21st when there were 53.0 percent. A 16.0 percent correction followed because (at the same time) the Fed talked about stopping QE. A different situation now exists since the Fed is implementing QE2, not ending it. Since bullishness is not good news (contrary indicator), we downgraded this indicator to bearish, removing two points from our stock market indicator composite (Table 1). Our Baa to 10- year ratio is bullish (Chart 1) and the 3-month libor to 3-month bill rate spread was upgraded, raising our composite points by three points. Since our overall indicators are above 42.0 percent, we believe this correction should be limited to 4.0 to 7.0 percent. To date, the correction has been 4.0 percent. We believe the correction should be over even though sentiment was downgraded. We have faith in quantitative easing (QE2) - see below.

It appears issues beyond the release of economic statistics were moving markets. The Irish debt crisis and tighter monetary policy in China were being weighed in (affecting commodity prices like crude oil). While the U.S. is aggressively easing, the Chinese are hitting the brakes. Sovereign risk re-emerged on the radar and has the potential to stifle our recovery. A key element of QE2 was that it was said to be unlimited, but the backlash that had developed here and abroad seemed to reduce the odds the Fed would be able to go beyond the $600 billion mark. This is likely why t-bond yields rose, the dollar declined, and stocks and gold declined recently. It is important for the economy to reaccelerate to support and validate the stock market rally. 

This morning Fed Chairman Bernanke, however, delivered a strong speech supporting QE2. He suggested that the Fed has no intention of giving in to pressures to abandon its policies prematurely. As mentioned, markets priced in a substantial chance that QE2 will be cut short, and Bernanke's speech indicates that those expectations may be unwarranted. A decision of when to exit will be made based on economic conditions, not political pressure. We believe the cyclical bull market is intact since the Fed’s clear focus is on easing until they reach their inflation target and growth is above trend. We remain unhedged.

QUANTITATIVE EASING FROM 1934 TO 1936 WORKED!

We can get some idea whether QE2 will be successful by looking at the quantitative easing that was initiated during the depression. The U.S. Treasury initiated QE then (not the Federal Reserve), when in May 1933, the President increased the U.S. dollar price of gold to $35.00 from $20.67 per ounce. The Treasury's gold increased in value by over 65.0 percent, thus increasing the Treasury's spendable funds so they did not have to raise taxes. The Treasury could increase its spending without any other part of the economy needing to contribute. The upward revaluation of the Treasury's gold holdings was similar to today's Federal Reserve purchases of securities. The growth of the money supply and GDP from 1934 to 1936 was double digit and the Dow Jones rose 122.0 percent (Chart 2).

We have seen how just the talk of QE2 has affected stocks. As mentioned above, when the Fed spoke about an exit strategy in the spring, stocks weakened. Then, when Bernanke spoke about QE2, stocks strengthened. Recently, when the backlash to QE2 increased last week, doubts emerged about further implementation of QE2 and stocks weakened.

ECONOMICS

Economic statistics have been fairly stable and there are signs that the economy is healing. The ECRI leading economic index rose again this week (Chart 3). Based on September improvements in retail sales, inventories, trade, and public construction, real GDP is on track to be revised up to 2.7 percent in the third quarter. Inflation stats were good as the PPI rose less than expected 0.4 percent in October, while the core PPI dropped -0.6 percent due to a -3.0 percent drop in auto prices and -4.3 percent decline in light truck prices. Industrial production was unchanged in October while manufacturing production jumped 0.6 percent – showing that the sector is fine. 

OUR RECOMMENDATIONS

We continue to like consumer discretionary (XLY), financials (XLF), industrials (XLI), materials (XLB), and tech (XLK) sectors. We also like housing (XHB) and gold (GLD). In high yields we currently like ETFs such as PKO (Pimco Income Opportunity, 8.0 percent yield), NLY (Annaly Capital Mgt. 15.6 percent dividend yield), JNK (SPDR Barclays High Yield Bond, 9.5 percent yield), HYG (iShares High Yield Corporate Bond Fund, 8.3 percent yield), and EAD (Evergreen Income Advantage, 10.4 percent dividend yield). As stated above, we believe corrections should be limited to 4.0 to 7.0 percent and we remain unhedged.

SECTOR ETF RECOMMENDATIONS

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