QE3!!!

Big risk-on day, as the market starts hearing rumors about additional easing.  It started with yesterday's FOMC Minutes, which had this little nugget in it.

"Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation....A few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run."

And is continuing today with Ben Bernanke's testimony before Congress, where he has so far said that the economic weakness appears temporary, but the Fed stands ready to act should deflationary pressures appear.

In the past, the Fed has acted when 10 year bond yields fell below 2.5%.  One would think that the Fed's buying of Treasuries would depress yields, but it actually moves the market out of bonds and into riskier assets.  The real demand for bonds comes from the flight to safety trade, which happened last year and is happening again as easing expires.

The above chart is a month old, but 10 year yields are currently still trading at 2.95%.  If the trend continues, QE3 could be right around the corner.  QE2 was announced at the annual global central banking conference at Jackson Hole last August.

Many feel that QE3 will take the form of interest rate targeting, where the Fed would put a cap on interest rates for Treasuries of a certain maturity.  Bernanke himself outlined such a program in a 2002 speech about fighting deflation when he was still a Fed Governor.

"Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time — if it were credible — would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt ... Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities ... Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond- price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade."

Such a program would not have a specific duration or amount of easing, which would cause the Fed to lose control over the size of its balance sheet.

Channels

I've taken down my Trading Plan page because it's currently going under some revisions.  Channeling techniques are a topic I've been meaning to add, because they are a fundamental part of technical analysis and work well for interpreting Elliott Waves.  I personally define an Elliott Wave as anything you can draw a channel around, though it need not be parallel.  They can also take the form of triangles and wedges. When a trendline or channel has been broken, you can infer that the market has entered a new wave and adjust your positions accordingly.

The central thesis of my trading plan is that markets move in impulses and corrections, and that understanding corrections is key to establishing a good entry for the next impulse. The recent market action is a great example of waves expressing themselves as channels and the purpose of the corrective waves.

Corrective waves occur because the market has moved too far or too fast.  What we have here is a base channel established by an upward impulse and a steeply corrective second wave.  The second wave is when new short sellers "sold the rip" at what eventually proved to be bad prices.  Their positions were ultimately reversed, accelerating the new trend as selling pressure exhausted before the market could make a new low.  The fourth wave we are in now is decelerating the trend because it carried upwards so quickly it was unsustainable.  Fourth waves will often retest an entry into the base channel, or said differently, to the original rate of change for the trend.

Channels on the Russell 2000 Index

Once the fourth wave is complete, you can often draw a channel around the entire movement by connecting the corrective waves.  When that channel breaks, you can infer the fifth wave has completed and either a reversal or large corrective pattern is in place.  For demonstrative purposes, I've drawn such a channel in white below assuming that the fourth wave does in fact stop at the top of the base channel.

Market Update

Stocks have been rallying strongly in a brutal short squeeze. Sentiment indicators had been at extreme lows, signaling that the trade had become too one-sided and that the bounce off the 200 day SMA would carry fast and furious.  Momentum indicators are signaling we are now at an opposing extreme, with the daily RSI seriously overbought at 77 on the S&P 500 and over 80 on the Russells.  Yesterday morning I sold my Russell long I'd been holding since last Friday's ISM due to the overbought indicators.  Good thing too, because this morning's NFP was a stunning miss, with only 18,000 jobs created this month on expectations north of 100,000.  S&P futures are down about 18 right now pre-market.

Intermediate Term Sentiment Indicator

The wave count has this as a fourth wave correction, with new highs still on the way once overbought conditions can be worked off.  The drop caused by the jobs report could be a nice opportunity to buy the dip.  Earnings season starts next week.

Russell 2000 Index Futures Hourly

A reasonable target for the wave four retracement is in the 1336 area on the S&P 500 or about 840 on the Russell.  This would be in the area of the fourth subwave inside wave three, an Elliott Wave guideline.  It would also align with a perfectly proportional wave where wave five = one with an ultimate target at 1376. It's not like we ever see perfectly proportional waves, but it's a good enough guideline.

S&P 500 Index Daily

Daneric has an excellent chart up comparing the similarities of this short squeeze to the one that marked the top in 2007.

Wilshire 5000 Total Market Index Weekly

Currency markets have been very volatile in general and even more so following the release of major reports.  One would think a poor jobs number would be bearish for the US economy and by extension, the US Dollar.  Typically that would be true, but the market we've been trading for the past few years shows an inverse relationship between equities and the Dollar. So in this situation one would think that a poor jobs report would be bullish for the Dollar, as risk comes off the table.  This is initially what happened, but obviously "someone" had a large bid on the Euro at 1.42.  This triangle looks close to resolution, and should resolve to the upside so long as Eurozone debt problems remain contained to the periphery.

EUR/USD Hourly

The right way to capture risk appetite and play Euro strength may be to buy it against the Swiss Franc.  The CHF has been relentlessly strong against the Euro, but it has broken a very key channel. I don't expect a long-term change in trend, but a very strong short-term technical bounce may be in the cards. Last week's risk on short squeeze was even more brutal for EUR/CHF shorts.

EUR/CHF Hourly

This is a very risky play, because even though the currency markets have yet to price in Euro debt contagion (thanks probably to China), the peripheral Eurozone sovereign debt markets continue to travel sharply downward. And what's more worrying is that Italy and Spain are getting a lot more attention lately. Italian bank stocks in particular have been taking a beating in European trading.

I believe that China will continue to support the Euro so long as the debt problems remain contained, which will exhaust sellers and carry the Euro to new highs. Eventually, as the debt problems for larger and more important countries like Spain and Italy become untenable, China will not be able to hold this market up any longer.

10 year bond yields
12.83%	5.29%	12.96%	16.87%	5.66%
Portugal	Italy	Ireland	Greece	Spain

PIIGS CDS Composite Index

Morning Commentary and Analysis

The ISM number was a massive beat, much like the Chicago PMI yesterday.  The actual number was 55.3, against a consensus estimate of 52.0, with the range of estimates from 51.0 to 55.0.  Digging into the leading sub-indexes, the headline number is overstating the strength of the report and could be forecasting weakness some time in the future.  New Orders only improved modestly from 51.0 to 51.6, while inventories jumped over 5 points to 54.1.  New Orders less inventories, a key leading metric, plummeted.

Regardless, this was still a very strong report.  My model had forecasted a modest beat at 52.7, and the p-value for a number greater than 55 was .076.  The 55.3 print was 1.56 standard deviations away from the estimate.  I'm going to have to look into this more deeply, but a cursory examination of other outlying reports shows that they were typically skewed by large increases in inventory.

Needless to say such a strong report was a pleasant surprise for the stock market, particularly when considering the weakness in various regional manufacturing surveys earlier this month.  I nervously went long the Russell futures into its release, but I wasn't quite confident enough to make a weekly options play.

The Euro has broken its channel, so now may be a good time to sell.  As I wrote yesterday, I am no longer  looking for long-term downside until this triangle sorts itself out.  It seems like any time a market is stronger than people think it should be, someone blames the Chinese.

Well in this case, it may be true.  Remember how the Euro was recovering while the Commitment of Traders report showed speculators exiting en masse, and I wondered who the Hell was buying it? That week we also saw Foreign Treasury Holdings drop by one of the largest amounts on record. China seems to be rebalancing its massive currency reserves from Dollars to Euros. The Yuan is pegged to the Dollar, so a strong Euro against the Dollar also means a weak Yuan for Chinese exporters to the Eurozone.

The steepness of the down moves show that the market clearly wants to sell the Euro, but it is being supported by someone out there buying the dips. The result is a large triangle showing a battle between the market and China.  I think for now China wins this one, but should the debt problems spread to countries larger and more important than Greece then they may end up regretting this move and rebalance their reserves away from Europe.  Many central banks have learned the hard way that no one is bigger than the market when attempting currency interventions.

EUR/USD Hourly

Stocks also look poised to make a run for new highs.

Russell 2000 Index Daily

ISM Preview

One of the most influential reports of the month will be released tomorrow morning, the ISM Manufacturing Index. The consensus estimate is 52.0, with the range of estimates from 51.0 to 55.0. Last month the ISM fell from 60.4 to 53.5, with the consensus estimate at 57.5 -- a huge miss -- and the markets reacted very negatively. I made a lot of money that day shorting into the report based on Bill McBride from Calculate Risk's very nice monthly preview using the regional Fed manufacturing surveys. Here is his chart for this month.

So will the ISM miss again? When the NY and Philly Fed surveys came out, it sure looked like it. It even looked like we would see a sub-50 print, signaling a contraction in manufacturing.  The more recent surveys, and in particular the Chicago PMI, have not been nearly as weak.

For this month, I'm attempting to improve upon the accuracy of Bill's chart by using linear regression to weight the regional indexes. I also made a second model using the Chicago PMI number.

Here's the regression summary for the model using the regional Fed surveys. This month the model is estimating the ISM will be 50.38, in line with Bill's chart.

Model Summary
Model	R	R Square	Adjusted R Square	Std. Error of the Estimate
1	.930a	.866	.854	2.56350
a. Predictors: (Constant), KC, VA, NY, PH, TX

Coefficientsa
Model		Unstandardized Coefficients		Standardized Coefficients	t	Sig.
		B	Std. Error	Beta
1	(Constant)	51.518	.592		87.012	.000
	NY	.033	.031	.085	1.061	.293
	PH	.099	.035	.271	2.835	.006
	TX	.082	.027	.296	3.013	.004
	VA	.117	.028	.300	4.161	.000
	KC	.044	.041	.094	1.063	.292
a. Dependent Variable: ISM

And the model including the Chicago PMI, which has been considerably more accurate. The KC Fed survey was discarded because it was shown to be an insignificant variable, and the PH survey was discarded because of multicollinearity. I also dropped the number of observations to 30, because that's about the minimum number you need to use a normal distribution and in a time series the most recent data is the most important. Also, two and a half years worth of data coincides with the beginning of the recovery in manufacturing. This month the model is estimating the ISM will be 52.72.

Model Summary
Model	R	R Square	Adjusted R Square	Std. Error of the Estimate
1	.987a	.975	.971	1.55420
a. Predictors: (Constant), CH, VA, NY, TX

Coefficientsa
Model		Unstandardized Coefficients		Standardized Coefficients	t	Sig.
		B	Std. Error	Beta
1	(Constant)	35.029	3.283		10.669	.000
	NY	.090	.028	.194	3.213	.003
	TX	.085	.035	.240	2.402	.023
	VA	.067	.023	.168	2.979	.006
	CH	.322	.055	.452	5.897	.000
a. Dependent Variable: ISM

The estimations for both models versus the actual ISM number can be seen visually in this chart.

And for fun, let's test some critical values.

	Fed Surveys		Fed and Chicago PMI
ISM	z	p	t	p
< 50	-0.1493	0.4404	-1.7473	0.0460
< 51	0.2408	0.5952	-1.1038	0.1397
< 52	0.6309	0.7360	-0.4604	0.3244
> 52	0.6309	0.2640	-0.4604	0.6756
> 55	1.8012	0.0359	1.4698	0.0766

It will be interesting to see how well the model works tomorrow. The most recent data is showing that an ISM miss is not likely. Overall, it looks to be a boring report in line with expectations, and will probably not have much of an effect on the market.