Front Running the Fed—Mike Swanson

Quote of the month:

“A collapse in U.S. stock

prices certainly would

cause a lot of white knuck-

les on Wall Street. But

what effect would it have

on the broader U.S. econ-

omy? If Wall Street

crashes, does Main Street

follow? Not necessarily.” -

Ben Bernanke, 2007

Inside this issue:

Front Running the Fed 1

Stock Market Traders 5

Feedback on Book 7

How Important was the Rally? 8

Sectors and Stocks 9

To subscribe to this newsletter go to WallStreetWindowMonthly.com—rate $250 per year. OCTOBER 4, 2010

Last month I turned the

stock market barometer

graphic you see on the top

left of the front page of

this newsletter to red.

Now I'm turning it back to

yellow. I moved it to red

because at the end of Au-

gust the S&P 500 was ap-

proaching its critical

1040 support level. If it

had broken that level it

would have entered a full

blown stage four bear mar-

ket and it is still in

danger of doing that going

forward if it breaks that

number.

However, at the beginning

of September it regained

its footing and rallied.

So the market is not in

danger of entering a stage

four bear market for now.

In fact the overall bias

is up for the short-term

in the context of the

long-sideways trading

range that the market has

been locked in since the

start of the year and in

my book sideways means

yellow. Don't get too

scared, but don't get too

excited about buying ei-

ther. The fact that I

moved this graphic from

one thing to another in

the space of a month is a

testament to the overall

sideways trend of the mar-

ket.

Friday night I went to the

movie theater and sat down

with some popcorn to watch

the new sequel to the

Oliver Stone Wall Street

movie. The first movie is

a classic for which Mi-

chael Douglas won an Oscar

for best actor. The se-

quel isn't so good and

suffers from a poor story

and unbelievable final

scene. As a movie it

really is pretty medio-

cre.

It had some neat depic-

tions of the stock market

collapse and financial

crisis of 2008. In it

they dramatized the deci-

sion not to bailout Lehman

brothers and then the

whole collapse of the

banking system and the

bailout a few weeks

later. They changed the

names of course, but it

was neat to see some

Stock Market Barometer

2

scenes depicting it.

In the first movie Douglas's Gordon

Gecko character makes a speech in

which he proclaims greed is good.

In this movie he comes out of jail

and gives a book tour in which he

is shown giving a speech predicting

the financial collapse and explain-

ing accurately exactly why it is

going to happen - and why the sys-

tem had gotten so messed up. If

you haven't seen the first one

though don't go see this one. Just

watch that one it is just so much

better.

Seeing it made me think back to

2008. It is still amazing that all

of the banks got caught up holding

these garbage mortgage securities.

It was obvious it was going to hap-

pen. In 2007 anyone who read a

newspaper and paid attention knew

that the housing market had topped

out and was in a bear market. Go-

ing into 2008 the stock prices of

mortgage companies had been in a

free fall for over a year and half.

I knew all that then. I didn't

know though to what extend banks

were exposed to the mortgage market

until the first quarter of 2008

when I read some articles that

showed the amount of toxic debt on

bank balance sheets that the gov-

ernment was allowing them to mark

up with fictional valuations. Then

in the summer it was public knowl-

edge that Fannie and Freddie Mae

were going to go bankrupt by Octo-

ber.

So that summer there were all of

the classic signs that the stock

market itself was in a bear market

and clear events that you could

point to that would drive the mar-

ket lower.

On one hand it still amazes me how

Wall Street proved itself to be run

by incompetents. Michael Lewis's

book The Big Short explains why it

happened and should be required

reading for anyone investing in

this market. However, when I look

back on then it is also clear to me

how it was crystal clear what was

going to happen, and when you look

at today things are not so clear.

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3

The market has been going sideways

all year so there has been no real

clear overall trend to the market.

Or to put it another way there have

been no trends that have been sus-

tainable. Sideways markets are

about the most difficult markets to

try to make money in as a trader,

because they tend to confound both

bears and bulls and just cause you

to churn your account.

This sideways trend won't last for-

ever. It will end either with the

broad market averages falling

through their long-term support

levels - which for the S&P 500 is

1040 - or by going sideways for

even longer and then breaking out

into a new big rally by the end of

the year or next year.

Last year in the summer I did a lot

of buying in individual stocks and

made some good money, but I sold

those positions at the end of that

year and in January, because I

thought the huge upward momentum

would come to an end and the market

would enter a sideways phase for

most of 2010 - which in fact is ex-

actly what happened.

I made a little money buying in

February, but when April came I be-

came very cautious on the market,

because we saw the investor senti-

ment numbers reach manic levels of

bullishness while all sorts of

negative technical divergences oc-

curred all in context of the side-

ways trend. I said there wasn't a

sign of a top in the market yet in

April, but didn't think it was a

good time to buy and was mostly in

cash myself.

Then of course we saw the flash

crash day. Much of the TV blamed

that day on a "fat finger" and this

week there have been news stories

claiming that it was caused by a

big order from a financial advisory

company, but whoever placed the or-

ders I took that day as a warning

sign that the overall trend of the

market had changed.

In the weeks that followed the

flash crash I became convinced that

we would not see the market trade

to new highs unless the market man-

aged to stabilize and go sideways

for months. This meant that the

overall risk to the market was now

to the downside and the market con-

ditions worsened once the market

averages went through their long-

term 150 and 200-day moving aver-

ages and stayed below them for sev-

eral weeks, which made me turn

bearish on the market.

I had no interest in going long

stocks so in order to try to make

money the only other option was to

try to trade on the short side. So

I did that, but didn't have any

success, because each of the market

drops that did occur came to an end

at support. Moves to the upside

were no longer sustainable, but so

were moves to the downside. It is

best to do nothing in a sideways

market, but I don't always feel

like I have that luxury.

That is a big problem for hedge

fund mangers who are under constant

pressure to try to beat the market

every month. So that can force

them to try to make trades when

there really aren't any to be had.

So in a sideways market you have

less overall investor interest

since few people are making money.

Volume has faded as a result and

what we are left with are hedge

fund robots and trading algorithms

competing with each other over

short-term gyrations.

4

Individual investors don't have to

face the wrath of angry or impa-

tient investors so they can be pa-

tient and wait for better condi-

tions, but they often succumb to

similar psychological pressures

anyway. When the market goes up

they feel like they cannot miss out

and as the market goes higher and

higher this pressure on them in-

creases. They can't stand the idea

of others making money without them

so they end up buying at tops and

if they succeed at doing that the

market suddenly turns down on them.

In a sideways market that can hap-

pen over and over again to someone.

The best way to make money in a

sideways market is through options

strategies. This is something Ike

Iossif has been doing the past few

months and you can get his options

alerts for free for the next few

months by going to optionsadvi-

soryreport.com. Once you go there

scroll down the page to the opt-in

box. We put together some educa-

tional audio reports on trading op-

tions you can listen to after you

sign up.

Although every single major market

has a similar chart as the US aver-

ages, there are some markets out

there in strong bullish trends.

Gold is trading near an all-time

high. Emerging markets recently

broke out and are in powerful up-

trends as you can see from the

emerging markets ETF EEM. Chile

and Thailand are currently the

strongest stock markets in the

world. There is no sideways pat-

tern to them. While Brazil appears

to be just breaking out too.

If you want to invest in a bull

market those markets are the place

to look. I'll highlight a few of

the best stocks in these markets in

the Power Investor Service this

week.

5

Stock Market Traders Front Run the

Fed — Mike Swanson

Last month marked one of the best

Septembers in years as the DOW ral-

lied 7.7%, which made for the best

September for the DOW since 1939.

Bulls are excited about the rally

and market while bears are wonder-

ing what is behind it. There are

no signs of a big economic boom

around the corner to justify the

stock market going higher. In fact

economic data continues to be weak

and all of the talk is that the

government needs to do more stimu-

lus to boost the economy and the

Fed may engage in more money print-

ing.

In fact I do not think we'll see a

real recovery in the economy until

real estate prices put in a final

bottom. Historically economic

troughs come when real estate bot-

toms and this should be more true

now than ever before, because it is

the real estate bust that destroyed

bank balance sheets and has caused

them to be cautious about lending

out money.

Real estate futures contracts on

the Case-Shiller real estate index

are not projecting a bottom in real

estate prices until later next year

and a recovery in them in 2012.

A few months ago the real estate

futures market was forecasting a

bottom for real estate in the sec-

ond quarter of 2010 so now they are

downgrading their forecast for real

estate.

To me that means that the overall

economic picture for the next 6-12

months is actually worsening in-

stead of getting better.

But the stock market has been going

up the past few weeks.

Why?

A lot of people think its because

of the upcoming Congressional elec-

tions. If you listen to FOX News

that is all you'll hear about. But

I think there is something more im-

portant that traders are looking

at.

You can sum it up in two words -

quantitative easing.

Quantitative easing is when a cen-

tral bank prints money out of thin

air and uses that money to buy gov-

ernment bonds, mortgages, and junk

bonds from banks and other finan-

cial institutions, in the process

they expand their balance sheet and

give banks excess reserves which

they hope they will lend out and

stimulate the economy as a result.

The problem is that QE is a very

difficult policy to implement. The

risk is that a central bank engag-

ing in QE buys too many securities

and then creates inflation - even

hyperinflation is a danger. The

other risk is that nothing happens

and instead of lending money out

the banks just sit on it. When

that happens investors and busi-

6

nesses lose even more confidence in

the economy and lose any hope that

the government can force it to

grow. In my view the latter is a

much greater danger than the former

in the current situation.

We already saw the Fed engage in QE

in 2008 and it had no impact on the

economy. It helped banks, but no

one else. Japan's central bank

used QE in the early 2000's to no

effect.

I first talked about QE in the Au-

gust issue of this newsletter and

said that it would begin to be an

important story to focus on. In

the long-run I didn't - and still

don't - think it will have much of

an impact on the economy, but it

has captured the minds of traders

more than I ever thought it would.

It has helped the market more than

I had originally expected.

Bradley Willet of Fallstreet.com

points out that the current rally

in the market began once Federal

Reserve Ben Bernanke gave a speech

in which he suggested that he would

use quantitative easing if the

economy continues to weaken.

In my view traders and hedge funds

have been buying up junk bonds,

treasuries, stocks, and gold ahead

of expectations that the Fed will

announce QE at their next Fed meet-

ing in November.

This is why treasury bonds appear

to be trading at crazy levels that

make no sense. Why buy a long-term

bond with almost zero yield? The

hedge funds buying these bonds are

doing so in anticipation that the

Fed is going to buy treasury

bonds.

Bulls are arguing that it doesn't

matter what happens with the econ-

omy. If economic data is weak the

Fed will print money. If the stock

market drops the Fed will print

money. Bernanke has in effect cre-

ated a "Bernanke put" on the stock

market similar to the ""Greenspan

put" that led to the moral hazard

that created the housing bulls and

the implosion of Wall Street banks.

James Vale of Beacon Equity writes,

"official statements from the Fed

serve to lower the ultimate cost of

its upcoming massive buying spree

by allowing the PIMCO-led herd to

feed at the trough first, other

less-connected fund managers to

feed second, and the public to pick

up the remaining feed last in order

to reduce the appetite needed from

the Fed to reach its objectives re-

garding interest rates."

"Whether QE II becomes official at

the FOMC meeting on November 3, De-

cember 14, or as far out as January

25, PIMCO’s Bill Gross and his ri-

vals have already scaled into as-

sets expected to benefit from the

coming tsunami of printed cash by

the Fed—and in amounts equivalent

to QE I, at least."

A month ago rumors were that the

Fed would do one big one trillion

plus QE buying program, but now the

Fed has been leaking stories to the

Wall Street Journal that they are

7

thinking of buying smaller amounts

of bonds multiple times spread out

over several meetings. One goal is

to bring long-term bond rates down

to below 2% in order to help the

mortgage refinancing market in

2011.

Bank of America projects that the

Fed will push 10-year treasury

rates down to 1.75% in the first

quarter of 2011.

Traders are positioning themselves

in front of QE. The big question

is what happens when QE comes?

The market still has heavy resis-

tance at its April highs and is

unlikely to be able to create a

sustainable rally through those

levels without first reaching them,

having a big pullback off of them,

and then going through them again.

That is a process that would take

the rest of the year to play out

and part of it would be a move to

those highs that would simply trap

a lot of people who buy into them.

It is just as possible that the

market rallies near those highs as

we reach the November Congressional

elections and a Fed QE announcement

and then it peaks on the news and

falls all of the way back down to

the 1040 level on the S&P 500.

What will be important to watch are

investor sentiment readings. If

sentiment gets as frothy as it did

last January and April in a few

months then we'll have be on guard

for another nasty sell-off like we

saw in May - in fact it would

probably be worse. But until sen-

timent gets all bulled up like that

for now the momentum for the this

month should be sideways to up with

a likely dip to start the month due

to the market's current overbought

condition on a daily chart.

Some Feedback on My New Book Stra-

tegic Stock Trading

A reader asked: "I have a QUESTION.

A lot of your examples cover the

2000-2003 period when you illus-

trate actual techniques. We all

know there are lots of techniques

which have their day, like OBV. My

question is whether you back-tested

these techniques on more recent

data, and whether they still have

the same power. I think you could

do it on Telechart.

In fact, I'm going to write up some

Telechart screens devoted to these

techniques. You stated them more

succinctly and specifically in the

book than you do here or in the

videos.”

Thanks for the comments! Awesome!

Actually the section of the book

about picking charts and stocks I

wrote a few years ago so that is

why the charts are from that time

frame. You can find charts that

are exactly the same last year.

Many of them in fact. One reason I

turned bullish on the market last

summer and started buying is be-

cause I was finding dozens of them

in June and July. This year there

aren't so many of them, because the

broad market has gone sideways so

much.

You might want to check out stock-

finder. This is another screening

product put out by the same people

who make telechart. It is a simi-

lar program, except it allows you

to make much more complicated

scans.

8

How Important was the move

we saw this past month? by

Andy Emerson & Kevin Amos

It couldn’t get any better for the

bulls. At the beginning of the

month the markets were oversold

short term and near the lows of

their yearly trading range. The

market was as close to entering a

stage four decline as possible.

What happened next was one the best

rallies the markets have seen in

years over the course of a month.

Where we’ll spend the rest of our

attention is when and where is this

market going to decide if it’s go-

ing to be bullish in the months to

come or is the bears just lying in

wait.

The most important part of this

whole rally was that the averages

were able to make higher highs.

This completely changes the charac-

teristics of the markets and one

has to take notice.

Now moving forward then we feel

it’s time to start looking at the

markets for places to start buying.

As for now the averages are con-

solidating and the SP 500 is trad-

ing sideways under 1150.

Even though the index is overbought

we feel it’s a good chance that the

averages will make a run at the 52

week highs before making any size-

able pull back, therefore in these

condition one has to be very selec-

tive in his buying and only buy

stocks that are healthy techni-

cally.

Below is a chart of the SP–500 and

the short term move we see in the

averages. Clearly above the 150 day

moving average in red ( bullish )

and for the short term the 50 day

moving average in blue is about to

cross up and through the 150 day

moving avg. ( bullish ).

Now for the longer term chart and

the one where we feel it’s a safer

bet to let the market show us be-

fore jumping in with both feet. If

the markets test the highs great,

that would be bullish but then it’s

super overbought and a pull back

will occur. It’s this pull back

where we really get excited about

buying. This could take months (

first of next year stuff) and that

takes patience, but then we’ll be

sure it’s truly bullish. Below is

what the chart would look like on

the pull back.

9

Sectors & Stocks There was an improvement across the

board in the indices, sectors and

stocks. Looking at the S&P 500

there fifty-four percent of the

stocks that make up the index are

now trading in a stage two advance

or consolidation range above their

long term trading ranges. Looking

at the industry groups it is even

more positive with sixty-one per-

cent trading above their long term

moving averages. These are some of

the most interesting sectors for

buying:

INTERNET

TRANSPORTS

INTERNET

10

CHEMICALS

AIRLINES

Below is a list of the under per-

forming sectors.

FININCIALS

BANKS

HOSPITALS CONSUMER STAPLES

11

PAPER

SEMIS

Now lets take a look at some of the

better performing stocks that could

be accumulated on pullbacks or some

that could be bought on breakouts.

In looking thru the sectors these

stocks were either the leaders of

their sectors or ones which have

the potential for a breakout to the

upside.

MOSY

HSTM

BROKER DEALER

12

ANAD

CVLT

BVN

ACV

RHT PRGO

13

PEP

AGN

CCE

SNMX

CCK

GSS

14

HRL

ECL

DUSA

Here is a list of stocks that we

are tracking also.

OREX PFE FIRE UTHR CERS SA SLXP

ILMN ENR SLGN CMP ORCL CLX SMG RGLD

GG ABV SGEN CVLT AKRX BMC INTU OPNT

BLL TQNT SATC QUIK OPLK INCY LXK

SLM IPAR CHKP ENLN PRX KMP GPK PCYC

KOF PRGS SAM AEM ABUT AEZS YGE BLPC

STV BPL OFO APL AZK VHC EGO KGN SOL

WES EXAS SXL RIC AMRN ONCY.

Again the stocks listed and the

stocks that are charted out here

are stocks that are either perform-

ing well within their sectors and

could be bought on pullbacks or

stocks that have the potential for

a break out to the upside and could

be bought accordingly.

15

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