Stock market averages staged impressive rallies so far this week and with just one week left to go before the month ends, expect that the market action will be fast and furious. The bulls and bears will be battling it out over the market's current level - Bulls trying to take it higher and Bears trying to take it lower. As I had mentioned before, it's normal for a market to come back and test the former support level (red line). What had previously been strong support can now be expected to be strong resistance.
There are some signs (in this moment) that the market may be beginning to stabilize. First of all, the Volatility indicator that I have discussed in previous blogs appears to finally be reversing. This shows me that the downside momentum is finally slowing for the first time in seven months. Usually, when this happens, price will either go sideways until it meets a trendline or rapidly move to the opposite extreme which currently is at Dow 12,700!
INTEREST RATES PROVIDE A CLUE
Another thing to consider is that in normal times, stocks and interest rates tend to move in the same direction.
As I have been pointing out (as early as 2005 http://marketreality.blogspot.com/) normally interest rates and stock market movements are highly correlated. This allows us to be diversified among asset classes and help us receive moderate returns year after year. Starting in 2004 however, interest rates and the stock market prices began diverging. This resulted in both stocks and bonds rallying sharply. (Remember, bond price rise when interest rates decline.) The chart above shows the divergence with stock prices rising and interest rates falling. Finally, the stocks dropped and came right to the level of the 10 year interest rate! It's possible that once again, markets will start acting somewhat predictably with stock prices and interest rates again being correlated. With the massive amount of government intervention in the markets though, who can say what might happen.
BUT, if stocks and bond rates begin to act as they should, moving in correlation, then there could be good news for stocks and here is why. In December, we saw interest rates plummet as the Federal Reserve threatened to manipulate the bond market to meet its objectives. The 10 Year Rate fell to below 2.25%. But we can see that even as the Fed outright stated that they would buy $300 BILLION of long term treasuries, rates did not yet fall below December's lows! If you have been reading some of my other posts, you might recognize one of my most favorite patterns, the Three Month Test of the Low.
If this pattern holds, then we can expect rates (at least in the 7-10 year sector) to rally. Stocks should follow suit.
Rising rates would not be good news to US Treasury Secretary Geithner nor Federal Reserve Chairman Bernanke as their goal now is to bring long term interest rates to as low a level as possible. And while the government may be bigger than many billionaire investors who prefer to stand back and let the government do their thing, the government IS NOT BIGGER than the global market for US Treasuries.