It’s not the news, It’s the reaction to the news that matters.

One of the most popular questions I hear is “Why did the market go down on good news?” The answer to the question can be complex and almost always lands in the camp of expectations, and the past few weeks has been a great example.

Over the past few weeks we have seen improved information on the economic front with improvement in productivity and leading economic indicators as well as a decrease in housing inventories and increases in purchases of cars. With these positive signs you would think the markets would zoom higher and to the contrary on days positive news has come out we have seen the market move lower. This is an interesting reversal from what we saw in April and May when the market moved up on bad news.

Most experienced investors and professional traders will tell you the reaction to news tells you more about a market than the actual news itself. Staying on the subject of the last few weeks it is known that market tops are processes that can take weeks to months to develop as psychology shifts from greed to uncertainty then fear. In our last market update we discussed the possibility of a short term market decline for July and August. We also mentioned we felt this decline would be smaller than expected from our writings in May. The markets did see a very small and short decline in the first 2 weeks of July (turning out to be much smaller and shorter in time frame than we expected). This small decline was answered with a significant rise the last 2 weeks of July and beginning of August on the back of better than expected earnings reports.

As we have mentioned in past letters earnings are the key to sustainable growth for markets. This past earnings season now complicates the picture a bit as most earnings expectations were met by cost cutting not increases in revenue. Regardless since the expectations were low and the news was better than expected the markets moved higher.

Two sides to every coin
There are two sides to this coin. On the heads side, a company that can cut costs will profit more if they get a small increase in revenue. This seems to be the psychology behind the large mutual funds as they purchased stocks in July. It’s important to remember mutual funds tend to make purchases with a 5-10 year time horizon and don’t mind seeing their funds drop 10% in the short term as seen last year or the beginning of this year. Therefore if your time frame is less than 5-7 years you may want to evaluate your mutual fund investments.

The tails side to this quarter’s earnings is the reduction in costs comes from laying off workers and implementing strict spending restrictions on the remaining employees. This increases unemployment and decreases consumption in the economy. So while the earnings news can be short term positive for the markets, it may give tell tale signs for longer term concerns as revenue can only increase if incomes are rising and more people are being put to work and the one fly in the ointment is that there has been no improvement in employment and it doesn’t look like there will be any improvement for quite some time.

The bottom line is if there is an increase in consumer spending and business confidence we could see further improvement in earnings as companies are running lean and mean. However, on the flip side if consumer spending and confidence is below expectations then we have a recipe for dicey markets which brings us back to our opening subject of expectations.

Stimulus vs. Organic Growth
There are times when economies thrive on organic growth, such as the 1950’s and 1990’s then there are times economies need stimulus to stay alive such as the 1930’s, 1970’s and 2000’s. There are multiple reasons for this with the largest factor being the expansion or contraction of credit. When credit is expanding as it did the last 30 years it provides fuel to the growth fire. When credit is contracting as it did in the 30’s, 70’s and current time the government is needed to step in and fill the gap to keep the wheels of commerce oiled.

We are currently witnessing first-hand how stimulus affects the economy and subsequently the shorter term market moves. On Tuesday 9-1-09 we received two pieces of data which exemplify how stimulus enters the economy and then gets interpreted by markets. On Tuesday we learned that the auto companies sold the most cars in many months as a result of “Cash for Clunkers” which expired last week. We also found there were the most applications for home purchases in many months as people scramble to take advantage of the new buyer tax credit which expires in November.

With this good news the markets had a 200 point decline on the Dow Jones. Why? You may ask – Expectations. With both stimulus programs – cash for clunkers and new home buyer tax credit – expiring, Wall Street expected these numbers to be higher and subsequently asked the question – What next? Now that these incentives to buy cars and houses are being removed is there enough organic demand to keep our economy moving along. Considering the 200 point decline the markets are saying that they don’t believe there is enough juice in the economy to keep the number of car and home sales elevated which brings us to the question of where we go from here.

Moving Forward
We now sit at an interesting place within the markets. On one side you have investors feeling confident after the past few months as the markets have bounced off the March lows. Their confidence is fueled with the fact that economic numbers have ceased to deteriorate and the belief that government stimulus will work. On the other side you have the group that says the move in the markets since March is nothing more than a Bear Market rally that will fail with the markets moving back down below the March lows sometime in 2010. This belief is backed with the facts that we are in the middle of the largest credit bubble burst since the Great Depression and without credit expanding there can’t be growth in the economy.

So which camp has the warmest fire? Only time will tell and since predicting the future is never foul proof it is best to have a plan that considers both options by placing price points that cause you to either invest or preserve. Below we cover the markets as well as asset classes such as Gold, Oil, the Dollar and interest rates since those are the pillars of the markets.

The Dollar
Once in a while you will find correlations within the market. This year the significant correlation affecting the market has been the dollar. There has been an interesting relationship where the market and the dollar move in opposite directions. If the dollar weakens the market strengthens and as the dollar strengthens the market weakens. You can picture it like a teeter totter with the dollar on one side and the markets on the other.

Currently the dollar appears to be attempting to form a bottom. The recent action in the dollar suggests that it is preparing to stage a multi month increase which could put some pressure on the stock markets. In the short term (next few weeks) you could see increased volatility within the dollar with one last decline before it begins a longer term growth phase. For those of you interested in watching this you can use the symbol UUP.

In last month’s market update we mentioned the importance of the 940 price level in gold. Since then and in recent days Gold has spring boarded higher (currently at 983) giving the impression that we will test the old highs of 1000 in coming weeks. However, this strength could be short lived if the dollar gains strength. Now the 975 price becomes the line in the sand. As long as Gold is above 975 it is best to be an owner of Gold. However, if the price slips below 975 you should reduce your exposure as there are some patterns and cycles that are predicting the recent strength in Gold could be the last move higher before a longer term decline that could take the price below 900. For now the price of 975 is your tell. A helpful symbol which tracks Gold is GLD.

Oil (currently at 68.50 a barrel)
Recently the hurdle for Oil has been the 75 dollar mark. Each time we have reached that price area Oil sells off quickly. Two factors affect Oil prices – consumption and the dollar. Considering oil has been unable to get over the 75 dollar mark it appears the market believes there isn’t enough demand within the global economy to push prices higher. It appears for the near term Oil may be stuck in a range between 65 and 75. For longer term investors it is probably best to watch this market from the sidelines until a more predictable pattern develops. A useful symbol to watch this market is USO.

Interest Rates
Over the past few months interest rates have declined which pushes the price of bonds higher. This is typically seen when investors are trying to take less risk. For the near term it appears interest rates are stuck in a range. At this time we don’t have a firm opinion on this market other than if stock markets have a decline you will see interest rates decline further and vice versa. Hopefully by next month there will be defined patterns within rates that we will be able to comment on.

The analysis on stocks becomes simply about price levels within the market. This year’s pattern in markets gives the visual perception that we have a strong bottom that was created in March. The current patterns support near term weakness in the market between now and September 15th. The patterns suggest this weakness will then be answered with increases in the S&P 500 into late September early October where a combination of larger cycles could give way to a larger market decline (probably the biggest since the March lows) into late November. Within these cycles there is an upside potential to see the S&P reach 1100 (currently at 1000) and a downside potential of 880. This makes the 950 level on the S&P 500 the price to watch. In the event the market where to break the 950 level then the high of 1030 seen on the S&P 500 in August would mark the top for this recent rally and opens the door that the market could decline more.

Bottom line we have an upside target potential of 1100 which means if the S&P were to push above the August highs you want to be an owner of stocks with the intention to lighten your load or reevaluate if the market reaches the 1100 area. On the flip side if the S&P were to breach the 950 level then something larger and more negative would be developing and preserving your capital by moving to money market would be best for those that desire to preserve.

In closing I would like to direct you to a helpful tax resource. This year has turned out to be a very dynamic year for tax programs and tax credits. A good friend of mine has put together some helpful information you should look at which covers everything from what happens when you do a short sale on your home to deferring this year’s IRA distributions and the treatment of capital gains. By clicking on this link you will find this info.

Until next month we hope you have healthy and wealthy days.

Warm Regards

Colby McFadden


**The opinions expressed are those of Colby McFadden and Quiver Asset Management as of 9/1/09. These opinions are subject to change due to market and other conditions.