Markets moved quickly after Federal Reserve Chairman Ben Bernanke indicated QE would end one day. That move left stocks oversold and ready to rebound.
Bernanke Might Be Too Optimistic
SPDR S&P 500 (SPY) fell from about $165 on Wednesday to close the week at $159.07. The down move began when the Fed chairman held a press conference. Offering a hypothetical example, Bernanke said that the Fed could begin decreasing its purchases of $85 billion a month in bonds later this year and stop buying next year if the economy improves.
Without any evidence that the economy is improving, SPY dropped more than 4% and the Dow Jones Industrial Average grabbed headlines with a fall of more than 500 points in two days. This drop occurred without any fundamental change in Fed policy, the economy or anything else. It is likely that stock prices will rally in the week ahead.
For the week, SPY closed down 2.52% and is now 5.91% below its all-time high set about one month ago on May 22.
The New York Times editorial page offered a more measured reaction than traders did to the opinion that the Fed has become optimistic about economic growth, noting "the Fed's underlying optimism is hard to fathom. There haven't been any compelling improvements in the economy since late last year."
Bernanke indicated that QE would end when the unemployment rate fell to 7%. It is currently at 7.6%. This decline is possible if the economy grows as the Fed expects, but its forecasts are well above the consensus of private economists.
The Fed expects GDP growth of 3% to 3.5% in 2014. According to Bloomberg, private sector economists expect growth of 2.7% next year. Growth has not topped 3% on an annual basis since the summer of 2006. If growth fails to meet expectations, Bernanke said in his press conference that the Fed would continue supporting the economy as long as necessary.
To illustrate how optimistic the Fed is, a chart from Wells Fargo's economic research team is shown below. The Fed's forecast for GDP growth (blue bars) is significantly above the recent pace of growth.
If we continue to see weak economic data, traders may rush back into stocks as quickly as they sold last week after they realize that QE may continue for quite some time.
In the short term, SPY is now oversold. Bollinger %B is included in the chart below. This indicator shows where the close is relative to the Bollinger Bands. When %B is below 0, the price is below the lower Band and is oversold.
In the week after %B falls below 0, SPY has gained an average of 3.51%. Over the past five years, this buy signal has occurred about six times a year.
Testing also shows that after a 4% loss in three days, SPY gains an average of 4.58% in the next week. After being stopped out of a long position last week, odds favor a rebound this week in SPY and a long trade could take advantage of that tendency.
Recommended Trade Setup:
-- Buy SPY at the market price
-- Place stop-loss 4% below entry price
-- Set profit target 4% above entry price and exit at the close on Friday if that is not reached
Gold is Also Oversold
The specific trade that I recommended was in ProShares Ultra Gold (UGL), a leveraged fund that should move twice as much as gold on any trading day. UGL fell 13.72% last week. If you had entered the trade on Tuesday's open and exited with the suggested stop-loss of $54, the loss would have been 3.09% and the trade would have been exited on Wednesday before the large decline.
Many traders are reluctant to enter a trade quickly after a stop-loss is triggered. But GLD is deeply oversold, and in the past, long trades have been successful from this level.
In the chart above, the lower Bollinger Band is 3 standard deviations below the moving average. In theory, prices should fall below this level only 0.14% of the time. This rare setup has occurred only five other times since GLD began trading and GLD was up one week later after four of those signals.
There have been 29 times when gold futures closed more than 3 standard deviations below their moving average since 1976, and 62.1% of those signals were profitable after one week.
Another reason to buy is because GLD has rebounded 83% of the time after a large loss like it experienced last week. There are only six previous examples of a loss like that, so this is not a statistically reliable signal, but it does confirm that a rally is likely.
This Week's News
Last week, the Fed hinted that QE could end when the economic data show improvement. This week, two key numbers come out that could help traders evaluate the strength of the recovery.
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