Markets at Inflection Point : Volatility Continues as Investors Long for Government Intervention

October 7th, 2011:

The real economy continues to limp along as illustrated by the broad unemployment rate, which has not budged lower since the official end of the great recession in June 2009. The markets are gyrating as investors long for government intervention.

Meanwhile, governments are obliging the market by leaking potential tactics and responding to the reaction these leaks evoke. In reality, governments’ hands are tied by an electorate that no longer accepts the idea of socializing the losses and protecting private investors at all costs. Witness the elections in Germany and the Occupy Wall Street protests in New York. Social unrest is increasing as living conditions for the average person have not improved. Stock markets are therefore following the credit markets, having recognized that pain from upcoming defaults will most likely be borne by private investors and not governments.

As always, the only two certainties in life are death and taxes. Death to bailouts is now a given, as are more taxes given the unsustainable deficit level. Combine these high deficits with record high corporate profits and even the Republicans are talking about raising government revenues, albeit by cutting corporate deductions.

So where does this leave the stock market? The real economy is far better off with lower commodity prices and a strengthening U.S. dollar. Yet these days, the stock market gets much of its earnings growth from the weakening U.S. dollar. The market continues to be quite volatile and finally set a new low below 1100 on the Standard & Poor’s 500 Index, only to swiftly rally up to the 20-day moving average of 1163. The 50-day moving average of 1178 is also quite close, and the rapid move higher has brought back optimism and eliminated the oversold condition.

Thus we find ourselves at another inflection point. The market could rally above the 20-day and 50-day moving averages, followed by the 20-day moving average rising above the 50-day moving average. This bullish scenario would set the stage for a potential year-end rally, even with a Greek default. The other scenario is not so rosy. If the market fails at these important moving averages, as it has previously, a move sharply lower should be expected. Volumes on down days are far greater than on up days, so there is probably another leg down and a Greek default to occur before a firm bottom can be established this year.

We are now in the fourth quarter and, just like a football game, each decision becomes more important and more stressful as the clock runs out to correct losses on the year. Any moves lower will surely lead to a new VIX high on the year because deleveraging will continue. This market is run by traders and not investors.

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