Key tests of market psychology

OK I was wrong about NFP on Friday (see Take the "under" in the NFP sweepstakes) and, as someone with a tactical bullish view, I was also disappointed with the stock market's reaction as it sold off after the announcement in the morning. Nevertheless, my Inflation-Deflation Timer Model moved to an "asset inflation" reading from "neutral" early last week indicating a risk-on environment.

After reviewing the charts on the weekend, I would cautiously agree. While I remain cautiously bullish, I am also closely watching how the market reacts to a couple of key events to see how the market reacts.

First of all, let's start with the bull case. While chartists were watching the SPX to see if it would overcome resistance, I am seeing signs of technical breakouts indicating a Santa Claus rally may be on the way.

By contrast, the broader NYSE Composite has already staged an minor upside breakout, though there is still overhead technical resistance at the 2012 highs. Similarly, the Dow (not shown) has also staged an upside breakout - another bullish sign.

The SPY (stocks) to TLT (default-free long Treasury bonds) ratio, which is a measure of the risk-on/risk-off trade, also staged a minor upside breakout.

Cyclical stocks continue to behave well, as the ratio of the Morgan Stanley Cyclical Index (CYC) to the market remains in a relative uptrend.

A tour around the world
Most other major stock indices around the world also had bullish technicals. Across the Pacific, in Hong Kong, the Hang Seng Index has staged an upside breakout in the context of an uptrend.

The outlook for China can be best termed as cautiously optimistic. The Shanghai Composite has been rallying in the last week to test downtrend resistance. If the index can overcome the downtrend line, it would represent another technical win for the bulls.

Next door in South Korea, where China is its largest trading partner, the technical pattern of the KOSPI can similarly be termed cautiously optimistic. KOSPI has been rallying since mid-November and at this rate will be encountering technical resistance - much like the pattern of US equities like the SPX.

Over in Europe, the STOXX 600 has staged an upside breakout. While other indices, such as the FTSE 100 and the Euro STOXX 50, are still testing their resistance levels, this development must still be regarded as bullish.

Key tests of market psychology
On the other hand, the news of Mario Monti's resignation and Silvio Berlusconi seeking to return to power may unsettle the markets. One of the key upcoming tests of market psychology will be how Mr. Market reacts. Has the actions of the ECB to largely eliminate tail risk cause the markets to shrug this off? Or will this news cause a major selloff?

Another catalyst for a major move may be the FOMC meeting Wednesday, where Tim Duy's views are typical of the consensus that the Fed will add further stimulus as Operation Twist runs out [emphasis added]:

The employment report offered me no reason to change my baseline opinion that the US economy continues to grow at a slow, steady pace regardless of the quarterly fluctuations we see in GDP growth. Indeed, there seems to be little news in November's numbers. This is good news in the sense that fears that the economy is slipping toward stall speed in the final quarter of the year is not yet translating into weaker job growth. The same is true for fears of the fiscal cliff, debt cliff, austerity bomb, etc. The bad news is that we are not seeing the 200k+ numbers that the Fed is leaning towards as evidence of stronger and sustainable improvement in the labor market. That means the Fed will continue to add to its stock of assets, converting most if not all of Operation Twist into an outright purchase program next week.

As another example of market expectations, here's what Bill McBride of Calculated Risk had to say:

I expect the FOMC to announce additional asset purchases at the meeting this week (to start at the conclusion of Operation Twist). It seems the FOMC will move to thresholds, but probably not until next year. On projections, I expect GDP to be revised down for 2013, and the unemployment rate to be revised lower for 2013 and 2014.

Watch the Fed news Wednesday and see how the market reacts.


How to grade the market psychology test
In summary, I am seeing technical signs that stock markets around the world are poised for a Santa Claus rally, though the markets need to show more technical strength in the days ahead. For the bullish case to prevail, we need to see technical confirmation in the form of further upside breakouts in major stock indices around the world and follow-up in the form of positive price momentum. The key is to watch how the market behaves in the next few days as tests of market psychology:

• Will the market shrug off the Monti resignation or will it panic?
• Can the Shanghai Composite stage an upside breakout through its downtrend?
• What will the Fed do Wednesday and how will the market react?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.