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Pullback Offers Great Chance for Quick Profit

Thursday, 16 Jun 2011 12:50 PM

When I wrote my mid-March blog, markets had corrected about 5 percent from their highs and investors were running scared due to a plethora of bad news — but especially because Japan had suffered a major natural disaster.

At that moment, markets had become short-term oversold and I advised: "don’t fall prey to the fear and use these sell-offs as opportunities to buy quality stocks that are undervalued."

From then onward, the market rallied until the beginning of May.

This time, the downdraft in stocks has been caused by nonstop negative news and disappointing macro data that point to sluggish — or even negative — GDP growth for the United States. As of late, the "Greek tragedy" has added to the bad stream of news as a probable default of the country and risks of contagion chill investors.

Markets have once again reached a short-term oversold condition amid media talk of a double-dip recession and that a new bear market is about to begin.

Technically, we have reached deeper oversold conditions than the pullback we had last March. The S&P 500 has fallen about 7 percent from its highs and has fallen for six consecutive weeks. Only 7.8 percent of the stocks that make up this index are trading above their 20-day moving average (markets tend to bottom when this indicator reaches 10 percent) and the equity put/call ratio has reached a bearish extreme only seen during the crash of the 2008 financial crisis and the May 2010 market flash crash.

Also with the current pullback, most world indexes have fallen toward their 150-day or 200-day moving averages, which still signal a general upward trend and should be strong support zones if buyers emerge.

Based on these conditions, I must advocate to once again "don’t fall prey to the fear and use these sell-offs as opportunities to buy quality stocks that are undervalued."

This is especially true if you are a short-term trader or a value investor. There are good opportunities right now for those types of traders.

Hopefully, the market will stop its fall and good rewards will be reaped for those who face the fear and use it to their favor and buy the market dip.

However, this time I must confess that in a medium-term perspective, my outlook isn't as positive for the equity markets.

During the last three months, we have observed deterioration in the U.S. economic data and other developed economies. Developed economies have mostly buoyed economic growth since the 2008 financial crisis based on aggressive deficit spending and easy monetary policies with programs like "quantitative easing."

In the case of the United States, deficit spending growth has maxed out (due to a staggering public debt that has reached 98 percent of GDP) and has started to slightly contract. However, this slight contraction in fiscal spending has been felt in the economy, where the private sector remains weakened and can’t support a self-sustaining recovery. The current fiscal deficit makes up around 10 percent of GDP and as the government has cut spending, economic data and GDP growth started to rapidly slow down.

From now onward, fiscal spending will probably remain very high but decreasing over time and won't be a growth engine going forward.

Based on these assumptions, the rosy forecasts for a 3.5 percent GDP growth this year for the U.S. economy won’t be met.

First-quarter GDP grew by only 1.8 percent while economists expected more than 3 percent. This quarter, they also expect around 3 percent growth but the macro data has been even worse than the first quarter so GDP growth will probably be even lower and the economists will be disappointed.

Slow GDP growth below expectations is a big negative for equities. There is also evidence that earnings growth and profit margins have peaked for U.S. companies, another negative.

Another factor that doesn't bode well for stocks going forward is that by the end of June, the Federal Reserve will complete its second round of quantitative easing. Studies have shown a powerful correlation between the size of the Federal Reserve’s balance sheet and the behavior of equities during the last two and a half years.

Now that liquidity will stop being pumped into the markets, a huge tailwind for equities and commodities will be lost. Also, the by the end of June, the Federal Reserve will have purchased about 36 percent of debt issued since the start of quantitative easing. Without the Federal Reserve as an important debt buyer, the government will have a harder time to continue stimulating the economy with deficit spending as interest rates will most probably rise.

Due to oversold conditions, technical aspects and bearish sentiment, I am short-term bullish and a rally is in the cards.

Medium term, I would expect weaker markets going forward unless the economic recovery finds firmer footing and is self sustaining and /or the Federal Reserve initiates a third round of quantitative easing.

About the Author: Victor Riesco
Victor Riesco, a financial analyst and trader in Santiago, Chile, works as an independent adviser and educator and operates a brokerage and trading business for local investors. Click Here to read more of his articles.

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When I wrote my mid-March blog, markets had corrected about 5 percent from their highs and investors were running scared due to a plethora of bad news but especially because Japan had suffered a major natural disaster. At that moment, markets had become short-term...
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2011-50-16
Thursday, 16 Jun 2011 12:50 PM
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