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Clash of the Titans: Buy on Fear, Sell on Greed

Thursday, 23 September 2010 07:11 AM

After the steep sell off in May, the S&P 500 has remained in a volatile trading range between 1,040 and 1,130, where strong opposing forces play tug of war with the market in a risk-on, risk-off trading pattern.

Here I will outline the forces that currently battle to control the market´s direction and explain its current behavior.

A key factor that negatively affects the market is that the U.S economy is slowing down.

In my opinion, we will enter a period of extended slow or negative growth. We witnessed a sharp boost in GDP during 2009 and early 2010, product of the massive stimulus package that consisted in tax credits, unemployment benefits and a soaring fiscal deficit that reached 12 percent of GDP.

Now that government expenditures have leveled off, a variety of economic indicators are showing signs of contraction. Contrary as proposed by some famous economists, we can’t rely on the economy to grow on more fiscal stimulus.

The U.S government can’t afford to keep expanding its debt unless it wants to run into fiscal-solvency problems. Remember that unlike Japan, where  most of the debt is domestically owned, the U.S government debt is largely held by foreigners. If foreigners perceive rising credit risk in their Treasury holdings (a product of the gargantuan deficits the government is running), they will enforce fiscal austerity by selling their bonds producing higher yields.

On the other hand, the private sector is still weak and deleveraging from a massive credit bubble that reached its peak in 2007. The consumer is suffering from credit contraction and thus won’t be able to spend as they once did.

Since consumption is about 70 percent of the U.S economy, a consumer that is paying down their debts and has limited access to credit isn't a growth factor. Despite the efforts of the Federal Reserve to force credit expansion via quantitative easing and zero interest-rate policies, the private sector shuns debt and banks are implementing tighter lending standards.

Also, the same quantitative easing programs and zero interest-rate policies are destroying capital formation in the economy, which is needed to produce new investment and foster businesses. Coupled with that, the mass liquidity produced by these monetary policies produces rising prices of commodities, food and oil, which further hinders the consumer´s ability to spend.

Despite all that gloom and doom, you might wonder, why is the market holding up and currently enjoying a powerful rally during September? The strong market forces that push the market up are negative investor sentiment and easy money policies.

Investor sentiment is a contrarian indicator and a high number of bears are fuel for a stock-market rally. During the last months, we have observed very negative investor sentiment, comparable to the peak of the financial crisis.

Investors are afraid of stocks and have been pulling money out of mutual funds and piling into Treasury bonds for 20 consecutive weeks.

This bearishness, coupled with the easy monetary policies put in place by central banks around the world, generate the conditions for sharp and powerful rallies when economic data is bad, but better than expected. High liquidity seeks yields and thus flows into risky assets when they become oversold.

I believe that unless something extraordinary happens, the market will remain clashed between the outlined forces and savvy traders that buy fear and sell greed can make a profit.

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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After the steep sell off in May, the S P 500 has remained in a volatile trading range between 1,040 and 1,130, where strong opposing forces play tug of war with the market in a risk-on, risk-off trading pattern. Here I will outline the forces that currently battle to...
Thursday, 23 September 2010 07:11 AM
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