Stock Market Disquieting Underlying Technical Deterioration

By: Peter_Navarro

Here's the lowdown on last week's action from Marketedge: “Stocks continued to march higher last week as both the DJIA and the NASDAQ posted modest gains for the period.… The technical condition of the market was mixed last week as the CTI lost a couple of points, there was considerable deterioration in the Strength Indexes but the Momentum Index remained strong." Translation: The upward trend remains intact but there's some disquieting underlying technical deterioration that we must take note of.

On the fundamental front, virtually all economic leading indicators are pointing towards a slow growth scenario over the next 12 months, in the range of 2% real GDP growth, which is significantly below our potential output of about 3% to 3.5%. If this forecast holds true, unemployment will remain high, income will remain stagnant, and it is unlikely that consumption will help pull the economy up to full and steady growth.

As for why the stock market is rallying on this lukewarm news, the most likely scenario here is that the market’s upward trend is more an illusion than reality once one discounts for the rapid, recent decline in the dollar.

It's a salacious little menage a trios we have goin gon: The Federal Reserve keeps short-term interest rates low and engages in quantitative easing to lower long-term interest rates and thereby turns on the monetary printing press. The increase in the money supply drives down the value of the dollar. Meanwhile, the Smart Money borrows money at low interest rates and buys stocks, with a heavy skew towards energy and commodity-based stocks which will hold their value through price appreciation as the dollar falls.

In other words, pierce this veil and you see that there's nothing really going on fundamentally to suggest a strengthening economy. Rather, it is more a house of mirrors from the Federal Reserve.

On that note, I used to think that Ben Bernanke was a very smart guy doing a very dumb thing by printing endless reams of money at

the Federal Reserve. Maybe he is just Machiavelli. Could this latest move with QE2 and a cheapening of the dollar simply be Beggar Thy Neighbor Ben’s way of stimulating our economy via exports and putting more pressure on the Chinese to let their currency float? Smart or dumb, Ben Bernanke is playing a very risky game.

So what does all this mean for traders and investors? For traders, there remain opportunities for short-term trading with the upward bullish trend – but be careful, as the technical indicators are suggesting softening. For investors, despite the upward trend of the market, I remain nervous about fully deploying cash into this market.

Finally, I have to talk (brag?) a little bit about TBT. After lamenting several weeks ago that this has been one of my worst trades – so far – I also indicated that I wasn't really worried about being in the red and that I had adopted a modified "double down" strategy that has involved adding to the position every time TBT (which shorts the long bond) went down.

Last week, that strategy finally paid off as TBT made a nice upward move and put the trade back into the green. The move was all the more amazing in the light of repeated announcements by the Federal Reserve that it would engage in more quantitative easing, which should push long-term bond yields down and prices up and further push TBT down. However, that didn't happen, and the reason I think goes back to the issue of the impact of a falling dollar on the inflation rate and an eventual bursting of the current bond market bubble. So I continue to like the TBT trade. Let's see where it goes.

I opened new positions in several rare earth stocks based on China's export restrictions on its supply – China is the OPEC of rare earths. (See my video about this at TheStreet.com.) This is strictly very high risk, penny stock stuff; and I run the risk of buying late in the run so I am only buying small positions and will only add them as the trade moves in my favor. So far, I have opened small positions in ARAFF, GWMGF, and LYSCF. (I purposely stayed away from Molycorp as it is way too expensive.) (If any readers have any thoughts on the rare earths stock plays, I'd love to hear from you.)

I also opened up a new position in FEED based simply on technical considerations – this is an agricultural play in China.

Stocks that I am long:

CYB,DTV,DUSA,GTXO,HOV,LPTN,MDVN,NRGX,QTWW,SVMI,SNT,SBOTF,TEVA,VVUS

Stocks I am short: GME.

Updates: I cashed out both DEPO and SNTA with very nice gains -- no news in the nearer midterm future to propel them much higher. I took a small loss in SOMX – a bad trade where i got sucked into a parabolic move. I also significantly trimmed my very large position in SNT – I still have faith in it but will only add back to this position as it moves up, which looks like it will take a long while.

Last take: I haven't mentioned previously my long position in DTV. This is kind of like a "Peter Lynch" play – the famous mutual fund manager who used to get his ideas from talking to his children about what they saw at the mall. I'm just seeing a lot of satellite dishes going up.

Navarro on TheStreet.com

Click here to review my videos on TheStreet.com.
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Professor Navarro’s articles have appeared in a wide range of publications, from Business Week, the Los Angeles Times, New York Times and Wall Street Journal to the Harvard Business Review, the MIT Sloan Management Review, and the Journal of Business. His free weekly newsletter is published at www.PeterNavarro.com.

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