U.S. Stock Market: FOMC, ZIRP, Alibaba, Scotland, and Other Related Topics

If you were fully invested in the U.S. stock market to begin the week last week, you were treated to the best of all worlds in terms of news that could impact equity prices:

1. At this past week's FOMC meeting, the Federal Reserve maintained its Zero Interest Rate Policy (ZIRP) and kept market-friendly language (ZIRP "for a considerable time") despite hints in recent speeches by several Fed governors that maybe interest rates might be raised sooner than most Fed watchers expected.

2. The largest IPO in history, Alibaba, was extremely well received. The Company's $21.8 billion offering was priced at the high end of its expected range ($68/share), and it still managed to post a 38% gain in its first day of trading on the NYSE (closing at $93.89/share).

3. Scottish voters said "NO" to a referendum seeking Independence from the United Kingdom for Scotland. The final vote count was 55% NO versus 45% YES. 

There were many other positives for U.S. stock market investors this past week, but these were probably the biggest three potential market moving events.

So what actually happened to share prices? How did U.S. stock market investors react after getting EVERYTHING they wanted (and needed to hear)?

If you look at the Dow Jones Industrial Average, it was a solid positive week for investors at +1.72%. However, on my screen the DJIA was the single best performing index while other closely watched benchmarks painted a different picture. The S&P 500 Index posted a decent gain of +1.25% on the week, but the Nasdaq Composite Index was barely positive at +0.27% on the week. And the Russell 2000 Index was actually DOWN 1.18% on the week. Incredibly, for the full week, declining issues outpaced advancing issues on both the NYSE and on Nasdaq. And there were actually significantly more new 52-week lows on the Nasdaq than new 52-week highs (232 vs 174, respectively). On Friday, September 19th, the DJIA closed "flat" while every other major index actually posted a loss on the day despite opening sharply higher in early morning NY dealings!

Yes, there was a lot happening last week. And yes, the news was mostly bullish for U.S. stock investors. However, stock prices were just mixed-to-mostly-lower, which should be of great concern to anyone who is fully invested. 

I think one particular story from last week did not get the attention it deserved. CALPERS, the largest pension fund in the U.S. with $300 billion under management, decided to exit its investments in hedge funds. CALPERS has $4 billion allocated to hedge funds, but after years of "underperformance" hedge funds maybe too complex and too costly according to CALPERS management. According to research from Wilshire, average annual public pension fund gains from hedge funds were just 3.6% for the 3-year period ending March 31, 2014 as compared to 10.9% from private-equity investments, 10.6% from stocks, and 5.7% from fixed-income investments. 

CALPERS is often on the leading edge of investment management trends and it began allocating pension money to hedge funds in 2002. How will CALPERS exit from hedge funds impact the overall U.S. stock market (if at all)? Let's do some back-of-the-envelope calculations, just for fun. It's already been reported that pension funds in Ohio and New Jersey are also retreating from hedge funds, so I don't think it's a stretch to conclude that many other pension funds will soon follow. So here we go! Let's use a conservative 10x multiple for CALPERS effect on the market place in this particular case. This means that $40 billion will be withdrawn from hedge funds as "copy cat" pension fund managers follow CALPERS lead. While I think this is a conservative number, we'll go with it for this example. And then let's say that the average hedge fund is leveraged 2 to 1 in stocks. This is a complete guess, of course, but I think these last two estimates are reasonable (if not conservative). So where does that leave us? CALPERS announcement that it will exit its $4 billion investment in hedge funds could conceivably lead to $40 billion of withdrawals from hedge funds by other pension fund managers which would then mean that hedge fund managers would then have to liquidate $80 billion in investments (most of which are in stocks). Like I said, these are back-of-the-envelope calculations, but I think they are very conservative. I actually think that hedge funds may have to liquidate more than $100 billion in stocks as pension funds follow CALPERS lead. Should be interesting!! In the interest of full disclosure, I currently have a significant short position in the S&P 500 Index using the double-short Pro Shares ETF (symbol SDS).

Here are the latest relevant charts from my computer trading system:

1. New York Composite Index - Daily chart sell signal triggered Friday, September 19th.

2. Dow Jones Transportation Average - Daily chart sell signal triggered Friday, September 19th.

3. Philadelphia Semiconductor Index (SOX) - Daily chart sell signal triggered Friday, September 19th.

4. Russell 2000 Index - Monthly chart sell signal triggered in July 2014, the first monthly chart sell signal since July 2007.

In addition to the sell signals on the charts below, daily chart sell signals were triggered at Friday's close in the following stocks and indexes: BKX, DJTA, NY Composite, SOX, IYT, ABAX, ABT, AIR, ALTR, AXP, BAC, BEN, BRCM, CB, CMC, DE, EMC, EQIX, JPM, KEY, KR, LL, LLY, LUV, MAR, MCHP, MMC, MS, PFE, PGR, QCOM, SNDK, SYK, TXN, UPS, and XLNX.

NY Composite Index Daily Chart with 200-day Moving Average Line & Computer-generated Buy & Sell Signals

Dow Jones Transportation Average Daily Chart with Computer-generated Buy & Sell Signals

Philadelphia Semiconductor Index (symbol SOX) Daily Chart with Computer-generated Buy & Sell Signals

Russell 2000 Index Monthly Chart with Computer-generated Buy & Sell Signals

U.S. Stock Market: Is Another Crash Like The One In 1987 Possible Here?

Of course, the answer is yes!

Certainly possible, but maybe not probable? Please note the question mark behind this last sentence.

In my view, the probability of a stock market crash like the one experienced in 1987 has risen dramatically in recent weeks. If there is a crash, here is the list of contributing factors that will be on the post-mortem:

1. Most investor groups are fully invested.

2. In fact, NYSE Margin Debt is now at a record high, which means that "fully invested" now translates into greater than 100% invested (with the leverage of margin debt).

3. Complacency among portfolio managers and individual investors is now at the highest levels since 1987 as measured by the latest Investors Intelligence sentiment survey.

4. Bullish investors are now "certain" that the so-called "Yellen Put" will protect them from any meaningful stock market decline. This reminds me of the so-called "portfolio insurance" madness in 1987, where many fully invested portfolio managers thought they could increase their normal allocation to stocks to dangerous unprecedented levels with the idea that on any correction they could quickly sell stock index futures to hedge and protect themselves. Of course, they never realized that the market would decline 36% over 55 calendar days and 23% in a SINGLE trading day. As was the case then in 1987, and is still the case now, when the proverbial "shit hits the fan", who will step in to catch the falling knives?

5. It doesn't matter whether or not Scotland votes in favor of independence on Thursday, September 18th. The "horses have already left the barn, and the barn doors are shut". The whole idea of independence for Scotland and a long list of other regions (i.e. Catalonia in Spain) is now out there and will result in the formation of many new independent nations over the next several years. The EU as we know it today will NOT survive. The economic and political chaos from this inevitable outcome is now only beginning to be realized by investors.

6. Investors have completely underestimated the potential ramifications of the ongoing crisis in Ukraine. Sanctions against Russia are already being ratcheted up by uninformed leadership across the EU and in here in the United States. However, President Putin of Russia clearly holds all the cards in this "battle", and his longer term objective is a Russian-controlled Ukraine. Yes, Putin has already won the "war" in Eastern Ukraine, but he won't stop there. Kiev is his ultimate goal, and I for one don't want to bet against him. And on his way to Kiev, the potential dislocations in the financial markets can not be understated.

7. Corporate share buybacks, the lifeblood of the U.S. stock market over the last five years, are waning and will no longer provide the necessary support for higher stock prices.

8. Corporate profit margins, now near record levels, will soon deteriorate rapidly as the U.S. economy falters in response to significant mistakes in U.S. fiscal and monetary policy that are about to unfold.

9. The U.S. Federal Reserve is about to telegraph a path to higher short-term interest rates (away from its current ZIRP). While I think this is a significant mistake (rates should remain near zero to meet the challenges immediately ahead), it won't be the first time that the Federal Reserve (and the U.S. Treasury) has made a critical blunder at a key time in the economic business cycle.

10. Monthly-chart sell signals have been triggered by my computer trading system in most major indexes for the first time since July 2007.

Russell 2000 Monthly Chart with Computer-generated Buy & Sell Signals

NY Composite Index Monthly Chart with Computer-generated Buy & Sell Signals

REIT Index (IYR) Monthly Chart with Computer-generated Buy & Sell Signals

Google (GOOG) Weekly Chart with Computer-generated Buy & Sell Signals

Philadelphia Semiconductor Index (SOX) Weekly Chart with Computer-generated Buy & Sell Signals

Merck (MRK) Weekly Chart with Computer-generated Buy & Sell Signals