The Fed Versus The Business Cycle

Morgan Stanley economist Stephen Roach's insightful testimony to the Senate Banking Committee last week about the relationship of the current economic downturn to the 1998 global downturn struck a chord with us.

Structurally, there are patterns in a couple of major stock indexes - most notably the S&P 500 and the Philadelphia Bank Index - that seem to support Roach's observation.

The S&P 500 is forming an almost perfect rounding top off the October 1998 lows, and turned back at the boundary of that pattern at 1209 yesterday. The index has at most another month before it will have to break down or out of that pattern. A move above 1225 would be a positive, because it would clear the tightest rendering of that pattern and set a higher high for the index.

But it is the banking index that is the most interesting pattern. The BKX appears to be forming a huge rising wedge off the October 1998 lows (see chart below). A rising wedge is bearish because it implies a weak rally - and projects an eventual complete retracement of the ground gained within the pattern, if not more than that. That pattern is a long way from breaking down, but we have to wonder if it doesn't imply some sort of structural problem within the banking system - perhaps just too much debt or bad credit created in the Fed liquidity pumping of 1998-1999 - that could eventually make for a harder than expected landing for the economy.

April 1998 was an important top for the NYSE advance-decline line, meaning that most stocks put in important tops then.

Which leads us to the bigger question: Is there some natural business cycle slowdown that has been trying to occur since 1998 that the Federal Reserve is trying to forestall with rate cuts and liquidity injections? According to some, the answer is yes.

First, some have the Kondratieff business cycle at or near the end of a long period of deflationary growth, which could make the next period one of depression. While we first mentioned the risk of deflation several months ago, we would take the view at this point that the risk of inflation is probably equal. Why? Because Federal Reserve liquidity injections continue at record levels, including a whopping $32 billion last week. It is almost as if the Fed wants to spark inflation. The troubling aspect of last week's pumping is that it had little effect on the stock market, unlike the Y2K liquidity injections of late 1999.

In a recent article in Barron's, P.Q. Wall wrote that the Dow may have already peaked under the basic Kitchin cycle, but also said that the index could surprise and go on to new highs in the September-January timeframe. And Chris Carolan, whose Spiral Calendar predicts market turns years in advance, has December 14 as the final bull market high. Carolan's cycle could invert and become a low, however, as it has on occasion in the past.

And finally, we would be remiss if we did not say here that most market technicians seem to be leaning toward a surprising rally coming in the stock market soon, based largely on the appearance of a bullish falling wedge in the Nasdaq indexes (see Nasdaq 100 chart below). That pattern could carry the Nasdaq to the 2300-2600 level.

That rally is definitely possible. However, it would have to come without the commercial traders, who remain short this market, a big warning sign that the smart money is not behind this market. And Microsoft is breaking down out of a bearish rising wedge, which makes any Nasdaq rally scenario difficult. Microsoft could negate that pattern with a strong upside break, but a strong move down for Microsoft in the near future is more likely. And finally, we continue to believe that the August 6-9 period is crucial for the market, due to the convergence of several important cycles. Whichever way the market turns in that timeframe could be the trend for two months or more. If the bulls are going to surprise, that would be the window for them to do it in, but it is also a period of high risk for the market.