The Most Important Chart on Wall Street

Better Economic Data And New Highs In Stocks

The most recent read on the U.S. economy was released before the fireworks began in the USA. From Fox News:

Last month, employers added 288,000 jobs and helped reduce the unemployment rate to 6.1 percent, the lowest since September 2008. June capped a five-month stretch of 200,000-plus job gains -- the first in nearly 15 years. After having shrunk at a 2.9 percent annual rate from January through March -- largely because of a brutal winter -- the U.S. economy is expected to grow at a healthy 3 percent pace the rest of the year.

After the labor report was released, the S&P 500 pushed to a new high. Since stocks continue to surprise to the upside, it is prudent to take a step back and ask:

"Has something changed from a longer-term perspective?"

We can answer that question by taking a holiday weekend investment quiz.

Hypothetical Investment Quiz

As outlined on May 14, investment bias can make it difficult for us to properly interpret fundamental and technical data. Therefore, a hypothetical investment quiz provides a method to reduce "context bias". Assume:

1. The daily chart of the S&P 500 below shows a 16-day period that occurred sometime in the last 40 years.
2. The period was marked by mixed economic messages; some reports in recent weeks had been favorable and some were disappointing.
3. The market was also anticipating an important Federal Reserve statement.

If we were given the historical context and chart above and then asked the following question on a generic investment exam:

"When the market breaks above previous resistance in the chart above (see red arrows), it tends to lean which way from a probability perspective?"

A. Bullish
B. Bearish

Experienced investors and traders would see the quiz question above and think "this one is easy" and quickly choose bullish and move on to the next question.

The Same Question In Today's Fundamental Context

The last 16 years have been a mixed bag economically; we have experienced economic booms and contractions. The chart from our hypothetical 16-day quiz is actually the present day chart of the S&P 500 looking back to 1997.

If we were asked the following question on a generic investment exam:

"When the market breaks above previous resistance in the chart above (see red arrows), it tends to lean which way from a probability perspective?"

A. Bullish
B. Bearish

The answer is once again easy and bullish. Breakouts can fail, but for now investment odds remain favorable based on the chart above.

It Is Hard To Argue With A 16-Year 'Major Fundamental Change'

Why should investors respect the stock market's recent breakout above a 16-year consolidation pattern? The answer is summed up nicely in George Kleinman's book Breakthrough Strategies For Capturing Market Profits:

"The longer it takes to form a consolidation, the more significant the breakout and the bigger the expected move to follow. A breakout on a daily chart is more powerful than a 30-minute chart, and a breakout on a weekly chart is even more powerful. A breakout from consolidation on a yearly chart is the most powerful, signifying a major fundamental change in the supply-and-demand balance of the market."

What Has Changed Fundamentally (2011-2014)?

Ultimately, only the market knows the answer to the question above. However, we can throw out some plausible ideas:

1. The perception of stability in the global financial system has improved dramatically since late 2011.
2. The market is anticipating a period marked by recessions that are less severe relative to the dot-com bust and 2008 financial crisis.
3. The market is anticipating a period of improved financial and economic stability; slow growth is better than any crisis.

'Whatever It Takes' To Avoid A Major Accident

In late 2011, the European Central Bank (ECB) announced the availability of unlimited three year loans to European banks, which was a significant turning point on the systemic fear front. From a March 2012 Wall Street Journal article:

The European Central Bank handed out €529.5 billion ($712.81 billion) in cheap, three-year loans to 800 lenders, the central bank's latest effort to arrest a financial crisis now entering its third year. Wednesday's loans were on top of the €489.2 billion of similar loans the ECB dispensed to 523 banks in late December. The ECB's goal is to help struggling banks pay off maturing debts and to coax them to lend to strained governments and customers. The takeup of this week's loans was roughly consistent with what bankers, investors and analysts had expected.

Later in the year, Mario Draghi made a game-changing statement for European (EFA) and global equities (VEA). From a July 26, 2012 Bloomberg story:

"To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate," Draghi said in a speech at the Global Investment Conference in London today. "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro," he said, adding: "believe me, it will be enough."

More Evidence of Fundamental Improvement

Is there other evidence that aligns with the market's perception that "things are getting better economically?" Yes, this week's stock market outlook video covers a handful of July 2014 chart patterns that paint a bullish picture for the economy and financial markets (from a probability perspective):

This Is All Just About The Fed, Right?

It is never just about any one thing in the markets, including the Fed. However, there is no denying the Fed and ECB have played and continue to play major roles in the rally in risk assets. The Fed and ECB are part of the markets. The Fed has been impacting the markets long before most of us were born and they will be doing so long after we are dead. The point is any investment plan has to account for the Fed's impact. If you are frustrated with the markets, consider building a system to answer the two most important questions, allowing you to handle markets that rally much longer than expected due to the Fed's easy money policies.

Investment Implications

The recent gains in the stock market were foreshadowed almost a month ago. On June 8 in The Bulls Are Winning The Battle Of Indecisiveness, we showed observable shifts illustrating an improving climate for stocks relative to bonds. Until the evidence shifts back toward the risk-off camp, we will continue to hold U.S. stocks (SPY), and leading sectors, such as technology (QQQ). Our market model, which allocates based on hard data, has been incrementally reducing our bond exposure in recent months. As of Thursday's close, we no longer have any exposure to longer-dated U.S. Treasuries (TLT). We will enter next week with a flexible and open mind about both bullish and bearish outcomes.