SENSEX Outperforms Asian Peers as Confidence Returns

Benchmark Indian indices have outperformed their Asian peers like Shanghai Composite SE (China), KOSPI (South Korea), Strait Times (Singapore, etc. Even when compared with Dow and Nikkei, the Sensex has fared better. The gap in valuations has narrowed down with its emerging market peers, while the same widened for developed market peers.

The trend reflects the growing investor confidence, and analysts feel, if the Sensex continues to outperform Asian peers, it may soon become the biggest index in the continent.

Analysts feel a higher level of confidence in the Indian market compared with other global markets has enabled the Sensex see a smart recovery. VVLN Sastry of Firstcall India Equity Advisors says, "Among emerging markets, the foreign investors have more faith in the strength of Indian market compared with the Chinese market and as a result, have given it a higher rating."

Interestingly, Indian indices' main rivals, the Chiinese indices, are month the worst performers. China has been, of late, facing the problem of overcapacity. As many facilities are being shut down in the absence of proper demand, foreign investors are cautious in making fresh investments. They also fear artificial weakening of the Chinese currency yuan. Mr. Sastry said, "Fear of any sudden fall in the yuan has decreased the inflow of foreign investment in china in the recent months."

Source: September 23, 2009 Economic Times, India.

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- Sanjeet Parab

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Mind, Intellect and the Choices you Make

We have two distinct entities: the mind and the intellect. The mind is the realm of emotions, impulses, likes and dislikes. The intellect is the rational, discriminating faculty. The intellect judges, discerns and distinguishes between pairs of opposites. Our actions can be driven by whims and fancies of the mind or by the clear counsel of the intellect. Impulse-led actions are weak; they lead to failure. actions propelled by the intellect take one to success. Often the mind and intellect point in different directions. The mind might go for instant gratification. The intellect might prefer short-term pain for long-term gain. Whenever there is conflict between the two it is the intellect that ought to prevail.

- Jaya Row. Visit http://www.vedantavision.com 

Source: September 10, 2009 Times of India

Don't forget to visit the Technical Analysis Base Website at http://www.technicalanalysisbase.com and blog at http://technicalanalysisbase.blogspot.com

-Sanjeet Parab

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DJIA Corrective Pattern...Recovery? So, Buy & Hold?

We witnessed six green days in the market with the market rallying 791 points (~9.8%) from its July 10, 2009 low of 8,057 to today's close of 8,848.

1. As I showed in my June 29, 2009 DJIA Forecast, the first wave is over and we are in the corrective phase of the wave cycle. So does the recent rally mean that the corrective phase is over?


2. Does it reinforce any beliefs of a V-shaped recovery?
   
3. Can you adopt the buy-and-hold strategy and passively watch your portfolio grow?

IS THE CORRECTIVE PHASE OVER? DOES THE RECENT 6 DAY RALLY SIGNAL THE BEGINNING OF A NEW IMPULSE?

I don't know if the corrective phase is over? The only time an Elliotician can call an end to a corrective phase is when a clear impulsive wave begins to form. Perhaps the correction is over because I see a simple A-B-C zigzag (Refer to Figure 1).

Supporting the idea of a continuing rally is the continuation H&S pattern. Clearly, the traditional H&S has failed as shown by the failed breakdown below the neckline. This signals a rally possibly of equal lenght as the rally from March 6 - June 11.

However, the three wave pattern identified as A-B-C may be the 3 wave in the 3-3-5 flat correction. Assuming that the fundamentals are still not improving, then a flat correction is in process (Refer to lower panel in Figure 1) and the recent 6 day rally is merely a corrective rally. The current move may have the momentum to carry the DJIA to 9,021-9,043 (max ~9,088).

Supporting the flat correction is the idea of complex H&S pattern. Two shoulders are evident on the left. Complex H&S patterns tend toward symmetry. Therefore, the recent rally (Wave B of the flat correction) may be forming the second right shoulder.

Figure





V-SHAPED RECOVERY

There are a number of people writing about this topic. I'll just present to you some articles that possibly support a U-shaped recovery. With the possibility of a flat correction identified above, a U-shaped recovery is more likely. That does not mean that traders cannot profit during this whole corrective phase. Will look into how traders can profit in the next segment on Buy & Hold.


Banks Fail to Make Adequate Loan Loss Provisions

By Jon Menon

July 20 (Bloomberg) -- Banks have failed to make adequate provision for the losses on loans and securities they face before the end of next year, Moody’s Investors Service said.


U.S. banks may incur about $470 billion of losses and writedowns by the end of 2010, which may cause the banks to be unprofitable in the period, the ratings company said in a report published

“Large loan losses have yet to be recognized in the banking system,” Moody’s said. “We expect to see rising provisioning needs well into 2010.”

Banks and financial firms worldwide have reported losses and writedowns of $1.5 trillion since the credit crisis began in 2007, according to data compiled by Bloomberg. New York-based Citigroup Inc. has reported $112 billion of writedowns, more than any other firm, the data show.

Any economic recovery is likely to be “weak and bumpy hook-shaped,” Moody’s said. Banks will also be challenged in an environment where government support is replaced by tighter regulation, the report said. Higher credit and funding costs may force a re-pricing of credit, Moody’s added.

“The fundamentals of financial institutions are still traveling on a downward slope,” Moody’s said. “No-one should consider recent improvements as assurance that the current rebound can be sustained.”


The Worrying Wall of Debt

The leveraged loan market got accustomed to big numbers over the past decade. There's $3.6 trillion, the amount of leveraged loans made since 2000, according to Thomson Reuters' Loan Pricing Corp. There's 735-fold, the amount of growth between 2003 and 2007 in the volume of collateralized loan obligations -- the funds that helped fuel the loan market's surge after the tech and telecom bust of 2001. And there's $375 billion, the amount of bank debt used to fund leveraged buyouts completed between 2005 and 2007.

But right now, the leveraged loan market is fixated on one number: $430 billion, the amount in leveraged loans due to mature between 2012 and 2014. Despite the big numbers of the past, this might be simply too big. Indeed, the $430 billion figure is already worrying lenders, borrowers and loan-market investors alike as they struggle with the possibility that a large portion of those loans will neither be repaid nor refinanced, raising the specter of a wave of defaults among the debt-fueled LBO borrowers of 2005 through 2007.

Click Here to read the entire article


SO WHAT DO YOU DO NOW? BUY AND HOLD?

January 6, 2009 Low: 8,868
July 20, 2009 Close: 8,848

Your portfolio is still in the red (solely considering capital appreciation). You would have missed the 27% correction from Jan 6 and the subsequent 35+% rally from March 6 lows - June 11.

I'm certainly not tell you to time the market. But, rather than being 20 points low for the 7 month period, you could have done well to trade the market and eke out some magnificent gains. You define what magnificent is for yourself.

So, the question is do you now buy and hold or do you trade? We have to go back to the first two questions of whether the corrective phase is over and whether we will witness a V-shaped recovery.

Based on my expectations outlined in the first two segments, I am expective a flat correction because the fundamentals are still relatively feeble. The current economic/market climate is more conducive for an active trading strategy rather than a passive one.

So, with a 2 year horizon in mind, I would not recommend a buy and hold strategy 'yet'. I expect the DJIA to complete its flat correction at around 7,450-7,600 (CLICK HERE to visit my June 29, 2009 DJIA Forecast) Anytime DJIA reaches 7,450-7,600, Buy in!

You ought to consider that my analysis is based on the assumption that a regular flat will be the most likely occurence. By reading some extremely bearish outlooks, a double/triple three is likely as well. Supporting this scenario is the failed H&S where prices continue to consolidate within a trading range. In this case, I would be keen on identifying a trading range and actively executive trades around these overbought/oversold price extremes.


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Sanjeet Parab
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Considerations when Fundamentally Analyzing Stocks, Real Estate, Interest Rates and Commodities

Credits to Fundamentally Speaking, Again (2004) by Philip Gotthelf
http://sfomag.com/Article.aspx?ID=497

It's an excellent read.

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Sanjeet Parab

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Bonds Lead Stocks: Watch the Bond Market for Clues on where the Equity Market is Heading

It is fairly obvious that the stock market serves as a leading economic indicator. In the 8 business cycles from 1948 to 1990, the S&P 500 led turns in the business cycle by an average of 7 months, with a nine-month lead at peaks and a five-month lead at troughs. A lead time of 7 months to get ready for a major change in the economy! How about a lead time of 27 months?

For such a lead time, you need to go to the bond markets. In Geoffrey Moore’s Leading Indicators for the 1990s, Victor Zarnowitz writes:

The [Dow Jones Index of Corporate Bonds] led at each of the eight business cycle peaks since 1948 and at each of the eight troughs. Its leads at business cycle peaks were very long and highly variable, ranging form 10 to 58 months, and averaging 27 months. Its leads at troughs were also long relative to the observed distributions of such leads and the durations of business cycle contractions: they ranged from 3 to 13 months and averaged 7 months.

Although the variability of lead times is concerning, by knowing that bond markets give a longer lead time than stock markets, an analyst is better prepared for anticipate changes in the stock market and the economy. Let me make it absolutely simple.

Business Cycle Peak (Trough)

Bonds will tell you 27 (7) months in advance that the economy will peak (bottom)
Stocks will tell you 9 (5) months in advance that the economy will peak (bottom)

So, once the bonds peak, you can expect the stock market to peak as well. You will be aware of overbought conditions, saturations, bubbles, and will be in a better shape to think like contrarians.

October 2007 Peak

As the chart shows, bonds (10-year US Treasuries) peaked in May-June 2006. That gave investors a lead time of 16-17 months before the October 2007 peak in the stock market. Bond yields approached the May-June 2006 peak in June-July 2008. Even this peak gave investors 3-4 months lead time to understand the overbought nature of the stock market. You might not have gotten out at the peak, but after identifying an MA or Head & Shoulders Top, you could have limited your losses.

CAUTION: It is always easy to pick peaks in perfect hindsight. But, with some experience and a lot of practice, you will foresee things that are possibly unbelievable true. It all sounds good in writing, but you need the patience to sit through a number of months before major turns.


Conclusion

I don’t think anybody would claim perfect market timing. Neither do I. But, by understanding the correlation between bond and equity markets, you are better equipped to evaluate the merits of price action and anticipate major trend changes.

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Technical Analysis Base Website at http://www.technicalanalysisbase.com and

Technical Analysis Base Blog at http://technicalanalysisbase.blogspot.com

Sanjeet Parab

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FED- Conduct of Monetary Policy Tools

It is important to understand the conduct of monetary policy because it not only affects the money supply and interest rates, but also the level of economic activity and the national well-being.

The Federal Reserve System’s Balance Sheet

ASSETS
Government Securities: US Treasuries
Discount Loans: Loans made through the Discount Window

LIABILITIES
Currency in Circulation: Amount of currency in the hands of the public (outside banks)
Reserves: Bank deposits at the Fed + currency physically held by banks (called vault cash)

TOOL 1: Open Market Operations

The central bank’s purchase and sale of US Treasuries is the most important monetary policy tool because it is the primary determinant of changes in reserves in the banking system and interest rates.

An open market purchase leads to an expansion of reserves and deposits in the banking system and hence to an expansion of the monetary base and the money supply.
An open market sale leads to a contraction of reserves and deposits in the banking system and hence to a decline in the monetary base and the money supply.

TOOL 2: Discount Lending

Discount lending is another tool that the Fed can use to affect the amount of reserves.

A discount loan leads to an expansion of reserves, which can be lent out as deposits, thereby leading to an expansion of the monetary base and the money supply.
When a bank repays its discount loan and so reduces the total amount of discount lending, the amount of reserves decreases along with the monetary base and the money supply.

TOOL 3: Reserve Requirements

Reserve requirements are the regulations making it obligatory for depository institutions to keep a certain fraction of their deposits as reserves with the Fed. Reserves can be further classified into required and excess reserves. Required reserves are those that the Fed requires the banks to hold and excess reserves are the additional reserves that the bank chooses to hold.

Supply and Demand in the Market for Reserves

Demand Curve

To derive the demand curve for reserves, we need to ask what happens to the quantity of reserves demanded, holding everything else constant, as the federal funds rate changes. As the federal funds rate decreases, the opportunity cost of holding excess reserves falls, and therefore, holding everything else constant, the quantity of reserves demanded rises. This is why the demand for reserves (Rd) is downward sloping.

Supply Curve

The Supply of reserves (Rs) can be broken down into two components. First, the amount of reserves that are supplied by the Fed’s open market operations are called nonborrowed reserves. And second, the amount of reserves borrowed from the Fed (discount loans) are referred to as borrowed reserves.

The cost of borrowing discount loans is the discount rate (Id). Because borrowing federal funds is a substitute for taking out discount loans from the Fed, if the federal funds rate (Iff) is below the discount rate (Id), then banks will not forr from the Fed and discount loans will be zero because borrowing from the federal funds market is cheaper. Therefore, as long as IffId, then banks will borrow more from the discount window at the lower Id and lend the proceeds in the federal funds market at the higher Iff. The result is a flat supply curve. Refer to Figure 1.

Figure 1







How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

Open Market Operations

An open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federal funds rate to rise. Refer to Figure 2.

Figure 2



Discount Lending

The effect of discount rate change depends on whether the demand curve intersects the supply curve in its vertical section versus its flat section.

Vertical Section

Most changes in the discount rate have no effect on the federal funds rate. Refer to Panel (a) in Figure 3.

Horizontal Section

If the demand curve interests the supply curve in the flat section, then the federal funds rate is affected. Refer to Panel (b) in Figure 3.

Figure 3



Reserve Requirements

When the required reserve ratio increases, required reserves increase, and hence the quantity of reserves demanded increases for any given interest rate. Refer to Figure 4.

When the Fed raises reserve requirements, the federal funds rate rises.
When the Fed decreases reserve requirements, it leads to a fall in the federal funds rate.

Figure 4



Refer to Central Banking and the Conduct of Monetary Policy (Mishkin) for a complete review of the FRS. All credits to Mishkin.

Conclusion

This post primarily examined how the Federal Reserve System can use open market operations, discount lending and reserve requirements to conduct its monetary policy. Refer to my previous post- Fed-Structure of the Federal Reserve System- to understand the basic structure of the Fed.

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Sanjeet Parab
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FED- Structure of the Federal Reserve System

The most important players in the world’s financial markets are the government authorities in charge of monetary policy- the central banks. In this post I will focus on the structure of the Federal Reserve System, the most important central bank in the world.

Formal Structure of the Federal Reserve System

The FRS is comprised of Federal Reserve banks, the Board of Governors of the FRS, the Federal Open Market Committee (FOMC), the Federal Advisory Council and member commercial banks. Figure 1 outlines the relationships of these entities to one another and to the three policy tools of the FED (open market operations, the discount rate, and reserve requirements).

Figure 1




Federal Reserve Banks

A glance at American political history should help you understand the motivations behind the structure of the FED. Before the 20th century, a major characteristic of American politics was the fear of centralized power. This fear and the traditional American distrust of moneyed interest were the reason behind open public hostility towards central banks. The bank panics of 1907 that resulted in widespread bank failures finally convinced detractors that a lender of last resort was necessary to prevent substantial losses. To address the fear of centralized authority, Congress wrote an elaborate system of checks and balance into the Federal Reserve Act of 1913, which created the Federal Reserve System with its 12 regional Federal Reserve banks.

Each of the 12 Federal Reserve districts has one main Federal Reserve bank, which may have branches in other cities in the district. The three largest Federal Reserve banks in terms of assets are those of New York, Chicago and San Francisco. Their combined holding is 50% of the assets of the Federal Reserve System with New York holding about 25%.

Each of the Federal Reserve banks is a quasi-public institution owned by the private commercial banks in the district who are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve bank (a requirement of membership), and the dividends paid by that stock are limited by law to 6% annually. The member banks elect six directors for each district bank; three more are appointed by the Board of Governors. Together, these nine directors appoint the president of the bank (subject to the approval of the Board of Governors).

The directors of a district bank are classified into A, B and C categories. The three A directors are professional bankers, B directors are prominent leaders from industry, labor, agriculture, or the consumer sector, and C directors are appointed by the Board of Governors to represent the public interest. The design for choosing directors is intended to ensure that al constituencies of the American public are represented.

Member Banks

All national banks are required to be members of the Federal Reserve System. Before 1980, only member banks were required to keep reserves as deposits at the Federal Reserve banks. Nonmember banks were subject to reserve requirements determined by their states. Because no interest is paid on reserves deposited at the Federal Reserve banks, it was costly to be a member of the system, and as interest rates rose, the relative cost of membership rose, resulting in declining membership.

To prevent this declining membership, the Depository Institutions Deregulation and Monetary Control Act of 1980 stated that all depository institutions are subject to the same requirements to keep deposits at the Fed. This legislation put member and nonmember banks on equal footing in terms of reserve requirements.

Board of Governors of the Federal Reserve System

The seven-member Board of Governors leads the Federal Reserve System. To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors serve one nonrenewable 14-year term, with one governor’s term expiring every other year. The governors are required to come from different Federal Reserve districts to prevent the interest of one region of the country from being overrepresented.

Federal Open Market Committee

The FOMC usually meets eight times a year and makes decisions regarding the conduct of open market operations. The committee consists of the seven member of the Board of Governors, the present of FRB New York, and presents of four other Federal Reserve banks. The chairman of the Board of Governors also presides as the chairman of the FOM.

Because open market operations are the most important policy tool that the Fed has for controlling the money supply, the FOMC is necessarily the focal point for policy making in the Federal Reserve System.

Informal Structure of the Federal Reserve System

As envisioned in 1913, the Federal Reserve System was to be a highly decentralized system designed to function as 12 separate, cooperating central banks. In the original plan, the Fed was not responsible for the health of the economy through its control of the money supply and its ability to affect interest rates. Over time, it has acquired the responsibility for promoting a stable economy, and this responsibility has caused the FRS to evolve slowly into a more unified central bank. Figure 2 depicts the informal structure of the FRS.

Figure 2



Refer to Central Banking and the Conduct of Monetary Policy (Mishkin) for a complete review of the FRS. All credits to Mishkin.

Conclusion

This post primarily examined the structure of the Federal Reserve System. In my next post, Conduct of Monetary Policy Tools, I will look into how the three monetary policy tools affect national money supply and the federal funds rate.

Don’t forget to visit my other sites:
Technical Analysis Base Website at http://www.technicalanalysisbase.com and
Technical Analysis Base Blog at http://technicalanalysisbase.blogspot.com

Sanjeet Parab
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