Don’t Fight the Fiscal Slice: QQQ, DIA, SPY, IWM

January 03, 2013, 15:20 pm ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

The “Fiscal Slice” that was the recent congressional agreement to avoid what otherwise would have been a higher magnitude economic headwind was met with initial jubilation, but after the first day investors are wondering what will come next.  There are a few things that we know, a few that we do not know, but there is a simple rationalization that will allow us to move forward no matter what happens.

We know:

1.  The current multiple of the S&P 500 is 16.25.

2.  The earnings growth rate for the S&P 500 in 2012 was 4.16%

3.  GDP growth averaged about 2.57% in 2012.

4.  There is a clear relationship between low GDP and low earnings.

5.  GDP is expected to grow by only 1.9% after the “Fiscal Slice”.

My assessment on earnings and market valuation is that the market does not deserve the multiple given current and future expected earnings growth rates.  However, the jubilation still exists.

We also know:

1.  QE3 sounds good on paper, $85 billion per month.

2.  But the US treasury also sells $74 billion more bonds every month as well.

3.  The “Fiscal Slice” will take about $16 billion per month out of the system.

4.  The real liquidity added to the system per month is roughly -$5 billion.

5.  QE3 is not stimulative like QE2, but it does increase the velocity of money.

We know:

1.  The Investment Rate tells us we are in the third major down period in US history

2.  This is like the Great Depression and Stagflation; it tells us this will last until 2023.

3.  The rate of change in the decline of the Investment Rate gets more negative after 2012.

4.  The Investment Rate is natural and they cannot stop it from coming.

5.  This is a demographic study that has never been wrong.

With no real stimulus the economy is actually left to grow more naturally, and if that is true what we know about the Investment Rate will likely result in a slow but steady economic deterioration as this year continues.  Find more information about The Investment Rate here:  Investment Rate.

However, the market is always right, even when it is wrong.  We cannot fight the tape, we cannot impose our will on to the market, but instead we must go with the flow of the market when the market oscillates.  If the market is poised to move higher than we must respect that, but the same thing holds true if the market is poised to move lower.  At least for now, as this year has begun, the market indeed appears poised to move higher, it has broken above important Fibonacci-based inflection levels, it did this on Wednesday, and so long as the market stays above these Fibonacci retracement values additional upside in the S&P 500 (NYSE:SPY), NASDAQ (NYSE:QQQ), and the Dow Jones industrial average (NYSE:DIA) appears likely. 

In addition, the Russell 2000 (NYSE:IWM) has broken above a major neutral longer-term resistance line, this coming from a technical perspective, and that is a bullish sign for the Russell 2000 so long as the Russell 2000 remains above this level.

Although my decision is clear and rational, notice the conditional tone in my pitch, and please take it to heart.  From both a valuation and a macro economic perspective the market has no business increasing from these levels, but because the market is always right we must adjust to the market and that means we need to respect what it does and where it is going. 

Purposefully my asset allocation models have removed any strategies that were dependent on market direction and all of our included strategies are therefore able to work regardless of market direction.  For example, our Swing Trading strategy, which only did about 14% last year (lagged the S&P), can work if the market increases, if it declines, or if it moves sideways, and it is an integral part of our asset allocation model.  Find more information about The Swing Trading Strategy here:  Swing Trading.

I suggest investors adopt a similar model because the market is not acting rationally, but we can’t fight it.

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