by Lance Roberts, StreetTalk Live

Over the last couple of weeks, I have been discussing the potential for a short-term rally in the markets.

That rally has now occurred and as I addressed this past Thursday:

“As you can see, the markets did retest the late August lows, and when combined with the very oversold conditions, led to a frantic ‘short covering’ rally back to previous resistance. It is worth noting that the recent market action is very similar to that of the August decline and initial rebound as well.”

Importantly, while the market has rallied back to its previous resistance levels, it has also become extremely overbought once again as well. This suggests that a bulk of the rally from the lows is complete, and investors should continue to ‘fade rallies’ until a more bullish trend resumes.

However, for that more “bullish” outlook to take root, the market will need to rise above 2060 currently. The problem will be the strong level of resistance provided by the two long-term moving averages that have only crossed during more severe market corrections.

With a large number of technical indicators currently suggesting that the easiest path for prices is downward, investors should remain cautious of overly aggressive exposure in the short-term. If the market is still confined within a more ‘bearish’ trend, the current rally, like the ones that preceded it, will be a ‘rally to nowhere.’

The following chart updates that note through Friday’s open and shows the market currently working its way back to a normalized 61.8% Fibonacci retracement of the decline from the highs.

GEEK ALERT: Okay, I know, I just threw out a bunch of jargon. Here is what it means in plain english.

If you stretch a rubber band as far as it will go in one direction, the initial snap back will almost encompass the same distance in the opposite direction. Each subsequent back and forth action will encompass progressively smaller distances until the motion is exhausted. In the financial markets, sharp moves in one direction will be offset by a subsequent “snap back.” These snapbacks are generally about 50% of the previous decline but can sometimes be a bit more. Fibonacci retracement levels are a mathematical measure of these potential retracements.

Importantly, this potential retracement will encounter extremely heavy resistance from the long-term moving averages that are just overhead. Furthermore, that resistance will be compounded by the now extremely overbought conditions of the market.

IF you have NOT taken any action in your portfolio in recent weeks, or months, this will likely be an excellent opportunity to implement the portfolio management instructions below.

What The Fed Really Said

The market rallied on Thursday after the release of the minutes from the latest FOMC meeting in September. With the market oversold, and sentiment bearish in short-term, the rally was not unexpected as I discussed over the last couple of weeks. However, what did the markets see in the minutes that gave the emboldened the bulls?

To put this into context, you must first understand WHY the Fed raises or lowers interest rates.

Increasing interest rates raises the cost of borrowing money within the economy. Therefore, the higher borrowing costs rise, ultimately the lower the demand for credit in the economy. As the demand for credit falls in an economy, economic growth will slow subsequently bringing down inflationary pressures. The opposite occurs when the Fed lowers interest rates.

The problem is that Fed actions do not occur in a vacuum. As shown in the chart below, this is why monetary interventions by the Fed have consistently led to booms and busts.

As discussed on Thursday, the economic backdrop in the U.S. is very weak and potentially in the early throws of a recessionary onset. However, we won’t know that for sure until the backward revisions to the data occur next year.

“Importantly, as with the GDPNow indicator, the CFNAI is showing that the economy is running weaker than headlines have suggested.

Despite Central Bank interventions, suppressed interest rates, and a surging stock market, the economy has failed to gain any significant traction. This is an anomaly that we can also see in the CFNAI data.

If we break the CFNAI down into a “supply” and “demand” model we see a very interesting, and telling, picture emerge.”

“As shown the supply side of the index has historically had an extremely high correlation to the demand side. That ended with the financial crisis. Since then the supply components have far outpaced the actual underlying demand in the economy. This goes a long way to explaning the ongoing weakness in economic growth as the lack of aggregate demand continues to weigh on labor and wage growth.”

This is clear evidence as to why DE-flation continues to rule the economic backdrop and why the Federal Reserve remains trapped at the zero bound for interest rates. To wit from the latest minutes:

“Nevertheless, in part because of the risks to the outlook for economic activity and inflation, the Committee decided that it was prudent to wait for additional information confirming that the economic outlook had not deteriorated and bolstering members’ confidence that inflation would gradually move up toward 2 percent over the medium term.”

“Members noted that recent global and financial market developments might restrain economic activity somewhat as a result of the higher level of the dollar and possible effects of slower economic growth in China and in a number of emerging market and commodity producing economies.”

While the Federal Reserve is still “hoping” that economic conditions will improve by year end to increase interest rates, the reality is such will NOT be the case. That reality was immediately reflected in Fed Funds Futures which implied a sharp drop in the potential for a tightening of monetary policy by year-end.

While much of the mainstream bullish media continue to suggest that increases in interest rates are NOT a problem for stocks, the truth is quite the opposite. Tighter monetary policy will reduce economic growth and inflationary expectations making already overvalued stocks even more overvalued on a relative basis. REMEMBER – the primary bullish argument for stocks has been the low level of interest rates. Remove the low level of rates and you have a problem.

This was fuel needed by the “bulls.” Continued “accommodative” policy by the Fed is good for stocks in the short-term. The long-term consequence of being trapped at zero rates, is an entirely different story and an article in the near future.

For the Federal Reserve, stock price action is very important. A decline in asset prices reduces consumer confidence and as such impacts economic growth. Such a negative event will keep the Fed trapped at zero. This was noted in the FOMC minutes: