What are Exchange Traded Funds telling us?

A few days ago I came across an interesting article from economist and investment advisor Mark Skousen, who wrote an article on the Friedman Effect that struck me as superficial.

What particularly irked me: "The stock market will probably continue to push higher for now, due to the lag time in the Friedman Effect. The Dow might even reach 10,000 by the end of this year. "

The dominant belief on Wall Street, and in the Ivory Towers of the academy, is that the central bank can minimize the pain caused by growth slowdowns by inflationary policies (dropping interest rates, backstop the banks, support increased government borrowing), and then later reverse those policies once the economy is growing again.

In contrast, Frank Shostak (Fed May Have Painted Itself into a corner) writes:

A major concern for Fed policy makers is a visible weakening in the US dollar against major currencies. If the Fed were to allow the dollar to fall further, the US central bank runs the risk that major holders of US-dollar assets will divest to nondollar assets. This could push long-term rates and mortgage rates higher, thereby igniting another crisis.

I am of the view that the markets may do what the Fed is incapable of -- raising yields on long term U.S. government debt, that will cause yields on other assets (particularly corporate bonds) to spike, killing whatever recovery is underway.

Instead of looking at the select individual markets I'm currently involved with, I decided to slice and dice the ETF universe to see what has really happened since the March 2009 low.

The swift turnaround in the major stock indexes since March 2009 remarkable, and more consistent with Skousen's outlook than my bearish one. Of the 17 major U.S. stock market indexes, only4 of them are not in what I would consider to be primary uptrends (a triple cross of the 21, 55, and 200 day moving averages). The remaining laggards are the Dow transports, Dow Utilities, Dow Industrials, and SP-500 value. But they are not too far away from putting in bullish primary trend crossovers of their own.

Of the U.S. markets, the QQQQ has held up relatively well throughout the downturn, as the following chart (click to enlarge) shows.

When a broader segment of ETF's, including the most liquid U.S. and foreign stock index ETF's (but excluding bull, bear, and commodity funds), more than 2/3 of them (23 out of 32) are also in probable primary uptrends. Of the foreign, unlevered ETFs, the strongest performers are Asian, including China (FXI), Taiwan (EWT), Singapore (EWS). (Click on chart to enlarge)

There is a distinct pattern--the reflation trade still appears to be on. Risk appetite has returned, with beaten down financials leading the way.

In spite of this remarkable turnaround, caution remains in order. As Shostak predicted, yields on long term U.S. treasuries continue to rise, and the "recovery" has come at the expense of government guarantees and backstops of the financial system. The Federal Reserve's easy monetary policy, coupled with massive government deficits continue to erode the value of the dollar. Job losses in the U.S. continue to mount, and that can only mean more stress in the banking sector.

In spite of the positives, there are some troubling symptoms about the sustainability of the current uptrend. Volume continues to decline for most markets, even as prices rally. This is not what you would like to see at the bottom of a bear market. Volume needs to expand on breakouts, and it simply has not.

This is not a "normal" recovery from a bear market and recession, and the government cannot protect everyone from loss. The real question revolves around figuring out who will benefit,and who will lose from the regulatory changes sure to come.

How to profit if you are a short term trader.

It would be wise focus on the relatively strong performers--technology, foreign ETFs, and precious metals for those who desire to be net long. I would prefer to be long the QQQQ and short the DIA.

For speculative position trades, I would enter on retracements, and avoid chasing breakouts, although that has worked on the long side for the past 3 months.

The magnitude of the rally from the lows, the lack of volume at these levels, and the relative uncertainty in the current environment warrent a cautious approach that favors missing out on potential trades, rather than chasing a breakout for the next big trend. When in doubt, stay in cash.