Will Selling Pressure Overpower ‘Operation Twist?’

The Fed last week unleashed a $400 billion package to boost the economy. To say the market didn’t react favorably would be an understatement.

The Financial Select Sector SPDR (NYSE:XLF) greeted the program with an 8% haircut. The S&P, Dow Jones and Nasdaq fell 4% to 6%. On the bright side, the yield of the 10-year T-Note dropped another 0.242%, from one all-time low to the next.

Will “Operation Twist” eventually buoy stocks, or will the market overpower the Fed’s half-hearted effort? Believe it or not, but after some more suffering, I believe the Fed eventually will reap some (temporary) credit for this stick save.

Bernanke Must Be Surprised

In his Feb. 9 speech before the U.S. House of Representatives, Ben Bernanke was quick to take credit for the results of QE2: “Since then (the onset of QE2), equity prices have risen significantly, volatility in the equity market has fallen. All of these developments are what one would expect to see when monetary policy becomes more accommodative.”

On Feb. 9, the S&P closed at 1,320, the VIX at 15.87. Today the S&P is 13% lower while the VIX has soared a stunning 160%. Bernanke’s credibility has tumbled somewhere between 13% and 160%.

Contrary to Bernanke’s upbeat outlook, the ETF Profit Strategy Newsletter published the following chart just a week after Bernanke’s comfy cozy assessment of QE2 and the stock market’s reaction.

The chart shows a giant bearish head-and-shoulders or “M” pattern. At the time, the Newsletter projected a market top at 1,382-1,385. The April 4 ETF Profit Strategy update refined the target range: “In terms of resistance levels, the 1,369-1,382 range is a strong candidate for a reversal of potentially historic proportions.”

Sleep in the Bed You Made

Operation Twist — the Fed’s latest concoction — became necessary because QE2 didn’t stick. Banks graciously accepted the generous $600 billion donation, but despite the huge cash infusion, the Banking Index today trades 22% below its Nov. 3, 2010 prices, when QE2 was launched.

Will Operation Twist be More “Successful” than QE2?

QE2 created $600 billion out of thin air while Operation Twist merely changes the maturities of the Fed’s existing balance sheet.

During the next nine months, the Fed will sell $400 billion worth of short-term (three years or less) Treasuries and use the proceeds to buy maturities ranging from six to 30 years. Maturing mortgage-backed securities will be reinvesting in MBS, not in Treasuries.

If you are wondering how this approach of transferring money from the left to the right pant pockets makes a difference, you’ve already found the reason for the post-FOMC-announcement meltdown.

Wall Street considered the proposal half-hearted and the stated goal of lowering long-term interests unnecessary, especially considering the yield on the 10-Year T-Note already is at a multi-decade low.

Range-Bound Trading With a Purpose

From July 21 to Aug. 8, the S&P lost nearly 250 points. Nevertheless, the Aug. 8 ETF Profit Strategy update made clear that there will be another low and stated that “One of the conditions for a market bottom is lower lows against improving breadth. Breadth was horrible today and no lasting low was reached. What generally tends to happen within a major sell off is a period of time where stocks take a breather followed by the final leg down. This final leg sports lower prices but improving breadth.”

Support at 1,121 held, and the S&P was due for a “breather period.” The back and forth of the recent weeks qualifies as just that. It also shows that there’s a method behind the market’s madness.

Range-bound trading lulls investors into a false sense of security and makes traders gun shy before pulling the proverbial rug out from underneath them.

In a special Tuesday pre-FOMC decision update, the ETF Profit Strategy Newsletter pointed out that the downside risk remains much bigger than the upside potential and that the direction for XLF is down as long as it doesn’t move above the 20-day SMA at 12.7 and last week’s high at 13.04.

Connoisseurs of technical analysis will find the following chart of interest. The update brought out that percentR (a measure of relative strength) moved above 80 for the first time since late July. The chart below showed what happened the last two times percentR moved above 80 — stocks dropped.

The actionable recommendation given was for aggressive investors to go short with a break below 1,191. Selling accelerated as soon as the S&P broke through the support at 1,191 and didn’t stop until the S&P reached support at 1,121.

There were seven other reasons why I expected new lows — one of them is seasonality. August-September-October is a bearish time of year, even during presidential election years.

Undeserved Credit

The bearish three-month span is in its last innings and selling pressure is subsiding (at least as of today). A look at the Relative Strength Indicator shows that RSI is notably above its Aug. 9 low even though the S&P is close to the Aug. 8 closing low.

This is the kind of bullish divergence you want to see near a tradeable bottom. Right now the S&P probably is in a small version of the range-bound breather we experienced throughout much of August/September. Another leg down could finish off the 2011 leg of the bear market.

If that is the case, the Fed will be happy to take credit for its hand in the market’s recovery, even though we know stocks would have rallied anyway.

There is one caveat to the notion of a looming bottom: It too will only be temporary.

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The ETF Profit Strategy Newsletter provides an idealized forecast for the remainder of 2011, which includes the target range for the coming market bottom and the life span of the ensuing rally.