Dow Jones closed at a new all-time high yesterday. The news was celebrated by all financial media outlets, as the world’s most famous index reached an impressive milestone.
Many investors argue that the rise in the stock market prices during the pandemic is artificial. Moreover, the same voices say that inflation comes next and argue that quantitative easing and money printing are the only reasons why Dow Jones and other indices are up.
That may very well be true. However, if we look at the past four years, we see a striking divergence. During this time, the Dow Jones traveled from 20k to 30k. Or a fifty-percent rise. What was the rise in inflation during the same period? Nowhere close to it.
In other words, we may say that the rise in the stock market prices is in real terms, as inflation is still tilted to the downside. Moreover, according to the theory of the business cycle, the stock market is a leading indicator – not lagging or coincident. More precisely, it leads the business cycle by six months on average.
If we consider that stocks rebounded in April and continued to rally ever since we may say that the stock market leads the business cycle to a new expansion phase. What expansion?
There are three potentially effective vaccines already announced and more in the pipeline. Believe it or not, the end of the pandemic as we knew it in 2020 is in sight. That can only mean a quick economic recovery.
Coupled with a change in the White House administration and the likelihood of no more trade wars led by America, and we have the potential of an extensive expansion phase.
USD Hammered Ahead of the FOMC Minutes
One of the indirect consequences of higher stock market prices is a lower USD. In fact, this was the theme for the year following the March stock market meltdown. The USD declined against almost all G10 currencies, with some exceptions – the JPY and the CHF.
Now that there is light at the end of the tunnel when it comes to the pandemic, all eyes should be on the CHF and the JPY. When the two end their bullish trend, the stock market may have yet another reason to rally due to the implicit economic recovery.
Another thing to mention on the milestone reached by the Dow Jones – the wealth effect. Higher stock market prices have such an effect on households. Because of that, households feel wealthier and, as a consequence, the savings rate declines and consumption increases. Therefore, economic recovery takes even less time that otherwise would be the case.
The FOMC Minutes today are unlikely to bring something new to the table. Also, considering that this is Thanksgiving week, there are little or no chances to see a reversal in the USD trend. At best, some consolidation may be in the cards.
However, some developments are worth considering. For instance, the new U.S. administration appointed Janet Yellen, the former Fed’s Chair, as the new U.S. Treasury Secretary. As we have seen so far in 2020, fiscal policy is as important as monetary policy. However, so far, the markets failed to react to the news for the simple reason that they wait for the Fed’s decision in December and the transition period from the old to the new administration to end.
Dow Jones Possible Rising Wedge
While bulls are overly excited, bears patiently wait their turn. The pattern below can be interpreted in multiple ways. One interpretation is a rising wedge – a bearish pattern.
Brave bears may want to sell short the Dow Jones index with a target of 27k-28k and a stop at 31.5k. The reason here is that, according to JP Morgan, some $300 billion in equity selling is expected towards the end of the year due to rebalancing. If that is the case, the rising wedge here offers the perfect excuse to go short.
Conservative bears may want to wait for the index to break below the 2-4 trendline before going short with a stop at the highs and a similar take profit level. However, the risk-reward ratio would be much lower than the earlier setup.
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