Systematic Relative Strength

The Federal Reserve has kept the discount rate incredibly low for a long time. At some point, they will need to increase it. But how?

An article in the Wall Street Journal points out how careful the Fed has to be, even with its language, in order to tighten without creating a ruckus.

At some point, the Fed must undertake some delicate wordsmithing in the statement it releases after policy meetings.

I admit I am very curious to see how this will be accomplished. Changes in Fed policy have been communicated successfully in the past-and they have also been botched. Markets tend to trade on expectations, well ahead of reality. With so many people hanging on every word from the Fed, it will be interesting to see if the market will react calmly or violently when the Fed signals a move away from the low-rate regime.

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.) As of 3/9/10.

The 10-day moving average of this indicator is 80% and the one-day reading is 91%. This oscillator has shown the tendency to remain overbought for extended periods of time, while oversold measures tend to be much more abrupt.

The Financial Times points out that lots of cash piled into government debt last year in a quest for safety.

In 2009, investors bought almost $250bn of dollar-denominated bonds sold by US and European banks, all with triple A guarantees from US and European governments.

Now, as the government-guaranteed bonds sold during the crisis start to mature and get repaid, investors are wondering where to reinvest the cash they receive.

As it matures, no doubt much of it will be reinvested in the bond market. But some of it, given the strong performance of global equity markets, might leak into stocks. Given that the size of the debt markets are many times the size of world stock markets, even a little flow could create a nice situation in stocks.