For Monday, Aug 22, the market forecast is uncertain

We recommend selling your equity positions. Avoid money market funds as a cash alternative due to exposure to European sovereign default risk.

Technical Comment:
Friday’s 1.5% drop in the S&P 500 index was on volume higher than Thursday and higher versus the 30-day moving average. Downward movement on higher volume is a negative signal suggesting further downward movement is likely, although our forecast has not identified a fully developed pattern indicating further decline will occur.

Subjective Comment:
Friday’s declines in US markets was not as large as some over the past few weeks, but it was still 1.5%, which is big by normal standards. The cause is still the sovereign debt problems in Europe. Officials of the European Central Bank (ECB) have reaffirmed their tight-money policy for the Euro. If Euro tightness continues, the Eurozone will contract and those markets will drop as malinvestments are liquidated. This will be healthy for the European economies if the ECB refrains from money printing. The contagion effect on US markets is both psychological and technical. European banks and other multinational companies needing cash for their operations in Europe are selling US assets (stocks, etc.) to raise funds. This puts downward pressure on US markets.

The US money supply continues to expand at accelerating rate as the $1.6 Trillion of excess reserves work through the fractional reserve multiplication process as banks issue new loans. Required reserves are increasing, confirming banks are making new loans. Eventually the money supply growth in the US will cause a monetary-manipulated economic boom and up-trend in US stocks. Unfortunately, this will come with accelerating price inflation. The conflicting forces of Euro tightening and Dollar expansion will continue to create volatility in US markets.

Back on July 13th, Federal Reserve Chairman Ben Bernanke told Congress the Fed would take additional action if the economy appears in danger of stalling or if deflation pressure emerged. The recent PPI and CPI numbers indicate inflation is growing. We doubt the up-tick in price inflation will prevent the Fed from resuming bond purchases via Quantitative Easing, although they will likely use a different name since QE received so much negative publicity. August 26th is this coming Friday. The temporary short-selling ban in some European countries ends on that day, and Chairman Bernanke will address the Jackson Hole conference for central bankers. We think a continued decline in US markets next week might be used as justification to announce new money printing measures. Additionally, the Philadelphia Fed’s index of regional manufacturing had a 30 point decline in August, and such low levels in this index have never been seen outside recessions. This index data could also be cited as justification for Fed action. Should no announcement come, the market will likely decline further as many participants fail to realize fractional reserve expansion is happening. US Banks can use their excess reserves to purchase US Treasury bonds without additional money printing from the Fed. If Banks do this, the Fed does not have to step in. If Banks refrain from buying Treasuries, then we expect the Fed will again become the buyer of last resort for the US Treasury.

For the reasons just discussed and others from our prior commentary, we think next week will continue to be highly volatile and could see continued declines in US markets. Chinese and European markets will continue to decline as well. Money market exposure to European debt continues to be a risk. Consider holding cash outside of money markets and wait for an opportunity following the Jackson Hole speech to reenter US equities. We will continue to publish our automated market forecast, but caution is warranted as this high volatility can cause our forecast to generate false-starts.

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