Will the S&P 500 Avoid the Summertime Blues?

-Dugald Malcolm, Montreal, Canada

The current big question within the financial world right now is whether or not Federal Reserve Chairman, Ben Bernanke, will unveil plans for QE3 once the current round of quantitative easing expires. Quantitative easing is a rather unorthodox monetary policy by which the central bank injects money into the financial system via purchasing of government bond. Through this action, bond prices are driven up and interest rates kept low.

The remarkable comeback of the financial markets since March 2009 has been attributed to the Fed’s policy of quantitative easing. This, of course, begs the question as to what will happen when the money printing press shuts down and quantitative easing is no more. QE2 is set to expire this June and many are worried that the markets amazing bull run might expire along with it.

The good news is that the late February to mid-March pullback of the markets brought the S&P 500 back down to earth from its overbought levels. Ideally, one would have liked to have seen a correction in the market, as this would have been a healthier move. The 7% move to the downsized was short of the 10% necessary to fall under the definition of a correction.

Still, the move brought the Relative Strength Index from the overbought level above 70 to just above 30. It also caused a bearish cross in the MACD as well as bringing it down below the zero line. As we can see on the ADX line, evidence of decreasing upward momentum started back in January. The good news lies in the fact that these indicators have since turned around and are showing some positive momentum to the upside. The RSI is currently rising, the MACD has had a bullish cross and has risen back above the zero line and the +DI has crossed above the –DI line.

The bad news scenario is the possible formation of a double top at the resistance level of 1344, the high put in back in February. If this this scenario doesn’t play out and there is no near term consolidation, it won’t be long before the S&P 500 is back in overbought territory. Had last month’s move been a correction and not just a 7% pullback, that would not have been the case.

There is also the concern that as summer approaches, so does thinner trading. As trades take their vacations, the market because thin and prices often become more volatile. If there is no QE3 in June, we could have an overbought, thinly traded market that could be easily spooked.

I have a feeling it will be an interesting summer.

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