October turned out to be one of the best months for stocks in quite some time. The New York Stock Exchange (NYSE) composite, for example, gained 11% for the period. After the steep gains posted during those four weeks, it isn’t too surprising that major indices have been taking a breather so far in November. But when trading ranges tighten as they have for the past couple of weeks, a sharp breakout often occurs.

Below is a chart showing performance of the NYSE Composite so far in 20011. It is easy to see the impressive rally that took place in October. Even after that sharp advance, however, this index remains negative for the year.  In some ways, the U.S. markets have benefitted in recent weeks by being less bad than other alternatives. Globally, as people look for places to invest their money, the U.S. could seem like a less risky option than Europe or emerging market countries.

After this week’s market action, major indices are again at a critical juncture. On Friday many—like the NYSE Composite—found themselves resting on technical support levels. The gold line on this chart is a 50-day moving average. So far, most of the major indices have held above that critical level.

The middle portion of the chart is a relative strength index (RSI). Investments with the strength and momentum to sustain a rally usually trend above 50 in their RSI. Today, the NYSE Composite and other major indices are resting right at that 50 level. If the advance is to continue, they must move back above 50 and remain at those levels.

The bottom portion of the chart is a stochastic oscillator. This indicator has not yet reached an oversold extreme. But such a situation is normal and typical during strong market advances.

In summary, most of the technical indicators we watch seem to be telling us that this latest move is a pause, not a new major downturn.

There is an important caveat, however. During periods of economic weakness, fundamental factors tend to trump technical factors. In other words, technical indicators can be telling us to expect a renewed market rally, but if Italy defaults on its debts or if the U.S. jobless rate spike to 10%, those types of events will overwhelm the technical forces that might be pushing stocks higher.

There is no way to predict what item of bad news could ultimately convince investors and traders to sell en masse. Right now, it seems there is plenty of negative economic news to digest. This week problems in Europe have dominated the headlines—although for a couple days we also heard how some members of Congress have used their positions to gain information that allowed them to profit handsomely from insider trading.

Market volatility and risk remain high, even though indicators seem favorable. Investors need to make certain they are taking steps to protect  their portfolios during these uncertain times.
Flint Stephens

Author’s Note: There will not be a weekly update next week. Our next update will be Nov. 18.

For many investors, the Federal Reserve’s attempts to manipulate the economy have had a significant negative impact. Specifically, the Fed’s actions could be prompting investors to purchase higher-risk investments in an attempt to earn higher returns.

In September, the Federal Reserve unveiled a plan to “twist” interest rates. The primary focus of the move is to drive down long-term interest rates. At its most recent meeting on November 2, the Federal Reserve Open Market Committee stated that it intends to continue that plan.

“To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September.” In that September announcement, the FOMC said that by June 2012 it intended to purchase $400 billion of Treasury securities with remaining maturities of six years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of three years or less. “This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.”

In general, one might think lower long-term interest rates are a good thing. Lower long-term interest rates mean lower mortgage rates—good for those hoping to buy or refinance a home. However, lower rates also mean lower interest payout on certificates of deposit (CDs), long-term bonds, and other types of fixed return, low-risk investments. That can be quite bad for risk-averse investors such as retirees who depend on investment income.

There was a time when retired investors could count on secure returns to supplement Social Security or pension payments. A few years ago annual return rates on CDs, fixed annuities or even money market accounts was 5 percent or more. Today short-term rates are about 1 percent. Investors willing to commit to longer terms might be able to find rates of 3.5 percent.

In fact, by driving down returns on low risk investment options, the Federal Reserve is forcing conservative investors to accept greater risk exposure.

For example, imagine that 10 years ago, a couple at retirement determined had $300,000 in investment assets. They determined that in addition to Social Security, they needed $15,000 each year to meet their income needs. At that time, their entire investment portfolio could be invested into long-term CDs with a 5 percent annual payout to produce the needed income. Today the return on those CDs might be 3 percent. At that rate the annual gain would only be $9,000, leaving the couple $6,000 short of their income needs.

As a result, the couple could feel pressure to choose investments with the possibility of higher returns but which also carry substantially higher risk.

Ben Stein has been a financial columnist, an economist, an attorney, a professor and more. Today on the financial program Breakout, he said that volatility “is going to crush the stock market as a vehicle of investment for the ordinary citizen… at least for a while.” That statement might be overly dramatic, but it highlights the fact that the equity markets have gotten riskier for most investors. The days of being able to buy an index fund and count on double-digit annual returns are long gone.

There is quite a bit of disagreement among economists and politicians about whether or not the Federal Reserve’s actions will actually help the economy. In fact, three members of the FOMC voted against the Fed’s plan dubbed as “Operation Twist.”  Minutes from that September 21 FOMC meeting revealed that the three dissenting members did not believe the action would contribute to the Fed’s mandates of reducing unemployment or controlling inflation.

One former member of the FOMC who does not agree with the Fed’s most recent “Operation Twist” or Quantitative Easing programs is GOP presidential candidate Herman Cain. In an exclusive interview with Cain after the presidential debates in Las Vegas on Oct. 18, Cain said this about the Fed’s latest plan: “I don’t agree with it. We need to get back to sound money. Every time the Federal Reserve comes up with one of these twists—no pun intended—they are just masking the failures of not having an effective economic policy.,”

Unfortunately, for investors who depend on interest income the future of fixed rates is gloomy. The Fed announced previously that it plans to keep its Federal Funds rate at or near zero through at least the middle of 2013 and it reiterated that commitment in the latest statement. It is unusual for the Fed to provide that kind of information for so far into the future.

Investors who want to participate in equities in the current environment need to do so with a plan for active management of their assets. Merely investing in index funds and hoping for returns could prove to be costly given the current global economic uncertainties.

Flint Stephens