Wednesday, April 30, 2008

Three Key Questions Going Into the Fed Announcement

* Have we put in a durable bottom in stocks? - I've been writing for a while about the drying up of stocks making new lows as we tested the January lows in March. Since that time, we've bounced nicely and are hugging that major resistance area around 1400 in the S&P 500 Index. I've also noted of late that the recent market strength has been accompanied by waning participation to the upside and uneven sector performance. We need to see the broad range of stocks in gear to the upside to confirm that this is more than just a catch-up move of beaten down stocks, sectors, and asset classes at the expense of first-quarter winners. I'll be looking to see if the Fed announcement can generate the rising tide that lifts all boats. Conventional wisdom has stocks selling off at the prospect that the Fed may be finished with its easing; less conventional wisdom (which I prefer) suggests that such a shift in Fed policy might be seen as a vote of confidence in credit markets and the economy.

* Will deflation or inflation concerns rule the markets? - Watch the fixed income markets in the wake of the Fed announcement. Will we see the risk-averse flight to quality, with rising Treasury prices and falling yields? Or will we see money continue to move from safety toward riskier assets, as has occurred this past week, with Treasury rates rising and yield spreads narrowing vs. mortgage-backed and high yield debt? The Fed may well offer a balanced perspective in their statement to preserve flexibility at future meetings, but the bond markets will tip us off to the market's interpretation of Fed priorities. Conventional wisdom is still focused on weak housing, and even the taxi cab driver seems to know about LIBOR. Less conventional wisdom is focused on the breakout moves we've already seen in yield spreads.

* Will sector themes mirror confidence or lack of confidence in the economy? - I've mentioned at numerous points over the past few months the importance of the financial sector and especially the bank stocks. With Citi's recent move for further cash infusion, those stocks have seen a recent resumption of weakness. Keep an eye on them in the wake of the Fed announcement. It is very difficult for me to believe that we'll sustain a bull move without confidence in the banks. But I'm aware that conventional wisdom is also focused on financials; less conventional wisdom also sees the influx of funds into consumer discretionary stocks vs. staples at the same time that commodities have been falling and the U.S. dollar has shown a bit of strength. I'll be watching the latter trends carefully as a barometer of nascent economic confidence.

Themes and transitions among themes reflect the flows of funds within and across asset classes. Even short-term traders can benefit from standing back and seeing where capital is flowing and why. The upcoming Fed meeting should prove instructive in this regard.
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3 comments:

Josh Ulrich said...

Dr. Brett,

I found it odd the dollar dropped, given it seems the market interpreted the Fed statement as signaling a pause. What do you think?

Goldenpiggie said...

When the Fed lowered rates to rock-bottom level in 2003 and 2004, the pundits interpreted the market rally then as repsponding to the Fed's easy money and liquidity injection

Then when the Fed starts to raise rates, the pundits explained the market's continued rally as a response to the strong recovering economy

Then the Fed stopped raising rates in 2006, and the market resumed its upward cliam in the summer of 2006. We were told by the pundits that's because "the Fed is done raising rates", so it's time to party - again.

In the fall of 2007, the Fed starts easing again, the market rallied to new highs, and the pundits explained the market is "discounting" the inevitable recovery by going higher.

With the latest Fed cut and announcement, everyone is hoping and anticipating a resumption of the stock rallying party because, again, the Fed is "done" lowering rates.

So, let's see: the market rallies when the Fed is cutting rates; the market rallies when the Fed is raising rates; the market rallies when the Fed is finished with raising rates; the market rallies again when the Fed is cutting rates _again_. When the the Fed is done cutting rates yet again, the market should then rally --again--.

If you think there's something wrong with this picture, congratulations, you still have an ounce of common sense left.

Brett Steenbarger, Ph.D. said...

Hi Josh,

I think the market interpretation is more nuanced than that, given the reaction of dollar, bonds, etc. The Fed has paused, but has given no indication of a reversal of recent policy.

Brett