Don’t Fight The Fed
The longer you are involved with the financial markets, the more meaningful the expression don’t fight the Fed becomes. In the simplest terms, if the Fed keeps interest rates near zero, it is next to impossible to make money in conservative investments. As long as the low-rate pledge is in place, investment capital will tend to gravitate toward risk in the search of positive returns. From The Wall Street Journal:
Federal Reserve Chairwoman Janet Yellen left markets comforted and reassured about continued low interest rates after a speech that emphasized her focus on low inflation and economic slack. Wednesday’s remarks, coming in her third major address in the past month, followed an eventful first policy meeting in March that left some investors worried the central bank under her leadership might be inching toward higher rates sooner than expected. Ms. Yellen studiously sought to keep the central bank’s interest-rate options open in the speech before the Economic Club of New York. “Because the course of the economy is uncertain, monetary policy makers need to carefully watch for signs that it is diverging from the baseline outlook and then respond in a systematic way,” she said.
Fed Still Thinks Weather Was To Blame
As noted on April 2, stock market corrections almost invariably are kicked off by economic or geopolitical concerns. The recent bipolar activity in the stock and bond markets was due in part to a soft patch of economic data. Janet Yellen addressed that topic Wednesday. From CNBC:
“In recent months, some indicators have been notably weak, requiring us to judge whether the data are signaling a material change in the outlook,” Yellen said. “The unusually harsh winter weather in much of the nation has complicated this judgment, but my FOMC colleagues and I generally believe that a significant part of the recent softness was weather related.”
Resource Utilization Justifies Low Rates
The Federal Reserve is charged with a dual mandate, which includes “fostering maximum employment.” While unemployment has come down, so has the labor participation rate. Yellen cited economic slack and idle workers as justification to keep interest rates suppressed. From The New York Times:
Even as a number of indicators point to better economic times ahead, the chairwoman of the Federal Reserve, Janet L. Yellen, reiterated on Wednesday that she expected interest rates to remain very low until the recovery is on a more secure footing and the American economy is more fully involving available workers and other resources.
Investment Implications – Lines In The Sand
We outlined the economic rationale for monitoring the strength of industrial stocks on April 4. Investors would be showing renewed confidence in the wake of Yellen’s remarks if their buying conviction can push the Dow to a new weekly closing high. The zig-zag look of the Dow is indicative of investor confusion. During periods of low conviction and indecisiveness, it can be helpful to draw some lines in the risk-reward sand. For example, one might take a more measured approach redeploying cash as long as the Dow remains below 16,478. If and when a weekly close is printed above 16,478, redeployment confidence could be ratcheted up a notch. The weekly close printed below 16,478 at 16,408.
We entered the week with a fence-sitting mix of stocks (SPY), bonds (TLT), and cash. Given the still uncertain outlook for the economy and Fed policy, along with still shaky technicals, we made no moves this week. If the Dow pushes to a new high and the S&P 500 can clear 1,870, we will most likely increase our exposure to stocks. Possible buy candidates include dividend stocks (DVY), broad U.S. stock exposure (VTI), industrials (XLI), and energy stocks (XLE).
Frustrated By Stocks This Week?
This week was unpleasant for many investors, which prompted the strategy tweet below:
Weekends are a good time to review investment risk management strategies. On March 29 we noted if an approach or system can manage to avoid the pitfalls below, the odds of successfully navigating though the next crisis should improve:
Heading into this week, the markets looked extremely vulnerable to additional downside. During the week, instead of correcting, stocks yo-yoed back up. The five points above applied to the past week of trading. The Fed was a big part of the turnaround in stocks (central bank intervention). We also saw some favorable economic numbers, such as the better than expected Philadelphia Fed Survey released Thursday. The five points above, especially flexibility, will be important next week as well.
Mobile Usage Hurts Google
The easiest way for investors to become more decisive in the financial markets is for earnings to justify higher stock prices. While after-hours quotes should always be taken with a grain of salt, Google was down 2.48% after releasing some disappointing figures late Wednesday. From Bloomberg:
Google Inc.’s costs are rising as the search provider finds it harder to keep up with a broad shift to advertising on mobile phones, with sales falling short of estimates. Google’s audience is steadily migrating to smartphones, where the company gets less money for marketing spots than on desktops and tablets.
Dow Making 3rd Attempt At 16,580
After pointing out a Dow Theory non-confirmation that was in place on April 4, the S&P 500 dropped over 50 points. Has the Dow posted a new closing high during this week’s rally? Not yet. The inability to print a new high is indicative of investor doubt about earnings, the economy, and central bank policy. Janet Yellen’s remarks helped boost stocks Wednesday, but those moves can be “one day wonders”. We will see if the gains can continue on Thursday.
IBM Not Helping The New High Cause
IBM carries the third highest weight (7.7%) of any stock in the Dow Jones Industrial Average. Therefore, the reaction to Wednesday’s earnings will impact the Dow Thursday. The early reaction was not favorable for Big Blue. IBM was down over 4% in the after-hours session on revenue concerns. From MarketWatch:
Revenue slipped to $22.48 billion, below the $22.91 billion projected by analysts polled by Thomson Reuters. It was the eighth straight quarter IBM has reported weaker revenue from year-earlier levels. Though the computing and tech giant remains a key provider of computer hardware, software and services to big corporations and governments around the world, IBM is struggling to respond to technological advances such as cloud computing, which allows customers to rent computing power and software over the Internet. Slowing demand in emerging markets, especially China, is also posing a challenge for Big Blue.
Janet Yellen’s stock-friendly comments helped spark a strong day in stocks Wednesday. Given the schizophrenic nature of the shifts between risk-on and risk-off in recent weeks, we prefer to see if stock gains can hold into the holiday weekend before considering any adjustments. You would think with stocks gaining ground Monday, Tuesday, and Wednesday, bonds would be getting killed. The long-term Treasury ETF (TLT) is up 0.49% this week, which indicates some ongoing economic skepticism. Both our stock (SPY) and bond positions are in the black for the week. We will see how the stock market handles the disappointing reports from Google and IBM.
Playing The Low Estimate Game
Isn’t amazing how the majority of companies meet or beat earnings expectations quarter after quarter? Wall Street has always done a nice job of managing investor expectations. From Bloomberg:
“It’s quite likely that U.S. earnings will beat expectations because analysts have set the bar quite low,” James Butterfill, who helps oversee about $50 billion as head of global equity strategy at Coutts & Co., said by phone from London. “There probably won’t be any particular pressure on margins this quarter, so earnings momentum will continue to rise. I do expect the harsh winter to have impacted the most energy-intensive companies.”
Inflation Aligns With Ongoing Fed Taper
The good news Tuesday came on the earnings front, with Coca-Cola (KO) and Johnson & Johnson (JNJ) eliciting a bullish response. The bad news was related to inflation. From Reuters:
U.S. consumer prices rose in March, but inflation pressures remained generally benign, which should give the Federal Reserve ample scope to keep interest rates low. The Labor Department said on Tuesday its Consumer Price Index increased 0.2 percent last month as a rise in food and shelter costs offset a decline in gasoline prices. Economists polled by Reuters had expected a 0.1 percent rise.
Central bankers tend to print money until inflation forces them to slow down the presses. Today’s inflation data aligns with an ongoing Fed taper.
Ukrainian Military Action?
The unrest continues between Russia and Ukraine. It is possible the markets will have to digest some form of military action, which checks a glass half empty box. From The Wall Street Journal:
A Ukrainian military operation to wrest control of cities in the east from pro-Russian militants has begun, Ukraine’s acting president said Tuesday, as Russia’s foreign minister warned use of force could derail international talks on the crisis. Oleksandr Turchynov said that a phased “antiterrorist” operation began in the early morning hours in the northern Donetsk region, where the majority of the cities commandeered by pro-Russian forces are located. But there were no immediate reports of specific action and it was not clear how big the effort was.
Investment Implications: Mixed Bag = Mixed Allocation
From a fundamental perspective, there are many positives (earnings Tuesday) and many negatives (Fed taper). From a technical perspective, the longer-term trends remain bullish, but the intermediate-term trends shifted to a “risk-off” stance last week. Our nearly equal weights to cash, stocks (SPY), and bonds (TLT) remain appropriate for the current mixed investment climate.
Resistance Test Would Come At 1,850
Another example of a mixed picture is the chart of the S&P 500 below. The good news is the index has gained back 25 of the 49 points lost last week (early in Tuesday’s session). The bad news is various forms of prior support (green arrows below) and prior resistance (red arrows) seem to be congregating near 1,850ish. A reversal below 1,850 could bring a return to last week’s risk-off environment. A decisive break above 1,850 could open the door to a retest of the recent highs (near 1,900).
We have shown frustrating and indecisive charts in recent articles. We could produce additional examples from numerous corners of the market, including the chart of the small cap ETF (IWM) below. If investors had strong convictions about a brighter economic future, we would expect small caps to be performing well, rather than treading water for six months.
Indecisive markets are frustrating animals. If we remain patient and disciplined, the market will tip its hand. For now, a mix of stocks, bonds, and cash offers an appropriate balance between risk and reward. We questioned the sustainability of the bullish advance in stocks on April 4 with the S&P trading at 1,865. We remain concerned with the S&P trading at 1,827.
Retail Sales: Better Than Expected
After the stock market sells off significantly, any form of good fundamental news can create a fairly significant “oversold” bounce. The stock market bulls got what they wanted Monday in the form of retail sales. From Reuters:
U.S. retail sales recorded their largest gain in 1-1/2 years in March in a decisive sign the economy is bouncing back from its weather-induced slumber. Monday’s upbeat report was the latest to indicate growth was set to accelerate in the second quarter after an unusually cold and snowy winter hobbled activity early in the year.
The good news did little to alter the “economic concerns are increasing” look of the weekly chart below. Consumer discretionary stocks (XLY) still looked ugly on a relative basis as of 2:00 p.m. EDT Monday.
ECB: Good News and Bad News
Risk takers prefer easy money policies from central banks since the added liquidity has to land somewhere. The good news from the European Central Bank (ECB) Monday was they signaled a willingness to expand their stimulative measures. From Reuters:
The dollar rose against the euro on Monday after European Central Bank President Mario Draghi signaled the bank would ease monetary policy further, while strong U.S. retail sales data also boosted the dollar against the yen. Draghi said in Washington on Saturday that “a further strengthening of the exchange rate would require further stimulus”. Bank of France chief Christian Noyer hammered home the message saying: “The stronger the euro is, the more accommodative policy is needed.” “The ECB is taking the value of the euro more seriously in their approach to monetary policy,” said Thierry Albert Wizman, global interest rates and currencies strategist at Macquarie Ltd in New York. The statements marked the ECB’s strongest signal yet that it would act to head off further gains in the euro.
Given the Fed’s easy money policies have been a big driver of stocks in recent years, it is fair to say that all things being equal stock market bulls feel more secure when the U.S. greenback is weakening. The bad news Monday was comments about ECB policy helped push up the U.S. dollar.
The Big Picture
Since investors have much longer time frames than traders, looking at risk from a weekly perspective makes more sense. This week’s stock market outlook video provides numerous forms of observable evidence that point to a deteriorating outlook for equity investors.
Ukraine: A More Peaceful Path?
There is no question the Russia-Ukraine standoff has weighed on the minds of investors in recent weeks. The bulls can make an argument that tensions eased a bit Monday. From The Wall Street Journal:
A day after threatening a full-scale military operation to drive pro-Russian militants out of a string of eastern Ukrainian cities, the country’s acting president offered an apparent olive branch Monday, saying he wasn’t opposed to a countrywide referendum on possibly granting regions greater autonomy. The move appears to signal increasing desperation from Kiev, highlighting it has few options for a real response as opponents take over further territory.
Investment Implications – Show Me
Is it possible stocks have found a bottom? Yes, but one day does not make a new trend. Last week we noted the concerning lack of progress in stocks, which is a symptom of increasing economic concerns. The “vulnerability box” was not altered in a meaningful way during Monday’s rally in equities.
We entered the week with an allocation of cash, stocks (SPY), and bonds (TLT); a mix that aligns well with an indecisive and hesitant market. As noted on March 21, discipline is the key to ending up in the right place once a period of consolidation is complete. Last week, the scales tipped toward risk-off. Depending on how the market reacts to the incoming data, including Tuesday’s report on consumer prices, we will ratchet up or ratchet down our risk exposure over the coming weeks.
This Week: (1) CCM Market Model, (2) DeMark counts on the S&P 500. DeMark charts and indicators are proprietary tools from Market Studies, LLC.
Should be available here sometime around 7:30 p.m. EDT on Friday.
The Vulnerability Box
The S&P 500 closed at 1,833 on December 24, 2013. It closed at the same 1,833 on April 10, 2014, or over three months later. Common economic sense and the law of supply and demand tell us that when stocks stop making bullish progress, bullish economic conviction is losing ground to bearish economic concerns. The previous sentence also tells us the market’s risk-reward profile has been deteriorating since late December 2013.
Bank Earnings Not Helping
What can push a vulnerable market over the edge? Answer: when the net interpretation of all the new information is bearish. One piece of new data that is adding weight to the bearish side of the scale is earnings from JP Morgan Chase (JPM). From The New York Times:
JPMorgan Chase reported an 18.5 percent slump in first-quarter earnings on Friday, as the nation’s largest bank grappled with dual challenges: sluggish revenue from trading and lackluster mortgage lending. Both issues, broadly buffeting the banking industry, damped profits at JPMorgan.
A Trip Down Correction Memory Lane
Since weekends offer an opportunity to study markets and improve our approach to investing, it may be helpful to take a quick refresher course on stock market corrections. We will focus on two questions:
Sample of Corrections 1982-2014
In 1984, stocks dropped 14.63%. Unlike the multiple-day pullbacks in 2013, this correction lasted two hundred and eighty-eight calendar days (288).
The 1987 stock market crash occurred within the context of a bull market, and the bull market resumed relatively quickly. Therefore, it is relevant to our correction study and 2014.
In 1990, stocks corrected sharply, dropping 20% over eighty-seven calendar days.
We have covered the importance of the investment landscape in 1994 numerous times, including this March 21 article.
In 1998, the correction may have felt like a bear market based on the sharp declines witnessed on brokerage and 401k statements. The 1998 correction was outlined in more detail on April 2.
The 2010 Flash Crash was quite a bit more than a one-day media event. Stocks dropped 16.71% over sixty-seven calendar days.
A political stalemate in Washington and escalating fears of the end of the euro, helped push stocks down over 21% in 2011.
Russia Still A Concern
If you know your market history, you probably remember the fundamental drivers behind the corrections in 1984, 1987, 1990, 1998, 2010, and 2011. The drivers in 2014 could be economic concerns and Russia. From Bloomberg:
Having annexed Crimea and deployed thousands of troops along the border, Russian President Vladimir Putin has been ratcheting up pressure on Ukraine, threatening yesterday to halt gas shipments. Ukraine is dominating discussions at the spring meetings of the International Monetary Fund and World Bank, which start today. U.S. Treasury Secretary Jacob J. Lew “emphasized that Russia’s ongoing occupation and purported annexation of Crimea is illegal and illegitimate,” the Treasury said in a statement after talks in Washington yesterday with his Russian counterpart, Anton Siluanov. “The United States is prepared to impose additional significant sanctions on Russia if it continues to escalate the situation in Ukraine.”
Corrections Can Be Harmful To Your Portfolio’s Health
What are the answers to our questions of how far can stocks drop and how long can corrections last? Based on the examples presented above, the average loss was 19.50% and the average duration was 114 calendar days. Can corrections be less painful? Sure, there are countless examples of more shallow pullbacks. However, understanding what is possible helps with investment contingency planning.
Investment Implications – No Problem, If You Have Contingency Plans
Why do we always reference contingency plans? It is not prudent to assume anything about what will happen next in the financial markets. Therefore, if you use an IF-THEN approach, and the bearish IF never happens, it prevents you from overreacting to vulnerable set-ups that may or may not morph into a correction. Let’s look at a simple contingency plan example for illustrative purposes only. Over the past week, we have outlined reasons to be concerned about increasing odds of a market correction in the articles below:
If the first contingency in your simple risk-management plan was if the S&P 500 closes below 1,815, I will reduce my stock exposure by 10%. The S&P 500 closed Thursday at 1,833. Hypothetically, if the S&P 500 fails to correct and never closes below 1,815, then no action would be taken. The concept of using IF-THEN contingency plans was outlined in detail on October 18.
Our contingency plans are governed by our market model. The model entered Friday’s session with a very large allocation to cash to offset the market’s increasingly vulnerable risk-reward profile. Based on how things look at Friday’s close, our rules-based system may call for two chess moves: (a) reduce stock exposure (again), and (b) add some conservative investments to the mix. Conservative investment moves typically involve bonds (TLT) and/or currencies (FXA). As outlined in detail on March 27, contingency planning is a quadrant two activity – important, but not urgent. Weekends are a good time for getting into quadrant two.
The consumer discretionary ETF (XLY) holds many common brands, such as Disney (DIS), Starbucks (SBUX), and Ford (F). If you are concerned about your personal finances, you might logically decide to postpone that trip to Disney, cut back on the mocha lattes, and put off test driving a new Ford Focus. It seems as if some consumers have decided to stop off at McDonald’s (MCD) for their morning coffee in recent weeks (see chart below).
A telltale sign of a relatively fragile economy is weak pricing power. When companies are unsure about consumer demand, they are hesitant to increase prices. From The Street:
Prices for Arabica coffee increased over concerns about dry weather in Brazil which could cut production numbers. Starbucks may not pass that price increase to customers this year. In recent interviews CEO Howard Shultz said the company would hold off on any price increases. Some Starbucks locations reportedly lowered prices last week to combat McDonald’s (MCD_) free coffee promotion.
Expectations Toned Down On Rising Rates
Investors almost invariably are early when it comes to expectations for Fed rate hikes. Bonds are not the place to be if you believe interest rates are on the verge of rising rapidly (bonds fall in value in a rising rate environment). Therefore, if investors were becoming more confident the Fed was on the verge of an aggressive campaign to raise interest rates, the last thing they would want to do is flock to interest rate sensitive long-dated Treasury bonds (TLT). The blue arrow below shows a short-term bias toward economic fear, rather than economic confidence.
We are also seeing increasing interest in dividend-oriented investments, such as REITS (IYR), and the iShares Select Divided ETF (DVY). Dividend-paying instruments, like bonds, tend to experience a drag from rising interest rates. Therefore, the interest in IYR and DVY aligns with the low-rate/weak economy theory.
Emerging Markets Point To Friendly Fed
When the Fed prints money to suppress interest rates, it tends to be a negative for the U.S. dollar. The dollar (UUP) has been weak of late, which supports expectations for relatively tame interest rates.
All things being equal, emerging markets (EEM) economies prefer to see low rates in the United States and a weak greenback. EEM has responded.
The IMF recently voiced concerns about emerging markets debt, especially in a rising interest rate environment. If rates remain tamer than expected, some of those fears would be alleviated in the intermediate-term. From The New York Times:
As fears mount about emerging markets, American mutual fund investors with significant exposure to bonds issued by indebted companies in fast-growing economies may be at risk, the International Monetary Fund warned in a report published on Wednesday. In the Global Financial and Stability Report, I.M.F. economists highlighted the trouble spots on the financial horizon, noting the potential for growth to slow and interest rates to rise. As that happens, they estimated that problematic corporate loans could increase by as much as $750 billion and many companies may be pushed into default. That situation would hurt global investors, particularly mutual funds in the United States.
Investment Implications – Patience Is A Virtue
Our concern about adding emerging markets to our portfolios is the recent big picture trend toward increasing risk aversion. We are happy to look at all attractive opportunities, but we prefer to see more bullish stars line up before adding what can be a volatile EEM to our portfolio mix. We have been harping on clear evidence in recent weeks that pointed to a highly-indecisive market. The last 24 hours align with that theory. Wednesday, the S&P 500 was up 20 points; as of 12:30 p.m. EDT Thursday, it is down 22 points. Even though Wednesday’s rally was impressive at face value, we warned yesterday that not much had changed:
Wednesday’s sharp reaction to the Fed minutes and statements from Charles Evans did little to change the market’s risk-reward profile. Therefore, we made no changes to our current mix of stocks (SPY) and cash.
Economic doubts have impacted the emerging markets space this week. Reports from China dashed hopes for an imminent announcement of a major new form of stimulus. From Reuters:
Chinese Premier Li Keqiang ruled out major stimulus to fight short-term dips in growth, even as big falls in imports and exports data reinforced forecasts that the world’s second-largest economy has slowed notably at the start of 2014. Li stressed on Thursday that job creation was the government’ policy priority, telling an investment forum on the southern island of Hainan that it did not matter if growth came in a little below the official target of 7.5 percent. “We will not take, in response to momentary fluctuations in economic growth, short-term and forceful stimulus measures,” Li said in a speech.
The fear trade has gained some significant ground on emerging markets in recent sessions, which is indicative of increasing concerns about the strength of the never-ending global “recovery” (see chart below).
China’s leaders are issuing increasingly clear signals that they plan another round of economic stimulus programs, as evidence accumulates that the economy is slowing more than expected this year.
The weight of the evidence is saying stocks (SPY) have greater downside risk today than they did in late 2013. Our market model has offset that risk by maintaining a very significant exposure to cash. If the indecisiveness breaks in the direction of “risk-off”, we will consider redeploying some cash into more conservative investments, such as bonds (AGG). We prefer to see how the remainder of Thursday and Friday play out before considering any chess moves. Wednesday’s bullish jawboning by the Fed is an example of how quickly an indecisive market can be influenced or flipped.
Evans Picks Up Megaphone
On April 8, we outlined reasons to be concerned about stocks. The Fed pays close attention to the market’s risk profile; maybe they didn’t like what they saw. In addition to the Fed minutes that were released Wednesday, Charles Evans seemed to be carrying the “talk stocks back up” torch for the U.S. central bank. From Marketwatch:
Many people who argue that inflation is just around the corner have been repeating the same warning for the past five years, said Charles Evans, the president of the Chicago Federal Reserve Bank, on Wednesday. “I confess that I am somewhat exasperated by these repeated warnings given our current environment of very low inflation,” Evan said in a speech at an economic policy conference in Washington D.C. Evans said he still sees the economic environment pointing to below-target inflation “for several years.” Evans debunked current arguments that inflation is just over the horizon. He said that there is “substantial room” for stronger wage growth without inflation pressures building and added the Fed’s large balance sheet is not a “classic warning sign” of inflation. Commodity prices also seem to be an unlikely propellent of inflation at the moment, he said.
Evans began making dovish comments Tuesday in an effort to calm tapering fears. From Reuters:
There is a real risk that the Federal Reserve could close the tap for monetary stimulus too quickly, a top official at the U.S. central bank said on Tuesday.”One of the big risks is that we withdraw our accommodative policies prematurely,” Charles Evans, president of the Federal Reserve Bank of Chicago, told a panel at the International Monetary Fund.
The minutes from the March Federal Reserve meeting were released Wednesday, providing another source of good news for those concerned about interest rates. From The Wall Street Journal:
The dollar weakened against other currencies Wednesday after details from the Federal Reserve’s most recent meeting showed no signs of higher interest rates ahead. The minutes from the Federal Open Market Committee’s March meeting discussed keeping interest rates low as long as inflation remained below 2% and made no mention of an accelerated time frame for raising them, said Alan Ruskin, global head of G10 FX strategy at Deutsche Bank. DBK.XE +0.26% Lower interest rates have weighed on the dollar.
Investment Implications – Flexibility Takes Fed Into Account
Federal Reserve jawboning is one of many reasons to maintain maximum flexibility in the financial markets. Did Wednesday’s pop in stocks materially change the indecisive climate on Wall Street? According to the chart below, not yet.
How about that Dow Theory non-confirmation we have been concerned about; was it cleared up? The Dow has not posted a new closing high, which means the answer is “no”.
Wednesday’s sharp reaction to the Fed minutes and statements from Charles Evans did little to change the market’s risk-reward profile. Therefore, we made no changes to our current mix of stocks (SPY) and cash. The chart below, presented earlier this week, reminds us that periods of uncertainty can be resolved to the upside. Our cash will be redeployed when the market shows some conviction in some corner of the asset class world. We are just not there yet.