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Fed Does Unexpected, But Was It Really A Surprise?

Below is Bloomberg's summary of Wednesday's highly anticipated Fed policy statement:

Ben S. Bernanke reinforced his standing as the most activist Federal Reserve chairman in history by doing the unexpected: nothing.

Wednesday before the markets opened and several hours before the Fed dropped the "no-taper" bomb on the investing public, we penned the following:

The bulls remain in control, which means something has to change for the bears.

What prompted us to write that even when our base case called for a $10B Fed taper? We will answer that question below using one of many examples of observable evidence that was in place before the Fed statement was released.

Bond Market Battle

Our market model uses numerous risk-on vs. risk-off ratios to monitor the market's risk tolerance. Markets are the mechanism that sets asset prices. It is prudent to monitor the mechanism that determines the value of your investment portfolio. The bond market (a.k.a. credit market) tends to focus on two major issues:

  1. How much does this bond pay?
  2. What are the odds of default?

When the market determines default probabilities, it includes assessment of the economy. If the odds of a recession are low, then the odds of widespread bond defaults are also low. Conversely, if the odds of a recession are high, the odds of bond defaults also begin to increase. If you believe the odds of widespread bond defaults are low, then you would prefer to own a bond that pays a higher yield. If you believe the odds of bond defaults are rising, then you would prefer to own a higher-rated and more conservative bond. We can monitor the battle between yield and defaults by tracking the performance of higher-yielding junk bonds (NYSEARCA:JNK) relative to more-conservative Treasuries (NYSEARCA:TLT).

Credit Markets: Bullish On Economy

What was the bond market saying about the economy and default risks before the Fed meeting? The aggregate opinion of bond market investors was pointing to bullish outcomes for both the economy and financial markets.

Pro-Stimulus Yellen Also Sides With Bulls

We all know what happens in a two horse race when one of the horses drops out. With Larry Summers now in the yesterday's news category, Janet Yellen is sitting in the catbird seat. While it is hard to believe anyone could be more pro-stimulus or pro-intervention than Ben Bernanke, Janet Yellen may be just that. From Bloomberg:

Yellen fought for more than a decade to put combating joblessness on equal ground with controlling inflation at the core of Fed policy. Now, her confidence in government's ability to smooth over the ruts of market economies has become the prevailing view at the Fed under Bernanke, the most activist U.S. central bank chief in its 100-year history.

Investment Implications - We Are Data Dependent

The owner of the Boston Red Sox, John Henry, made his fortune in the money management business using a method known as trend following. He subscribes to the concept of paying attention to what is happening rather than what may happen.

"If you take emotion - would be, could be, should be - out of it, and look at what is, and quantify it, I think you have a big advantage over most human beings."

John Henry of John W. Henry & Company, Inc.

Our market model looks at "what is" and "quantifies it". The market's pricing mechanism continues to favor a risk-on allocation. Thus, we have continued to maintain exposure to U.S. (NYSEARCA:SPY) and foreign stocks (NYSEARCA:EFA). We also have exposure to leading sectors, such as small caps (NYSEARCA:IWM) and technology (NASDAQ:QQQ). While not as far along as EFA, emerging markets (NYSEARCA:EEM) have shown enough to earn a spot in our allocation as well. When "what is" begins to shift to a more risk-averse profile, we will shift as well.

The bullish reaction to Wednesday's Fed announcement began to emerge in early September when investors' tolerance for risk began to improve. After the close on September 6, we noted:

Our market model did see incremental improvement during the week. Consequently, we increased our exposure to broad market positions .

Observable evidence, including the ratio of junk bonds to more conservative Treasuries, allowed us to participate in the market's recent gains. For the record, the S&P 500 has tacked on 70 points since we noted the "incremental improvement" on September 6. What do we do now? The tweet below from early Thursday morning summarizes our approach.

Disclosure: I am long SPY, QQQ, IWM, EFA, EEM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Evidence Said Be Bullish Before Fed - Still Does