Good news from the June FOMC highlights strong GDP growth, falling unemployment.
Bad news is that inflation projections have risen and QE will end by year-end.
Correlation between S&P 500 rise and easy Fed policies is very high. A reversal will spell trouble.
Volatility analysis shows a sanguine environment, but we call for the party to end Q4 of 2014.
June 16th, 2014, FOMC statement had both good news as well as alarming news to digest. Good news is that the Fed has a very upbeat growth forecast. They said that "Growth in economic activity has rebounded in recent months," "Labor market indicators generally showed further improvement." and "Business spending resumed its advance." Their forecast for GDP growth, while pulled back from March projections still calls for a 2.2% increase. While the 2.2% forecast for 2014 is tepid, investors are likely to focus on the 3% projection for 2015. Unemployment rate has fallen to a healthy 6.3% as of June and is further projected to fall to 5.3% by 2016. These are all very bullish leading indicators for economic growth in the US. Given the market's focus on economic numbers lately, we would say that this bodes well for increased capital flows into the equity market and a continued bull run for the S&P 500 in 2014.
Now for the bad news. The FOMC has continued trimming its bond buying (QE) program by reducing the bond purchases by $10 billion for a fifth straight meeting, to $35 billion, keeping it on pace to end the program later this year. While this is not news, we have to remember that most of the 190% rally in the S&P 500 from the lows of March 2009 has been engineered by easy Fed policies. I am sure most of you have seen the following chart, which shows the positive effect of various bond buying (QE) programs on the S&P 500 and the pullbacks when the bond purchases stopped.
If you are wondering, why is the S&P 500 up 5% for 2014 when it is common knowledge that the bond buying program will come to an end this year? Rationally one would expect investors to start taking money off the table in anticipation of the ending QE program. Anecdotal as well as empirical evidence suggests that hedge funds have trimmed their long exposures and hedge fund managers like David Tepper have publicly warned against having large long exposures to the S&P 500. So while the institutional investor circles are getting defensive, retail buying continues. We think there are three main reasons for this:
1. Investor psychology of missing most of the 190% rise in the S&P 500 since 2009 is seeing a lot of latecomers throw in the towel and grab whatever they can while the party is still on.
2. Disbelief that the Fed will ever end its easy policies and embark on tightening in the face of global deflation worries. The ECB on June 5th announced negative interest rates in Europe, a first for any global central bank. Furthermore, the IMF is now calling for the ECB to adopt QE to fight deflation. Throw geo-political risks like Ukraine and Iraq into the midst and the global picture looks far from sanguine.
3. The third reason for the continued rally is that so far investors have been ignoring the pickup in US inflation indicators. The latest CPI report showed a pickup in U.S. consumer prices, which was the largest increase in more than a year. Consumer Price Index increased 0.4 percent in May, with food prices posting their biggest rise since August 2011. Combine this with the fact that the FOMC raised its core PCE inflation target to 1.8% average for 2015, 2016 and in its latest dot-plot forecast, the Fed did see a slightly faster pace of tightening in the cards.
2014 - Sanguine for now
Our approach of assessing market risk is decidedly systematic rather than fundamental. In the chart below, we show the S&P 500 daily movement and our proprietary risk indicator. The risk indicator is a function of the size of the daily returns and the daily volatility of the index. When the daily returns are positive and the volatility of those returns is low, the risk indicator is high. A high risk indicator implies that the market is in a nice bull trend. A risk indicator close to 0 implies that the S&P 500 is in a volatile bear market.
The current volatility picture shows no sign of volatility and a high risk indicator. While the risk indicator fell earlier this year, the current readings are similar to what we have seen over the past 3 years.
Caution at the end of 2014
So why do we feel that the party will end towards the end of 2014? Let me first start by saying that I do not have a magic crystal ball. It is pure conjecture based on past investor behavior patterns. QE will most likely end at the October FOMC meeting and if the Fed is going to follow-up on their 2015 rate hike forecasts, their rhetoric should turn decidedly hawkish by then as well. This is most likely going to start spooking some investors and it does not take long for a pause in buying to turn into profit taking by some to profit taking by many to outright short bets on the market. We saw it happen in March 2000, again in August 2007, and maybe the cycle repeats itself in Q4 2014.
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