In the last week the S&P 500 has dropped 2.5% with a marginal pickup in daily volatility. This drop has sparked fears of a correction and speculation whether investors should step aside or grasp the opportunity presented to buy this dip. We believe that while a correction will come eventually, it is not here now. This dip presents an opportunity to reestablish a long position in the market and here are our reasons to support our hypothesis:
1. The main factors driving this 5 year bull run/easy monetary policy are still intact.
The rally from the lows of March 2009 has been driven by low interest rates and quantitative easing. The main purpose of quantitative easing was to bring down not just the short end interest rates but also the long end interest rates, i.e. in the 5 year to 30 years sector. The main purpose behind lowering long term interest rates was to lower the borrowing costs for mortgages and long term financing by corporations.
Consequently, the Federal Reserve's balance sheet has swelled from $895 billion in December 2007 to $4.3 trillion as of May 30, 2014.
Source: Federal Reserve Board of Cleveland
Many investors fear the consequences of the Fed reducing its balance sheet from $4.3 trillion back down towards $1 trillion in a short period of time. While the Fed has declared an end to further purchase of securities, it does not imply that the balance sheet will fall back to $895 billion any time soon. There are quite a few risks that the Fed has to contemplate before it starts reducing the size of its balance sheet. At the top are a possible rapid rise in long term interest rates and inflation.
To mitigate both these risks, the Fed is most likely to hold the bonds to maturity and let them quietly drop off its balance sheet without creating undue duress for the markets by selling them through its open market operations. If the Fed does proceed down this path, by the Fed's own estimates its balance sheet would shrink down to $1.7 trillion (a 60% reduction) by 2021. This multi-year reduction program poses little risk to the stability of the S&P 500 and we believe the fear of a sudden reversal of quantitative easing policy is unfounded.
The second monetary policy risk that worries the market is the fear of rising short term rates. With the Fed Funds rates stuck between 0% and 0.25% for nearly 6 years the fear is that even a small increase will reverberate through the markets. For the past few months the FOMC had been hinting at rising rates but over the past couple of weeks the Fed has changed its tune significantly. The weaker than expected July employment report was followed by Janet Yellen's comments that, "the job market still isn't at full health." Yellen also noted the slow pickup in wages which does not jive with a robust job market. In a robust job market close to full employment, employers would be paying more for fewer workers. Most Americans have received little or no pay raise this year as the average hourly earnings have risen just 2 percent over the past year which is less than the rate of inflation. The other 2 aspects of the job market which worry the Fed are a rise in part-time employment at the cost of full time employment as well as a drop in workforce participation from 66% to 62.9%.
As long as the job market picture remains weak, we do not believe that the Fed will be in a hurry to raise interest rates any time soon.
2. Volatility Has Not Picked Up Significantly
The pickup in daily volatility over the past week, as shown below, is well within the limits of what we have seen since November 2011. Since the end of the crisis in March 2009 we have seen 2 periods of a pickup in daily S&P 500 volatility which led to a correction of greater than 10%:
i. May 2011 to September 2011 - A drop of 17.1%
ii. May 2010 - July 2010 - A drop of 14%
The intermittent months outside of those two periods saw only minor corrections of around 5%.
Source: MA Capital Management
Therefore, given the easy Federal policy and a relatively small pickup in S&P 500 volatility we believe that this is not the beginning of a major correction and should be viewed as an opportunity to stay in the equity markets.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.