Why I Don't Trust This Rally

Includes: DIA, QQQ, RINF, SPY
by: Vahan Janjigian, CFA

On Tuesday, Federal Reserve Chair Janet Yellen delivered a speech to The Economic Club of New York. Her words often move the markets, and this time, they caused stocks to rally by almost a full percentage point. We've become pretty used to swings in the market lately, but this "Yellen rally" created a fountain of optimism that in turn created a mountain of wealth.

So I decided to take a closer look at the transcript of her speech and see if there was anything particularly noteworthy that I missed. Was there more than met the eye?

First, let me remind you that the Federal Open Market Committee increased the closely-watched fed funds rate in December by a quarter point. This marked the first increase in almost 10 years. After nearly a decade of extraordinary measures, including zero interest rates and several rounds of quantitative easing, the Federal Reserve decided the time was finally right to begin normalizing monetary policy. But it began doing so in baby steps and made it perfectly clear that future rate increases would be "only gradual."

Still, investors freaked out and stocks began 2016 by selling off strongly. The Fed did not like the reaction. Stocks have since recovered, but only because the Fed is on hold. It hasn't yet increased interest rates a second time.

It was in this environment in which Yellen addressed The Economic Club. Investors obviously appreciated her cautious and dovish comments. Here is one line from the speech that stands out:

Reflecting global economic and financial developments since December, however, the pace of rate increases is now expected to be somewhat slower.

But back in December, the Fed had already told us that interest rate increases would be "only gradual." Now Yellen was saying that rate increases would be even more gradual than the Fed initially planned. But this is not a surprise. In fact, after December's FOMC press release, most economists were expecting four quarter-point interest rate hikes this year.

However, following the FOMC meetings in January and March, economists had ratcheted down their expectations to only two quarter-point increases this year. Yellen's speech on Tuesday changes nothing. To put it bluntly, there was absolutely nothing new in Yellen's speech that should have caused stocks to rally as much as they did.

"Only gradual" is a term that comes up frequently with the Fed. It was in December's FOMC press release, and it was found in several places in Yellen's speech on Tuesday. But it was also in January's FOMC press release. And, surprise! There it was again in March's FOMC press release.

But for some reason, this "only gradual" mantra from the Fed seems to be like the opposite of "The Boy Who Cried Wolf." Instead of paying less and less attention, the more the Fed utters "gradual," investors seem to get more and more excited about it. And when you're talking about investing, getting excited is what starts to really separate asset prices from asset values.

The truth is, Yellen's speech this week merely reiterated what she and the FOMC have said before - on numerous occasions. Because stocks rallied so strongly on nothing that could be considered new, I don't trust the rally. In general, I don't trust any rally that was generated by the comments of a central banker. Stocks have done quite well since the end of the financial crisis in 2008, yet the economy has continued to struggle.

Ironically, both the economy and the stock market would probably be better off today if the Federal Reserve had begun normalizing monetary policy years ago. However, as Janet Yellen just reminded us, if we do ever get back to normal, it will be "only gradual."