The Recent Rally May Be A Head Fake

| About: SPDR S&P (SPY)

Last Wednesday, when the Federal Reserve released the minutes from its April meeting, many investors were surprised to see that it was seriously considering a June interest rate hike. The common wisdom until then had been, no June hike, so stocks are safe. As you might expect, as soon as the strong possibility of a June hike was made real by the release of those minutes, stocks sold off.

But just look at what's happened since then. The S&P 500 has rallied more than 2% from last Wednesday's close even though the probability (as implied by the futures market) of a rate hike in June has shot up from virtually zero before the release of the April minutes to more than 30% now. So why are investors rushing to stocks just as the Fed seems more likely to raise rates?

Here are a few things to keep in mind. First, even though rising interest rates aren't typically good for stocks, they are worse for bonds. In other words, rising rates make stocks comparatively more attractive than bonds. If you have to put your money someplace when rates are rising, the thinking goes, you might as well put it into stocks.

Second, stocks may be rallying now, but that doesn't mean they won't sell off when the actual rate increase occurs. There's a reason that "Buy on the rumor, sell on the news" is an old saw. Furthermore, a one-third probability of an interest rate hike in June is far from a certainty. Investors may be taking an "I'll believe it when I see it" attitude. The Fed may be doing its best to prepare investors for a rate hike, but that may not be enough to keep stocks from selling off when the rate hike actually happens.

Third, the stock market has been stuck in a trading range. In fact, it's been just over a year since the S&P 500 hit an all-time closing high of 2131.82. We're approaching that level, but we're still about 2% away. Technically speaking, if stocks can't break through that mark, the index may go back down to around 1900 again.

So where do we stand? GDP growth for the second quarter is expected to come in around 2.5%. That's much better than the first quarter, yet it's still an anemic rate of growth. Corporations continue to cut costs, yet they are having trouble growing revenues. And if the Fed does not raise the fed funds rate in June, it almost certainly will raise it by year-end - at least once if not twice. If you throw in other uncertainties such as a possible vote to exit the EU by Britain in June and the presidential election in the U.S. in November, there seems to be little reason to increase one's allocation to stocks right now. There are always special situations that make particular stocks undervalued. But as an asset class right now, I think the stock rally is a head fake and that the market is more likely to go in the opposite direction, at least over the near term.