Don't Mistake The Fed - Or The Market

Includes: DIA, IWM, QQQ, SPY
by: Kevin Flynn, CFA


The market's reaction to the FOMC meeting.

First quarter softness.

A window of vulnerability.

This week has so far presented a good window on market dynamics, with things to keep in mind as we roll through 2014.

To begin, the rally on Monday-Tuesday was not a Ukraine-Russia rally. It certainly helped that Putin didn't announce an invasion of Eastern Europe, but the market was ready to go anyway, in particular the algorithmic ("algo") trading programs that are typically in buying in the two or three days leading up to a Fed statement. Most of the market's gains over the years can be extracted from the days surrounding Fed meetings, so the algos are buying.

Lacking something else to think about, markets might have been in the red Tuesday on Putin's surprisingly swift endorsement of annexation of the Crimea. Not by too much, because that's generally not the way the stock market operates - the first signs of a problem cause a flutter, and then the usual tendency is simply to ignore it until it either goes away or blows up. One can easily imagine some floor trader telling the cameras, "we already know about the killer asteroid. The important part is the Fed is going to stay accommodative until the end - and if it misses, you don't want to be short this market."

In the same vein, the market's post-statement sell-off had little to do with new chair Janet Yellen's vague hints about the taper or raising short rates, or even her admission that maybe the Fed had been a little too optimistic on the economy in January. Yellen wasn't hawkish, the market was simply hoping for something more dovish than it got. Whether or not the central bank's policy approach will work I will leave to the many other writers taking stands on either side of the issue, and concentrate on the market outlook aspects.

Momentum doesn't break up easily in the stock market. There's been enough volatility so far this year to signal that the chances of a serious correction have gone up substantially, but the bull isn't quite dead yet. It would be a mistake to assume that equities will immediately plunge into the abyss on perceived changes in Fed policy, for the simple reason that they haven't in the past.

The historical pattern is for some volatility at the outset of policy changes, and then as traders adapt, they will start buying in anticipation of a possible end to Fed tightening - or in the case of the taper, "reverse easing." Equities don't sell off on the first couple bumps in rates (unless momentum was already clearly negative) - first they put on relief rallies that the increases weren't larger, then they follow up with rallies on hopes that they're nearly over.

Set against that is the fact that the market is now dangerously overbought on a long-term basis and there is almost no valuation cushion left to support it. Than in itself isn't enough to derail the market - historically, equity prices typically can last about six to eighteen months in such a zone before rolling over. In the tech bubble, they lasted over two years.

One of the potential catalysts for a roll-over is the economy. I wrote last week about signs of the economy slowing and there were more this week, although you wouldn't easily conclude so from the positive spin the media (helped in no small part by the Street) put on reports, or the endless parade of smugly confident fund managers droning on and on about how the killer asteroid has historically missed the earth, and all the pent-up demand there will be once the black plague has run its course (got to get in on those restaurant stocks early).

Commentators were beaming on Tuesday, for example, about the upward January revision in housing starts, but very few ever bother to look at the data and even fewer look at it for than a few minutes. The January gain was simply December's loss, the matter of shuffling some of the starts from the earlier month into the latter. I would say that of more importance is that starts are down 6.3% through the first two months of the year. Certainly the weather has played a substantial role, but consider that starts have been booked for a 15%-20% gain in most projections, and even yours truly is expecting a 10% gain.

In other words, starts are running close to 20% short of where we were thought to have been headed, and while I've no doubt that there will be some decent catch-up later on, I can't in good faith put all the blame on the weather, not when the West Coast and Florida - two of the biggest markets - were largely unaffected by the cold and snow. Don't expect stocks to price boring reality in any time soon, though. At the first whiff of even the most mundane of rebounds, the projections for paradise are going to take off again.

One thing that isn't happening so far is a pickup in retail sales - still soft through the first two reporting periods of the month. Neither are mortgage purchase applications - down 1% last week and 15% year-on-year. Something that won't happen soon is a big pickup in construction jobs, not in the jobs report anyway, which has greatly overstated the sector in its seasonally adjusted data through the first two months.

While many commentators crowed about the estimate beat in February's industrial production release, the year-on-year rate hasn't changed in the last four months. The seasonally adjusted twelve-month rate is 2.8% overall, boosted by 8.3% for utility production. That's hardly the acceleration that so many keep boasting about (it's in the surveys) - it's one of those stories that gains credence by virtue of pure repetition. Year-on-year manufacturing growth is 1.5%. The cap-ex spending theory got a boost from the 1.3% increase in business equipment (seasonally adjusted) - but the year-on-year rate declined.

This vein of near-term softness, combined with the lack of rosy-glow dovishness from Yellen, could mean trouble for the market in the coming days. China is rapidly softening - don't go by the GDP numbers, the government prints what it wants. Pay attention to how quickly they've been softening the currency, trying to revive the export side to balance off the problems in real estate. The fullness of their problems will take more time to unravel and meet with considerable denial along the way, but further hiccups could be problematic over the next few weeks.

The stock market will find a way to regain its faith in the Yellen/Fed put. That kind of faith isn't rooted out so easily. But it looks set to enter a period of vulnerability until the data can pick up again and revive the fallback position of the accelerating recovery.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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