Stocks Throw A Hissy Fit

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Includes: DIA, IWM, QQQ, SPY
by: Melotte Financial Advisors

Summary

FOMC statement disappoints as traders yearn for more cheap money from the Fed in light of strengthening dollar and falling inflation.

What better solution for a drinking (debt) problem than more alcohol (debt)?

Honestly assess your tolerance for risk and the susceptibility of your strategy to market corrections then adjust accordingly. Too many investors get caught with more risk than they can handle.

Market was down over 1.3% Tuesday and again yesterday. The S&P 500 is down over 4.2% from its high close on 12/29/2014.

Earlier Wednesday, immediately upon release of the Federal Reserve's post-meeting statement, I posted my quick take:

My take in short: Fed believes recent lower inflation is temporary based on lower energy prices. If lower-than-2% inflation persists (realized or expected), however, the Fed will do whatever they feel necessary to ensure purchasing power of the USD is reduced by 2% each year. So for now, no changes this month with regards to either interest rates or asset purchases.

Keep an eye on inflation data, inflation expectations, and dollar strength to anticipate monetary policy in future meetings.

Some background. Many of you should know by now I believe most of the market returns of the last few years were only made possible because of the Federal Reserve's QE program (monthly asset purchases) and suppression of interest rates. Many of you also know that I believe the economic fundamentals are actually very weak and that the natural tendency, absent any Fed intervention, for the market would be falling prices (consumer and asset) and debt reduction on a national scale. In other words, the United States would have been experienced a deflationary deleveraging cycle - medicine we desperately need. This restructuring would have allowed the economy to rebuild upon sound, stable footing once prices fell far enough to incentivize genuine, sustainable (i.e. not artificially-induced) investment and consumption and debt fell far enough to free up the resources necessary for consumption and investment.

Of course, there has been no absence of intervention over the last six years as the Fed has kept rates at zero and literally conjured over $4 trillion out of thin air with the specific purpose of inflating asset and consumer prices and incentivizing more borrowing. After all, what better cure for a drinking (debt) problem than more alcohol (debt)? So the result is a patient that is sicker than ever even six years later when the economy should be (would have been) experiencing truly robust, sustainable growth by now.

However, in October of 2014 the Fed announced they were abandoning their monthly asset purchases and would likely start increasing interest rates in 2015. My thought at the time, and remains today, that without the Fed's support the economy would enter a recession and the market would probably experience a bear market once the Fed's painkiller wore off. The reason? The underlying economy is weak and still plagued with its disease (excessive debt). Because the economy was never allowed to heal but was merely injected with painkillers in the form of stimulus, the day of reckoning still lies ahead.

My thesis of a weak underlying economy: The core thesis is that corporate earnings will be challenged over the next several years, which could further challenge an already-overvalued stock market.

Since the Fed stopped its QE program in October, however, the Bank of Japan did the opposite and expanded their stimulus program (when are they going to get that it just doesn't work?). Then just within the last few weeks the European Central Bank announced a new QE-type program that could amount to over 1 trillion euros. One of the effects was to cause the U.S. Dollar to strengthen relative to most foreign currencies. Of course, in the upside-down world of phony (Keynesian) economics nothing could be worse than a strengthening currency!

Given the recent dollar strength and falling inflation many started to wonder if the Federal Reserve would change their tune on rate increases and even hint at delaying those increases. However, that didn't happen... at least not yesterday. Wednesday's statement indicates that the FOMC believes the recent lower-than-desired inflation rate is temporary as a result of lower energy prices so they continue to feign that rate increases are right around the corner. Personally, I wouldn't be surprised to see them keep delaying those rate increases that were once promised upon unemployment falling below 6.5% (unemployment is now at 5.6% by the way).

Even if they do proceed with increasing interest rates as planned any increase will likely be tiny and more symbolic than anything if current conditions persist. But until the time when the Fed changes its tune on rates or even decides to embark on QE4 (yes, a fourth round of stimulus and money printing) don't be surprised to see greater market volatility and, potentially, even a bear market.

Am I saying to sell all your assets and move to cash? No. Why not? Because consistently timing market moves is impossible. There are just too many factors and people that affect movements from day to day. I truly cannot say whether the most recent peak was the highest point before the next bear market or if the recent downturn will just turn out to be a blip on a further upwardly-sloping chart.

So what is the takeaway? The 2007-2009 bear market exposed many investors' poor / inappropriate portfolio strategy. The reason is that investors had a lot more risk than they could tolerate because the market was on the tail end of a great bull run. People forget how severely and sharply markets can drop when things are strong for so long. Investors become complacent, even euphoric, which clouds their decision-making ability. Shame on advisors for not doing a better job at controlling investor emotions and setting realistic expectations. My job as an advisor is to set reasonable expectations and help my clients make better-informed decisions. With the goal of, hopefully, ensuring they don't have more risk in their portfolios than they can truly tolerate because that tolerance will absolutely be tested at some point.

So don't put off reviewing your portfolio strategy. Be honest with yourself about your tolerance for volatility and downside risk then ensure your portfolio is aligned accordingly. Understand that markets can and will drop then ask yourself, "When that day comes, am I comfortable with the implications for my portfolio?"

Not intended as specific investment advice. Investment advice can only be provided upon a thorough understanding of an investor's risk tolerance, investment expertise, and financial goals.

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. The author has no business relationship with any company whose stock is mentioned in this article.