Market Setting Up For Pre-Fed Meeting Rally And Post-Fed Meeting Decline

by: James A. Kostohryz
Financial markets have fully absorbed most of the hits that I have expected would come its way in September. For this reason, global equity markets may exhibit a positive technical bias in the context of a “relief rally” between now and the next Fed meeting on September 20-21. For this reason I expect to have closed out all bearish positions before the close today.
Whether equity market (SPY, DIA, QQQ) rallies can be sustained beyond that is an open question.
News Not Bad Enough
Perversely, perhaps the most bullish scenario for the market would have been for recent economic data releases to have been so bad that the “doves” within the Fed would have gained the upper hand in their push to implement aggressive monetary stimulus.
While the data have clearly shown a significant deceleration of the economy in August, the general consensus has been that the data has not been “disastrous.”
Those who want to see the glass full can point to improvement in the relatively sanguine ISM service sector report as well as results reported by many retailers. Those who wish to see the glass as half empty can point to severe deceleration and even contraction in the various manufacturing PMI reports as well as an alarming deterioration in the labor market.
Today’s Commerce Department retail sales data straddles the middle. It shows very substantial deceleration on a sequential basis so that MoM growth is at a virtual standstill. However, on a YoY basis retail sales are expanding. Though it must be acknowledged that easy comparisons are driving the YoY data.
Not Enough Consensus For Aggressive Action
Chicago Fed President Charles Evans and others have made it clear that there are many options for potentially aggressive actions by the Fed. I have detailed what some of those options are here.
However, it is in the nature of the Fed as an institution that it is unlikely that very aggressive action will be taken without unanimity or near unanimity.
The Fed does not want to create a political firestorm by acting aggressively in the context of internal divisions. By publicly revealing deep internal divisions, Fed decision-making would be perceived to reflect the same cleavages that are dividing the nation along ideological lines. This perceived politicization of Fed decision-making would tend to compromise the status of the Fed as a politically independent institution. It is not in the interest of the Fed as an institution to be placed at the center of a political firestorm.
Keeping this in mind, it is my view that that data thus far released in September will not be sufficient to garner unanimous support for aggressive monetary stimulus. The “hawks” on the committee will plausibly argue that the recent slowdown was sentiment driven (and probably temporary for that reason) and that the Fed should wait for a couple of more months before making any hasty decisions. Furthermore, they will argue plausibly that there could be some positive surprises in store in coming months as a “payback” effect from supply line disruptions associated with the disasters in Japan could materialize.
Thus, in the absence of very bad news between now and the Fed’s extended meeting of September 20-21, I believe it is unlikely that the Fed will take aggressive action. At best, the Fed may tinker with the current policy around the edges.
After Next Fed Meeting Market Will Be Exposed
A lack of aggressive action by the Fed would leave financial markets relatively exposed until the following gathering. In between meetings several catalysts could drive the market lower.
First, the 3Q earnings period reported in October and November could disappoint. Based on some key pre-announcements, it is my expectation that many companies will guide downward in terms of revenue and margins.
Second, until Greece has defaulted and/or European officials have implanted a credible plan that would halt contagion to Italy and Spain, the crisis in Europe will continue to exert a strong negative bias on global markets.
Finally, I would expect downside surprises in Chinese economic activity as its export dependent economy begins to feel the impact of slow and even contracting growth in the developed countries.
Technically speaking, the market has “rolled with the punches” quite well. A relief rally leading up to the Fed’s next meeting between September 20-21 seems likely.
After that, things become very uncertain. The reasons to suppose that the U.S. economy could bounce back somewhat in the fourth quarter are as plausible as arguments for continued deceleration.
A combination of bad economic news, disappointing earnings and continued troubles in Europe could ultimately send the market to my announced target area of 950-1,020 on the S&P 500 (^SPX).
On the other hand, if consumer and business sentiment were to improve (due to a perceived improvement of the European situation, for example), pent-up demand derived from various months of retrenchment could become activated. This combined with the normalization of Japanese supply lines could lead to an economic rebound.
Equity markets (^SPX, ^DJIA, ^IXIC) have another important thing going for them: There is strong fundamental value in stocks such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), AT&T (NYSE:T), Verizon (NYSE:VZ) and even some financials such as Goldman Sachs (NYSE:GS). Fundamental value is proving to be an important source support for equity prices. For many investors, stocks with free cash flow yields of more than 10%, PEs in the low single digits/low teens and strong growth prospects are proving to be too good to pass up. In the case of many stocks, each of the recent declines has been met with enthusiastic buyers forming some interesting technical bottoming patterns.
At this point it is a contest between good fundamental value and the delta of macro fundamentals. As detailed here, at current prices, stocks are already pricing in a very negative scenario for the next decade. This basic fact must be kept in mind. However, as we all know, stock prices do not always reflect their fundamental value. Delta factors tend to dominate in the short term. Applied to present circumstances, if macro-fundamentals were to continue to deteriorate, it is likely that stocks will become cheaper.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long SPX puts. Short TLT. Long TBT and SBND

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