Steady Fed Policy Strengthens The Stock Market

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by: Clif Droke
Summary

Wall Street was disappointed by Fed's failure to cut interest rate.

Yet the Fed's steady policy bias is attracting foreign capital to U.S.

Stocks will ultimately benefit from current interest rate levels.

Investors clearly weren’t happy about the Fed’s failure to lower interest rates at its latest policy meeting. Many participants were hoping to see a rate cut, and when this didn’t materialize they reacted with a veritable temper tantrum by selling stocks. Yet as I’ll demonstrate here, the Fed’s decision to leave interest rates steady is actually helping to pave the way for higher stock prices in the months ahead. Investors therefore have reason to cheer the Fed’s decision rather than castigating it.

Wall Street was clearly disappointed by the Fed’s decision to leave interest rates unchanged. Many participants were anticipating a rate cut, but Fed President Jerome Powell’s statement to the effect that low inflation is likely only “transitory” disappointed these expectations. Subsequently, the Dow 30 average dropped more than 270 points in the two days following the Fed’s latest policy meeting.

Are investors justified in their belief that a rate cut is in order? Given the strength and improvement reflected in the last few economic releases, the Fed would appear to be justified in leaving its benchmark rate unchanged. An argument could even be made that the 10-year Treasury yield is too low in view of the economic growth since March. But here’s something else to consider: When the U.S. is virtually alone among the nations in maintaining a steady interest rate policy, while central banks around the world are cutting rates, the U.S. stands out as a pillar of strength in a sea of global weakness.

Indeed, the economic strength and stability of the U.S. is acting as a magnet to attract capital inflows from around the world. And these strong inflows will only serve to support higher equity prices in the coming months. Thus, by leaving rate unchanged the Fed is actually helping (intentionally or not) to strengthen the global standing of the U.S. financial market.

One sign that the U.S. is attracting foreign capital can be seen in the relative strength of the U.S. dollar index (DXY). As you can see here, the dollar is rising against most major foreign currencies and has been trending higher for the last several months. The dollar index has begun accelerating higher in recent weeks as evidenced by the increasing rate of change in its 50-day moving average (below). A rising dollar over an extended period is an undeniable sign that the U.S. economy is strengthening. This in turn serves to further facilitate capital inflows into the U.S. in the fashion of a feedback loop.

U.S. Dollar Index

Source: BigCharts

Turning our attention to the equity market, there has been much talk about the supposed seasonal bias against stocks beginning in May and extending through October. Over the last 50 years, there has certainly been a statistical advantage in buying and holding during the November-April period compared with the May-October period. Yet in the last five years, the Dow Jones Industrial Average has averaged 4.31% in the May-October period, versus a 5.48% average gain during November-April. So while the latter period retains a seasonal advantage, the months between May and October haven’t exactly been bad for investors.

Nonetheless, many small traders have exited the field by taking the slogan “sell in May and go away” literally. If the next few months are anything like the previous two years, the May-September period should be relatively benign for equities with lower-than-normal volatility in long stretches. The extended absence of the retail trader tends to diminish volatility and makes it easier for Wall Street’s buy programs to push equities higher in a low-volume environment.

In the immediate term, the equity market is looking a little ragged around the edges as the disappointment of the past week’s FOMC meeting has depressed investors’ expectations. The number of stocks making new 52-week lows on both major exchanges has increased in the last two days, although the new high-low differential remains positive on the NYSE. The SPX is a bit over-extended from its underlying 50-day moving average (below), so a period of rest and consolidation might be in order for the next few days before the market’s next rally.

S&P 500 Index

Source: BigCharts

As for what may serve as a catalyst to the market’s next rally phase, look no further than the possibility of a U.S.-China trade deal. According to a CNBC report, the U.S. and China could announce a trade deal Friday, May 10. A resolution to the trade dispute which has led to increased tensions among investors and an increase in global market volatility would almost certainly be greeted with cheers by investors. A broad market rally would likely result from a deal that benefits both nations and relieves investors’ anxiety about the global trade outlook.

Regardless of what the next few days might have in store for stocks, the NYSE broad market remains internally strong as measured by breadth indicators (e.g. the advance-decline line) as well as the positive momentum of the new 52-week highs and lows, both on a short-term and intermediate-term basis. Additionally, the forward earnings and forward revenue growth continues to increase at an impressive pace, which provides the fundamental context behind this bull market. And with the Fed’s steady interest rate policy serving as an incentive for investors in weak-performing countries to look to the U.S. as a safe haven, the U.S. equity market will continue to benefit from overseas demand. Investors are therefore justified in maintaining a bullish bias toward stocks.

On a strategic note, traders can maintain a long position in my favorite market-tracking ETF, the Invesco S&P 500 Quality ETF (SPHQ). I suggest raising the stop-loss to slightly under the $31.70 level for this ETF trading position on an intraday basis. Only if this level is violated will I move to a cash position in my short-term trading portfolio. Meanwhile, investors can maintain longer-term positions in fundamentally sound stocks in the top-performing industrial, consumer staples, and financial sectors.

Disclosure: I am/we are long SPHQ, XLF. 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.