Mr. Powell Has Set The Price

Summary

• The uptrend in stocks remains intact despite recent weakness.
• Economic fundamentals remain poor despite the recent employment report.
• The disconnect between stock prices and underlying fundamentals.
• An alternative lens to inform our stock allocations.
• This idea was discussed in more depth with members of my private investing community, Global Macro Research. Get started today »

No holding back. The U.S. Federal Reserve completed its latest Open Market Committee meeting on Wednesday. Virtually everything Chair Powell stated during his post-meeting press conference was widely expected and already known. This included the Fed’s explicit indifference to high asset prices. The stock bubble green light is officially lit amid the worst economic backdrop in nearly a century. What should we reasonably expect from here?

Stocks on fire. The U.S. stock market remains on fire. The S&P 500 had rallied nearly +50% since the market lows on March 23 through the start of this week. This included a +17% advance over the past three weeks since mid-May. These are blazing hot returns, to be certain.

Of course, being on fire is not necessarily a good thing. Over the last three trading days through Thursday’s close, the S&P 500 has fallen back by more than -7.14%. This included a -5.89% plunge on Thursday alone to close at 3002.

Hand-wringing? The widespread hand-wringing across financial media during the trading day on Thursday was notable. Why? Consider what was taking place at face value. Sure, anytime the S&P 500 falls by nearly -6% in a trading day is notable. But consider what had taken place in the market leading up to Thursday’s pullback, which is shown in the chart below.

First, the S&P 500 had risen in nine out of the previous eleven trading days and thirteen out of the previous seventeen trading days since bottoming at 2766 less than one month ago on May 14. In other words, the S&P is still higher by nearly +9% in less than a month even after Thursday’s sharp correction.

Next, the S&P 500 had been grinding at or above the top bound of its Bollinger Bands for each of the past fifteen trading days through Monday. In other words, it was repeatedly trading at a high level that would reasonably be expected roughly only 2.5% of the time or less repeatedly for most of the past month.

Also, the S&P 500 by Monday was trading with a Relative Strength Index of 74.48, implying that the U.S. stock market had become extremely overbought.

In summary, the S&P 500 was long overdue for a measurable short-term pullback coming into this week. And after drifting lower on Tuesday and Wednesday, it delivered a solid punch to the downside on Thursday.

But let’s assess the damage.

To begin with, the Thursday close at 3002 brought the S&P 500 all the way back to levels last seen on - wait for it! - nine trading days ago on May 29.

Also, what was once resistance is now support. While the S&P 500 closed marginally below its upward sloping 20-day, 150-day, and 200-day moving averages, these key support levels are all still effectively holding.

So, while Thursday’s price drop was dramatic, it was long overdue from a technical standpoint and has inflicted minimal damage on the market so far. Despite short-term corrections that should be expected, the recent uptrend remains solidly intact.

So how high should we reasonably expect the S&P 500 to rise if it continues to the upside in the near term?

The path to all-time highs at 3393.52 remains the next logical stop. Any return to this level should be closely watched for signs of a potential double-top formation from a technical standpoint. And if the S&P 500 blasts through all-time highs in the same way it sliced through heavy recent resistance at the 3000 level, where the 100-day, 150-day, and 200-day moving averages had all recently converged, the S&P 500 could reasonably reach as far as the 3500-3600 range before hitting trend line resistance (green line in chart above) dating back to the start of 2018.

How stocks respond if and when they reach either of these key technical levels will be important. For if the S&P 500 arrives at either of these levels and falls back hard, a descent back lower toward trend line support (red line in chart above) also dating back to the start of 2018 is very possible.

This potential downside reality may help explain the financial media hand-wringing on Thursday. For it is widely known that the primary, if not exclusive, reason the S&P 500 is travelling higher is because of the Fed. And if it turns out at any point along the way that selling pressure overwhelms Fed support, the short-term direction for the stock market would be decidedly to the downside, based on the persistently stark fundamental reality.

But what about the recent jobs report? Many continue to point to the stunning monthly employment report for May as a key indicator that the worst is now behind us for the U.S. economy and the rebound is well underway. Frankly, I continue to find this even more surprising than the financial media hand-wringing on Thursday. Let’s explore this jobs report in more detail to explain why it is getting far more attention than is warranted.

Before going any further, it was a good employment report considering the circumstances. And I sincerely hope that it truly is the start of better economic days ahead. But I have my concerns, for the following reasons.

First, it was just one data point. A key point that I always preach when it comes to interpreting economic data is to avoid placing too much emphasis on a single release. This is due to the fact that one data point does not make a trend, and that most recently released reports are subject to considerable revision. Given that the May employment report was compiled in the midst of one of most unusual economic environments that we have experienced in nearly a century, we should anticipate the potential for error and revision in this reading, particularly when it was such an extreme outlier relative to consensus expectations and is based on the extrapolation of survey data that ran in stark contrast to the weekly jobless claim data reported by the states as well as virtually every other major economic release surrounding it.

Second, recent-known miscalculation has been significant. By the admission of the Bureau of Labor Statistics that releases the monthly employment data, it has been subject to error due to workers who were recorded as employed but absent from work due to “other reasons” that should have been recorded as unemployed. This would have resulted in an unemployment rate that would have been roughly 1% higher in March, 5% higher in April, and 3% higher in May. This would imply unemployment rates of 5.4%, 19.7%, and 16.3%, respectively, over these past three months.

Third, we should consider those that would otherwise be in the labor force. The calculation for the unemployment rate is equal to the unemployment level divided by the civilian labor force level. And as unemployment exploded with the onset of COVID-19, a sizeable group of the population also dropped out of the labor force. As a result, they are not counted in the headline unemployment rate. If we use the long-term trend to extrapolate forward what the civilian labor force level would have been had the COVID-19 outbreak not taken place, it is estimated that we would have had 1.8 million additional unemployed in March, 8.4 million in April, and 6.7 million in May. Adding these people back into the unemployment rate calculation would have resulted in an unemployment rate of 6.4% for March, 23.8% for April, and 19.7% for May.

So, while the May employment report was indeed an improvement over April, we are still in reality looking at an unemployment rate that is currently around 20%. And as shown in the chart below, the improvement in the number of employed for May, even if it holds through future revisions in coming months, comes nowhere close to even beginning to support the stock market at its current prices. It may ultimately be a solid first step, but at this point, it is nothing more than that.

Looking ahead, we should expect that the U.S. employment situation will continue to improve when the June data is released at the start of July, particularly given all of the state economies that have shifted toward reopening. But a risk facing the June report is the potential impact of the misclassification that has taken place in recent months. For example, if the BLS is able to correct for this issue in the June report, it implies that the U.S. economy will have to add another 5 million jobs simply to break even with the May report that did not correct for this issue. This is a big hurdle to clear.

Also, a risk for upcoming employment reports as we progress through the summer is the fact that fiscal relief programs like the Paycheck Protection Program (PPP) will start to roll off. This has the potential to result in a number of workers that had held on to their jobs up to this point eventually being added to the unemployed.

Thus, if nothing else, we should expect employment reports in the coming months to be choppy, uneven, and unpredictable. And none of this considers the potential that the virus takes a negative turn over the summer, which is an issue that we are now starting to see emerge across certain states.

In short, the May employment report that seems to continue to have so many market participants excited and is the one fundamental positive that so many are clinging to right now should be taken with a big block of salt along with caution about what future employment reports may bring in the coming months.

“A financial system that's not working can greatly amplify the negative effects of what was clearly going to be a major economic shock.”

-Federal Reserve Chair Powell, June 10, 2020

All good, no bad. We continue to have a major economic shock. Even the best of economic data, such as the May employment report, continue to look strikingly poor. And while I strongly disagreed with so many of their policies over the past decade leading up to this point that I would contend played a meaningful role in making things much worse than they would have otherwise been, I agree with Chair Powell that a financial system that is not working can greatly amplify the associated negative effects of what was clearly going to be a major economic shock.

But I would also contend that a financial system that completely ignores the negative effects of what has turned out to be a major economic shock is also not working. And it can be just as detrimental, if not more so, as it unnecessarily creates imbalances and distortions that lead to new crises both today and in the future.

“What we want is investors to be pricing in risk, like markets are supposed to do.”

- Federal Reserve Chair Powell, June 10, 2020

Do you, Jay? Do you?

I understand that the Fed’s emphasis has been to narrow spreads in the corporate bond markets, but are markets supposed to be pricing in risk implied by current spreads that are at or below historical averages at a time when a historically high wave of corporate bankruptcies are only starting to wash over us?

I also understand that the Fed’s emphasis has been to support equity prices to make sure that stock prices are not crashing lower, but are markets supposed to be pricing in risk when stocks are trading at a forward price-to-earnings ratio that is 50% higher versus where it was trading prior to the crisis?

Taking this one step further, is a market that is properly pricing in risk one that has a company that is currently in bankruptcy is actually even entertaining the idea of issuing equity? Really?

Chair Powell is right. Markets are supposed to be pricing in risk. But they are not doing so. In reality, they were heading toward pricing in risk when they were plunging to the downside in March before the Fed intervened, as fair value for both stock valuations are considerably lower and corporate bond spreads are considerably higher than where they are today. And since they actually don’t want a market that is pricing in risk, we are left with a market that is becoming increasingly unstable and detached from fundamentals, thus bringing us closer to an ultimate day of reckoning where disconnects that may have once been resolved through a short recession will eventually require an implosion of the global financial system. So unfortunate.

An alternative lens. The U.S. stock market is distorted beyond all recognition. But it remains a key component of a broadly diversified asset allocation strategy. So, what is the best course of action for an investor who wishes to allocate to the U.S. stock market to participate in the high stock asset prices that the Federal Reserve remains so eager to provide, while also protecting themselves from the downside risk once the widening disconnect between stock asset prices and underlying fundamentals finally unravels?

First, it is important to remember that the U.S. stock market is a market of U.S. stocks. If the S&P 500 Index does not make fundamental sense to you, pass on it and focus instead on individual stocks either within or beyond the S&P 500 that make fundamental sense to you. Regardless of whether the S&P 500 is trading at fresh new lows or all-time highs, the U.S. stock market almost always has attractive individual stock investment opportunities on offer for consideration. One can even own these individual stocks while using the broader S&P 500 as a downside hedge.

Looking at markets through an alternative lens is also highly useful in informing our stock allocations. To this point, consider the chart of the long-term U.S. Treasuries as measured by the iShares 20+ Year Treasury Bond ETF (TLT). To begin with, those that have been allocated to the TLT have enjoyed a more than +50% return over the past year and a half in a steadily strong uptrend. No sharp and sudden -35% peak to trough correction like U.S. stocks. And unlike U.S. stocks, a category that has the strong support of economic fundamentals.

So, how can long-term U.S. Treasuries inform our U.S. stock allocations? First, they can provide an indication as to whether stocks are properly pricing in risks at any given point in time. Consider the chart below in this regard.

Over the period from 2016 to 2018, U.S. stocks were rising along with U.S. Treasury yields. This relationship made sense, for if underlying fundamentals are solid, it implies that investors should be rotating out of the safe haven of U.S. Treasuries and into the higher return potential of stocks. But starting at the end of 2018, this relationship completely disconnected. For while U.S. Treasury yields started to fall (and prices rose) as the economy gradually weakened even before COVID-19, U.S. stocks continued to soar to the upside. And after the COVID-19 outbreak nearly resolved this disconnect before the Fed intervened, the fact that U.S. Treasury yields have remained stubbornly low despite the fact that U.S. stocks are rallying higher is telling as a notable lack of support of its validity.

Such is the advantage of broad asset allocation. For not only does the blend of uncorrelated asset classes provide a differentiated portfolio return experience that is designed to withstand undue weakness in any single category like stocks over the last several months, but each asset class can be used to help better inform the behavior and expected performance of many other asset classes in the strategy. And right now, U.S. Treasuries are not supporting the sustainability of the U.S. stock market in any measurable way.

This may change in time. And if it does, the portfolio strategy will be adjusted accordingly. But in the meantime, U.S. stocks as measured by the S&P 500 continue to rise for all of the wrong reasons that may eventually come home to roost. For this reason, stay long U.S. stocks, but emphasize individual names instead of owning the index with a focus on quality, low volatility, and attractive value from more defensive sectors. And complement these long U.S. stock allocations with exposures to other asset class categories to optimize your diversification and downside risk protection.

Analyst’s Disclosure: I am/we are long TLT, TIP, PHYS, SH, RWM. 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.

I am long selected individual stocks as part of a broad asset allocation strategy. Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Global Macro Research makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.

Comments

[Luck of the Irish]

Thanks again for the article and information.

[Eric Parnell, CFA]

Thanks Luck of the Irish!

[dstb]

Since Volcker the Fed chairs are all the same. Ignore actual inflation, print money and pump asset prices. It is a completely broken institution and neither political party will dare try to fix it.

[kimbillro]

Each political party will use it @dstb .

[Perciad]

how about going the whole hog. If trillions of pounds can be added to the national debt and shovelled into the private sector economy by clicking a mouse on a computer screen, then why not abolish taxation and keep on clicking that mouse again and again ?

[kimbillro]

That is coming too @henry133 .

[AZalewski]

Speaking of Fed ammo and using bonds as a predictive instrument, I found this article from Jan:

www.wsj.com/...

"As part of their contingency planning for the next recession, Federal Reserve officials are looking at a stimulus scheme the U.S. last used during and after World War II.

From 1942 until 1951, the Fed capped yields on Treasury securities—first on short-term bills and later on longer-term bonds—to help finance war spending and the recovery.

Here’s how it might work. If the Fed cut rates to zero and concluded it was likely to hold rates at that level for at least two years, it could enhance this commitment by capping yields on every Treasury security that matures before January 2022."

[kimbillro]

Watch out for a wall of money @AZalewski coming your way.

[clrodrick]

@AZalewski - agreed, that is exactly the plan. Fed will let whatever inflation comes about to run hot if needed while capping rates

[alan shapiro]

If I were to take the BLS, or Jay Powell at their word (which I don't), I would still recall that it's commonplace for downward revisions of 10%, and sometimes far more. Can't help but feel that the May report was nothing more than misleading. Stay safe Eric!

[Eric Parnell, CFA]

Hi Alan - Thanks for your comment and great points as always. I hope you are doing well! Eric

[JohnP]

Love the title. The content, not so much.

"Pricing in risk" is based on your opinion of the future. Opinions are sharply bifurcated lately.

[Eric Parnell, CFA]

Hi JohnP - Thanks for your comment and feedback. You are right about the wide range of opinions lately. I suspect this will continue through the summer. Thanks again!

[Buyandhold 2012]

What a droopy slinky, Eric.

So flaccid looking.

Not a good metaphor for the stock market.

I read today that the last 50 days were the best 50 days in the stock market of all time.

Faster your seatbelts. It's time for liftoff.

[Eric Parnell, CFA]

Hi Buyandhold 2012 - Thanks as always for your comment. I was actually working to retire the Slinky for this article and replace it with Sonny The Cuckoo Bird from Cocoa Puffs, but I was running up against copyright issues. Perhaps a untethered balloon might take its place. Nonetheless, these markets remain interesting. Thanks and hope you are well!

[kimbillro]

Put the slinky up for sale on eBay @Eric Parnell, CFA . It might bring you a profit if it can be dated.

[Eric Parnell, CFA]

Great idea kimbillro! With all of the inflation inducing liquidity out there, it might fetch a particularly good price! Thanks again!

[User 1105879]

Another bad sign for Markets going forward. From Advisor Perspective:

The pandemic is affecting one of the best perks of workplace retirement-savings plans: company matches to employee 401(k) contributions.

www.advisorperspectives.com/...

Many firms in the hard-hit hospitality and retail industries have already suspended, reduced or deferred matches, including Expedia Group Inc., Hilton Grand Vacations Inc. and Best Buy Co. Even with the recent rally in stocks, many more companies are planning or considering such a move.

As of late April, 12% of 816 companies representing 12 million workers had suspended matching contributions, according to a Willis Towers Watson survey. An additional 23% said they will or may halt them this year.

—
Soooo....Let’s see... fewer 401K dollars flowing into the market, and greatly reduced buybacks, and a greater likelihood that capital gains taxes will be raised after the election. What did I miss?

Oh yeah, the worst economic conditions in recent memory.

Hmmmmmm... what could possibly go wrong?

[Eric Parnell, CFA]

Hello motionstream - Thanks for your comment and great points here. You are right that there are so many indicators that suggest challenges for this market going forward. It will be interesting to see where the inflection point exists between the euphoric effects of monetary policy and the depressing effects of the various realities including those you have done such a good job in outlining here. In the meantime, it appears that the path of least resistance continues to be higher. Thanks again!

[kimbillro]

Nothing could go wrong @motionstream .

[User 1105879]

Sure @kimbillro — everything works, until it doesn’t.

[Yuppp]

Excellent article. I've been taking profits and accumulating cash recently because the market run up seemed a little artificial to me. Thought about jumping in with the huge drop yesterday on some wish list stocks but appears they all just fell back to where they were trading about 2 weeks ago (?!). My trading recently has mostly been quick in and out of calls/puts in Robinhood infested stocks, taking advantage of exuberant ignorance.

[Eric Parnell, CFA]

Thanks Yuppp for your comment and observations!

[Tony Konig]

Could you suggest a source to learn about calls and puts? I've heard of what you're describing, but don't know how to go about it

[Yuppp]

@Tony Konig Tons of books on options trading out there. I really liked Understanding Options by author Michael Sincere when I got started. Teaches from a beginner level and progresses to advanced level strategies. I still go back to review with it every so often. $12.92 for a used copy on Amazon. Good luck to you.

[RoseNose]

Thanks @Eric Parnell, CFA for saying this all so eloquently and truthfully.
Stick with quality and hopefully value. I feel frozen in place right now with the upswing to high valuations, but they are coming back down again, but for some not enough. Some sectors are still being maligned, but I guess rightly so, so I am watching and waiting all of this with patience (I hope). Have a great weekend :)) Rose

[Eric Parnell, CFA]

Hi Rose - Thanks as always for your great commentary and perspectives. The market has certainly been an adventure these last few months that I suspect will continue into the summer. I hope you are doing well and thanks again! Eric

[William Darusmont]

Just spin the wheel and pray it doesn't come up 00!
My VXX hedge paid off yesterday - in spades!

[Eric Parnell, CFA]

Hi Bill - Thanks for your comment both here and on my other recent article. I appreciate your perspective and also enjoyed visiting your blog. I look forward to checking out your book once it is finished too!

Thanks again!

[kimbillro]

I love Powell's wall of money just like I liked Phil Spector's wall of sound.

[Eric Parnell, CFA]

Thanks kimbillro for your comments here and on my other recent article!

[kimbillro]

You are welcome sir @Eric Parnell, CFA . I don't know how you can keep producing these quality articles and charts. Good luck!

[Eric Parnell, CFA]

Thanks kimbillro - I appreciate it!