DIA: The Dow's Plunges May Worsen As The Fed Tightens Its Grip

Summary

  • The Dow plunged on May 18, following more hawkish comments from FOMC Chairman Jay Powell.
  • The Fed is working against the stock market at this point.
  • That is likely to result in more downside pain for stocks.
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Fed Chair Jerome Powell And Janet Yellen Testify At Senate Hearing On COVID-19 And CARES Act

Alex Wong/Getty Images News

Stocks have been hammered all year, and today is no exception. Jay Powell's latest performance on May 17 didn't do much to help. It has become clear that the view of the Fed is to cripple demand in the hopes that it will bring inflation down. The problem here is that it's not entirely clear just how much the Fed will need to raise rates and how much demand destruction it will need to do along the way.

It has resulted in the Dow Jones Industrial ETF (NYSEARCA:DIA) moving toward its recent lows and giving back all of the gains since late last week. The DIA now sits at a critical level of support that, if broken, may lead to an additional 5% drop.

The Neutral Rate

The problem with the Fed's plan is that it's becoming increasingly clear that the Fed will need to raise rates above neutral, which, based on Fed speak, seems to be around the 2.5% level. It may turn out that the neutral is much higher or lower than the 2.5%. The problem is that if the neutral rate is lower than 2.5%, the Fed could inflict a lot of pain on the economy and do long-lasting severe damage. If it turns out that the neutral rate is much higher than 2.5%, the Fed may have to raise rates much higher than what the market is currently pricing in.

Tighter Financial Conditions

Additionally, financial conditions are tightening at the fastest pace in years. The Fed wants these conditions to tighten and needs these conditions to tighten even more. Since 2010, the only time the Chicago Fed National Financial Conditions Index has tightened faster over 21 weeks was in 2020 and 2011. It was due to market panic during those times, not because the Fed was purposely trying to tighten them. Now, as conditions tighten, they will not ease right away as they did in the past; they will stay tight.

Chart

Bloomberg

The impacts of these tighter conditions have impacted the Dow Jones Industrials in previous instances, and this time is proving to be no different. However, it's worth noting that overall financial conditions are still easy. While they're tighter on a relative basis, they need to rise above 0 to suggest that financial conditions restrict the economy. So if the Fed's goal is to make financial conditions restrictive, then those conditions will have to rise above 0, which will equate to lower prices for the DIA.

The Dow Is Breaking Down

What is crucial here is whether the DIA can hold support around $315. If not, there's no significant level of technical support again for the ETF until it hits the $298 region, a good 5% lower than its current prices.

The ETF and the average are in a very well-defined downtrend, telling us that we're no longer in a bull market, and the downside is a potential threat. Additionally, momentum indicators such as the relative strength index are also pointing lower, confirming the bearish bias for the DIA.

Given the RSI and the Bollinger band's current placement, one can't even say that the ETF is oversold. For that to happen, the ETF would need to drop below its lower Bollinger band and have its RSI drop below 30.

Chart

TradingView

The risk is significant. This current market is not the market we have seen over the last decade. In the past, buying the dip worked because, ultimately, the Fed supported the market and worked to ease financial conditions, leading to those famous "V" shaped bottoms. But at this point, the Fed is not there to support the market. Everything the Fed is doing works against the market rising.

So you're more than welcome to fight the Fed if you must, but the Fed's goal here is not to save the market but to kill inflation.

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This article was written by

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Designed for investors looking for stock ideas and broader market trends.

I am Michael Kramer, the founder of Mott Capital Management and creator of Reading The Markets, an SA Marketplace service. I focus on macro themes and trends, look for long-term thematic growth investments, and use options data to find unusual activity.

I use my over 25 years of experience as a buy-side trader, analyst, and portfolio manager, to explain the twists and turns of the stock market and where it may be heading next. Additionally, I use data from top vendors to formulate my analysis, including sell-side analyst estimates and research, newsfeeds, in-depth options data, and gamma levels. 

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Additional disclosure: This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is a member and investment adviser representative with Mott Capital Management. Mr. Kramer is not affiliated with this company and does not serve on the board of any related company that issued this stock. All opinions and analyses presented by Michael Kramer in this analysis or market report are solely Michael Kramer's views. Readers should not treat any opinion, viewpoint, or prediction expressed by Michael Kramer as a specific solicitation or recommendation to buy or sell a particular security or follow a particular strategy. Michael Kramer's analyses are based upon information and independent research that he considers reliable, but neither Michael Kramer nor Mott Capital Management guarantees its completeness or accuracy, and it should not be relied upon as such. Michael Kramer is not under any obligation to update or correct any information presented in his analyses. Mr. Kramer's statements, guidance, and opinions are subject to change without notice. Past performance is not indicative of future results. Neither Michael Kramer nor Mott Capital Management guarantees any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment commentary presented in this analysis. Strategies or investments discussed may fluctuate in price or value. Investments or strategies mentioned in this analysis may not be suitable for you. This material does not consider your particular investment objectives, financial situation, or needs and is not intended as a recommendation appropriate for you. You must make an independent decision regarding investments or strategies in this analysis. Before acting on information in this analysis, you should consider whether it is suitable for your circumstances and strongly consider seeking advice from your own financial or investment adviser to determine the suitability of any investment.

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