Updating Market Expectations: Fed Raises Its GDP Forecast

Includes: DIA, SPY
by: Michael Parmar

Yesterday, before the Fed announcement, I outlined the most likely estimates for the S&P500 path under the assumptions that market participants were using the June US Fed forecast as a means of informing their expectations and that such expectations would be met.

The estimates can be found here, which suggest the S&P500 on an upward trend.

The actual position of the S&P500 was front running this trend for 2012 Q3 to date, a rare event. The most likely outcome would be to come back to trend. I speculated that the expectation of QE3 had been priced in, but a downward revision to its GDP forecast had not, which could lead to a small correction.

The Fed, has in fact raised its central forecast for GDP growth for 2013 and 2014. This forecast must now include what it believes will be effect of the QE3 programme.

Below is the FED GDP forecast data released with the QE3 programme announcement, showing the new forecast and difference from June Forecast.

(Click to enlarge)

Source: U.S. Federal Reserve

Presented below is the updated "expectations path" of the S&P500 updated with the new (Lower Central Tendency) Fed forecast. In doing so, I note that the Lower Central Tendency published by the Fed for its June forecast yesterday, does not match the data obtained from the Fed website the day before, and perhaps there are differences in reporting the two.

The chart below uses yesterday's June lower central tendency and compares it with the revised lower central tendency.

(Click to enlarge)

Source: Own calculations based on market available data.

S&P500 values shown are average nominal closing price for the quarter.

The upper and lower bounds in the graph above represent a 65% channel of expected S&P500.

For further details of how the expectations channel was derived and performance methodology against past data, please see the previous article "Deconstructing Market Expectations."

Importance to investors:

Yesterday's announcement by the Fed of open-ended QE, will VERY soon raise the question: "Under what circumstances will QE end and when?"

To answer this, investors will begin to focus on how strong the economic recovery is likely to be, and whether QE3 will in fact deliver what it says on the tin: in other words how much growth (or not) will occur, triggering a new round of concern about whether expectations (and therefore stock valuations) are justified.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any 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.