Tail Wagging the Dog
The day after Janet Yellen’s Jackson Hole Speech two Fridays ago, The Wall Street Journal’s headline read, “Yellen Sends Strong Signal on Rates”.[i] According to the article, the Fed chairwoman believes the economy is at a point that the Fed will more strongly consider raising interest rates. Naturally fed funds futures increased the likelihood of a September increase to 36% and a December hike to 64%. Other markets reacted as expected – bonds yields moved higher and stocks reversed morning gains and sold off.
This has become a common occurrence. Every press release, statement, speech, hangnail and sneeze are analyzed for clues of future policy changes. Only the most isolated or distracted (such as excited Met fans after their team got back into the wildcard race) are not aware of the intense level of focus that the markets have on the Fed.
To be sure, the FOMC’s interest rate decisions are a component of monetary policy which have economic influences which affect capital market prices. Undoubtedly they are significant. However, the markets have developed an addictive condition when it comes to the Fed that has grown to a point where it appears to be a case of the tail wagging the dog. In other words, rather than the Fed watching the economy and adjusting policy accordingly, the economy and the markets are watching the fed and trying to front run their next move. Corporate earnings and valuations have become afterthoughts.
During the past several decades the relationship between the Fed and the capital markets has changed. The Fed traditionally used money supply and short term interest rates to implement the desired monetary policy to slow activity when the economy was too strong and to boost things when needed. Dating back 100 years, the central bank’s original purpose was to smooth out the cycle of booms and busts and keep the economy as steady as possible.
Obviously, this role has transformed into its current character of financial repressor and protector of asset prices. The Fed claims to be ‘data dependent’ so they are closely watching and striving to get better GDP growth. But the reality is that setting interest rates at zero and buying bonds has done very little to help the economy. Indeed, the chief result of the zero interest rate policy (ZIRP) and quantitative easing has been to drive speculation into higher risk assets.
While stocks have probably been the biggest beneficiary of global central bank mechanizations, perhaps the capital markets are starting to wonder if their confidence is misplaced. Interestingly, on the day of Janet Yellen’s speech, the Journal’s front page headline was “Fed Stumbles Fueled Populism”.[ii] The article critically points out how the Fed has misjudged the effectiveness of their decisions. Further it hints that some discontent is growing among the markets. Jon Hilsenrath, the author, notes, “Three key miscues by the bank since the financial crisis add to public disillusion with institutions”.[iii]
While a confidence crisis could be a problem, the fact remains that stocks trade at record levels. This is more impressive given we are in the dreaded August – September period. During the past 5 years, August has averaged a 1.87% drop which makes it the worst month for the period. September has been the second worst month with an average decline of 1.19%.[iv] Stocks made it through August 2016 in good shape (minor losses for the month) so maybe this trend is changing.
Here are the year-to-date returns for the major indexes as we begin September.
2016YTD
Dow Jones Industrial Average +6.1%
S&P 500 +6.7%
Nasdaq Composite +4.8%
Russell 2000 +10.2%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
After breaking out in July, the equity markets have traded in an incredibly narrow range. Looking at the past 40 days, the S&P 500 has traded in a range of 1.77% which is the tightest 40-day range ever!![v] Given the volatility in the first and second quarters, maybe we continue sideways for a little longer.
The markets’ resiliency in the face of all of the obvious headwinds has caught many off guard. As noted in previous newsletters, there have been many high profile predictions for a nasty market drop starting in the spring. Yet stocks refuse to fall (so far). We think investors should remain flexible and open minded. The stretch from Labor Day to New Year’s Eve could see a return of the dog wagging the tail.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional
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