Is the latest rally a problem for the Fed?

Last week, the market continued to rally with investors seeing upside for stocks and bonds into year end, on dovish Fed forecasts and mixed economic data. NVDA’s great earnings report was the main catalyst of the shortened trading week. Despite the stock’s “sell the news” reaction, this was not the reversal catalyst bears were hoping to see.

As a consequence, SPY is now reaching the high watermark established in late summer ($457). With a full retracement back to previous highs now virtually complete, the next leg of the market can commence. However, broad sentiment is extended almost to “Extreme Greed” and many individual sectors, factors and names are highly overbought. Jerome Powell is set to speak on Friday, and the next FOMC meeting is just 16 days away. Odds of a rate hike have creeped up from 0% to 4.5% - a tiny probability shift that has us thinking Fed’s messaging will get hawkish yet again.

Using our latest fundamental research (which we highly encourage you to read here) as a basis for the chart below, SPY’s support moves up to $445 (R2) while end-of-year theoretical upside reaches $474, a 4% gain from the last close. However, a seasonal pullback would also be in order first, and would be a healthy development for a continued bull run.

SPY Analysis

The bullish setup also sets the 50-DMA, at $433, as the maximum drawdown level for December- a potential 4.8% pullback. Given these risk-reward assumptions for the month ahead (4% upside / 4.8% downside) the benchmark ETF currently offers a slightly unfavourable set-up. Typical seasonality also aligns with the idea that a better entry point for adding risk exposure can be found, going forward.

Notice the early December dip in performance - that is caused by a large number of mutual funds that need to distribute capital gains, dividends and interest income for the year, adding selling pressure to the equity markets in order to meet these outflows. Distributions usually start in late November and peak during the first 2 weeks of December.

While the potential for a year-end rally remains intact, a short-term dip would be welcome so that overbought conditions can be worked off. Nimble investors can find a much better entry point to increase equity exposure, if needed, during the next couple of weeks. Chasing performance at this juncture is unadvisable. Heading into 2024, however, the stock and bond rally creates a fundamental problem for the Fed.

Loose Financial Conditions are a Problem for the Fed

Just in case there is a degree of confusion regarding financial conditions and the “wealth effect”, consider the following statement issued by Ben Bernanke in the Washington Post dated November 2010, regarding the second round of quantitative easing:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Lower bond yields and higher stock prices ease financial conditions by creating a “wealth effect”, which in turn promotes higher spending. 2010 was a year when the Fed aimed to do just that - boost consumer spending, increase inflation (which at the time was 1.6%) and avoid back to back recessions.

Today, the Fed aims to do just the opposite: decrease personal spending, discourage corporate capital investment and suppress inflation. Currently, growth and inflation expectations are still well above the Fed’s own targets. The latest reading for 1 year expected inflation is 2.79% and has proven resilient in the last couple of months.

In the 70’s inflation had reached double digit figures. It took 2 central bankers and 3 recessionary periods in almost a decade to finally put an end to the phenomenon. Between 1972 and 1974, then chairman Arthur Burns hiked interest rates enough to slow the economy and cause a contraction. Initially, inflation responded by falling to near 5% by 1976, but then reversed higher, exceeding the previous high, by 1980.

It was chairman Paul Volker that became the figurehead for the fight against inflation, by engaging in an aggressive rate hike campaign starting in 1979. He raised interest rates to levels that triggered 2 back to back to back recessions with unemployment rates higher than 10% at one point.

The Fed is very much aware of this precedent and wants to avoid a 1970’s scenario at all costs. That cost includes a shallow recession combined with muted stock market returns. The Fed does not want to provoke a “financial crisis” or any other kind of shock to the economy. However, their stance on interest rates creates a much higher probability of such a shock occurring. From a “wealth effect” perspective, the Fed is fine with having a stock market that goes nowhere, as we’ve seen in the past 2 years.

That is why our own trend following strategies have been under-performing lately (there is no trend to follow). Instead, a range trading instrument, like our sentiment indicator, has worked wonders for timing the market in the past 2 years:

It may seem straightforward and very intuitive to follow this instrument right now (and we suspect many algorithmic systems have adapted already), but this approach did not work up until 2021. The sole reason for this shift in dynamics is the Fed’s own messaging. By jawboning the market up and down using a “carrot and stick” approach, the Fed have basically guided stocks in a flat pattern, with slightly negative annual returns.

For now, we expect this regime to continue. While market participants are already pricing in rate cuts starting in June 2024 (43% probability), the Fed has no reason to start cutting rates just yet, as they insist “higher for longer” is the way to go. If the Atlanta Fed’s GDPNow is offering a correct estimate, Q4 2023 is going to be another period of economic expansion.

We believe that by the next FOMC meeting in mid-December, looser financial conditions will force the Fed to revert to a more hawkish stance and pour cold water on the rally. Crucially, in the short term, both the stock and the bond market equally vulnerable to short term disappointment, as they are inversely correlated with the US Dollar, now under significant selling pressure.

Our Trading Strategy

Nothing has changed in terms of overbought conditions in the past week. The market is still not trading in “Extreme Greed” territory just yet, and we are fully allocated to risk already. We’d like to see the market consolidate or dip this week, in order to set up for a more powerful rally in December.

Absent a 2-3% correction, we’ll need to start taking profits in more overbought positions in the portfolio. While the market may remain extended for more time than expected, extreme deviations don’t last forever. Some more patience is required either for booking profits, or adding to equity exposure for the year-end rally.

Right now, the prudent thing to do is wait for a better entry or exit point, depending on objectives. Losses can also be booked for tax benefits, and clearing the portfolio of laggards is also a good idea. If those positions didn’t rally up until now, then there’s less hope of a recovery going forward. Unfortunately, the entire iShares Russell 2000 ETF (IWM) fits in this category. Some food for thought in 2024…

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