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posted on 02 November 2015

Fed Trick Delivers Market Treat

by Lance Roberts, StreetTalk Live

X-factor Report 01 November 2015

This past week, the Federal Reserve, as expected, failed to raise interest rates once again due to ongoing economic weakness and weak labor market results.

However, while that meant "accommodative policies" are here to stay for a while longer, it was their forecast that got the "bulls" excited. As Mohamed El-Erian penned for Bloomberg:

"Of critical importance to markets is that a decision to raise interest rates for the first time in almost 10 years is now more of a 'live' possibility at the Fed's next policy meeting, in December. In reasserting this policy flexibility and making it explicit, the central bank refrained from providing specifics about the elements that would drive the decision.

The Fed's message conveyed greater unity among its policy-making officials. Only one member of the Federal Open Market Committee -- Jeffrey Lacker, the president of the Richmond Fed, dissented. The near unanimity was an important accomplishment by Chair Janet Yellen, especially given the range of views expressed in the weeks leading up to the meeting, including by the usually united governors.

Many of those in the markets who had grown comfortable with the idea that the Fed would delay a hike until next year are now rushing to adjust. The result will be higher interest rates, especially for shorter maturity Treasury bills, and a stronger dollar."

The last sentence is the most important. While the "bulls" came piling back into the market (creating a short-covering squeeze late Wednesday afternoon) the consequences of higher rates as noted really isn't that bullish for stocks.

First, let's take a look at the beloved yield-spread which is currently signaling "no recession" in the economy. As the chart below shows, the spread currently between the 10-year and the 2-year Treasury bonds is positive. However, as shown by the dashed red-line, when the Fed starts hiking the short-end of the curve, without economic growth picking up the long end, recessionary inversions can happen very quickly.

10-2-InterestRate-103015

Secondly, as we have already witnessed over the past year, a strong dollar in a world where every country is battling deflationary pressures due to accelerating debt levels, has not been bullish. This has particularly been the case for the more economically sensitive sectors of the economy.

USD-vs-Market-103015

Think about that statement for a moment. The Fed will raise short-term borrowing costs, which makes credit more expensive, which will increase the value of the dollar, which makes exports more expensive, and this is GOOD for the stock market.

Historically, this has not been the case even when the economy was growing much more strongly than it is currently.

However, for now, the bulls "liked what they heard" and have sent investors stampeding back into the markets.

Bulls Regain Leadership

October has pulled in one of the largest monthly point gains in history surging over 8.5% for the month. Driven by a combination of short-term extreme bearishness and record short interest, the market pushed rapidly through previous resistance levels putting "Bulls" back in charge of the market for now.

SP500-Chart1-103015

The rally, not so unlike what was seen in 2014, took the markets from extreme oversold to extreme overbought in a very short period. That advance, like then, was once again driven by hopes of improving economic growth and promises of more monetary support (ECB, PBOC, and BOJ).

As I discussed over the last couple of weeks, this action, much like last winter, coincides with the entrance of the market into the seasonally strong period of the year. To wit from last week:

"However, there is a reasonable expectation that following a weak summer performance, that there could be better performance as we enter the historically stronger period of the investment year."

The table below shows the statistics of the seasonally strong/weak periods of the S&P 500 from 1957 to present using the data from the Federal Reserve (FRED).

Seasonally-Strong-Statistics-102015

As noted above, there is a statistical probability that the markets will potentially try and trade higher over the next couple of months particularly as portfolio managers try and make up lost ground from the summer.

However, it is important to note that not ALL seasonally strong periods have been positive. Therefore, while it is more probable that markets could trade higher in the few months ahead, there is also a not-so-insignificant possibility of a continued correction phase.

Furthermore, the probability of a continued correction is increased by factors not normally found in more "bullishly biased" markets:

  1. Weakness in revenue and profit margins

  2. Deteriorating economic data

  3. Deflationary pressures

  4. Increased bearish sentiment

  5. Declining levels of margin debt

  6. Contraction in P/E's (5-year CAPE)

(For visual aids on these points read: 4 Warnings)

With the markets EXTREMELY overbought short-term, the setup for putting money into the market currently is not ideal.

However, as shown in the chart below, the markets have registered a short-term BUY signal which suggests that we remain alert for a pullback that generates a short-term oversold condition without violating any important supports. That important support level is currently 1900 on the S&P 500 index.

SP500-Chart3-103015

While the "Sell Signal" earlier this year reduced portfolio exposure to the market, all that was missed was a lot of volatility with no real gains.

As restated below, I have continued to print instructions during this "sideways" period to reduce risk and rebalance portfolios. While portfolios are currently overweighted in cash, that overweight position has led to much less volatile portfolios during the summer decline. This has reduced the potential for "emotional" mistakes to be made.

Now, with the "seasonally strong period" upon us, some of that cash can be redeployed during any corrective action that provides a better "risk/reward" entry point. That point is not today.

Short-Term Opportunity, Long-Term Risk

As shown in the chart below, while I am talking about increasing equity risk exposure "opportunistically" over the next couple of weeks for the short-term seasonally strong period, the long-term outlook still remains heavily biased toward risk.

SP500-Chart2-103015

The combined "sell signals," as measured by both momentum and MACD, have only coincided near major bull-market peaks.

However, as you will notice, these coinciding signals can occur several months before the "bullish momentum" of the market is ground to a halt. This is why the relevance of these signals should not be ignored. However, it also doesn't mean that you should immediately run to cash and hide.

I will continue to monitor and update the markets each week for you and adjust allocations accordingly.

For now, however, enjoy "Halloween" with your family and I will be back next week with either a "Trick or Treat."


Portfolio Management Instructions

Repeating instructions from last week, it is time to take some action if you have not done so already.

  1. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits) (Discretionary, Healthcare, Technology, etc.)

  2. Positions that performed with the market should also be reduced back to original portfolio weights.

  3. Move trailing stop losses up to new levels.

  4. Review your portfolio allocation relative to your risk tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

Have a great week.


Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. At times, the positions of Mr. Roberts will be contrary to the positions that STA Wealth Management recommends and implements for its clients' accounts. All information provided is strictly for informational and educational purposes and should not be construed to be a solicitation to buy or sell any securities.

It is highly recommended that you read the full website disclaimer and utilize any information provided on this site at your own risk. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level, be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and applicable laws, the content may no longer be reflective of current opinions or positions of Mr. Roberts. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he or she is encouraged to consult with the professional advisor of his or her choosing.


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