August 22, 2014
By Steve Blumenthal
To me, the next cyclical market down trend is linked to Fed Policy and the timing of their change in interest rate policy. For now, I remain in the Don’t Fight the Fed or The Trend camp (constructive on equities).
So what happens when the Fed raises interest rates? Do you have a plan in place to deal with the risk? Important questions as you’ll see the equity markets do not do well when the Fed raises interest rates.
One can argue that this time might be different but that is a tough bet as noted in the following chart. It shows the number of times the Fed has hiked rates without a negative equity market consequence. The data goes all the way back to July 1, 1954 and tells us we should stand on guard. Out of the 15 times the Fed has raised rates, there were ZERO times when the market gained. Not once did it avoided a negative outcome. The average decline was -23% (note the Subsequent % Decline in Market column – red arrow).
So it is pretty clear that the market does not do well when the Fed raises interest rates though I’ll add that, historically, it is typically after the second rate hike that market indigestion begins. Further, I believe that given the unprecedented six years of Fed zero interest rate policy, this time could be even more challenging. Don’t know – we’ll see.
When your clients tell you that the economy is doing better thinking that it will justify an even stronger stock market, show them this chart. The time to buy is when everyone is selling and a business cycle is at a low (2002, 2009). The best times to buy is when the economy and the market is in crisis. A perverse business we are in. The logic is seemingly backward. As Bullard mentions in the interview link provided below, Fed policy is “very far from normal”. That means normalization (raising rates and selling acquired financial assets) may take a very long time this time.
It is Fed week in Jackson Hole. Given the importance of the timing of Fed rate hikes, let’s focus in on what the guys steering the great big ship are saying.
I share the following in this week’s On My Radar:
- Fed Officials Said Job Gains May Bring Faster Rate Increase
- The Current State of Inflation
- Trade Signals – Cyclical Bullish Trend for Stocks Remains – 08-20-2014
Fed Officials Said Job Gains May Bring Faster Rate Increase
Bullard Says Better Labor Market Causing FOMC ‘Rethink’ (16 minute audio link)
Some selected quotes from the interview:
- Monetary policy is a long, long way from normal.
- We have a long way to go on normalization.
- The economy is improving and the interest rate rise will come sooner and quicker.
- Dramatic improvement in labor markets.
- Economy looking like it is finally taking hold. 3% second half GDP.
- With inflation coming up this year and employment coming down, we are much closer to our goals.
- Combine this with the funds rate some 350 bps from normal and a balance sheet north of $4 trillion, how are we going to get that on a path to getting back to normal.
In short, some Fed officials are forecasting the first rate hike in March 2015. Consensus seems to be June 2015. Following are a few more links if you are interested:
I strongly recommend listening to the Bullard audio podcast. It will give you a peak into what the guys behind the curtain are thinking and how they interact with each other. As for timing of the coming interest rate increase, my best guess is a June 2015 rate increase followed by a September 2015 additional rate increase (but this is really just a guess).
I favor a disciplined risk management process following the cyclical trend of the market (currently bullish) and a bias towards “don’t fight the Fed or the tape”. See Trade Signals below.
The Current State of Inflation
Given that inflation is one of the Fed’s objectives, following are several of my favorite inflation related charts. In looking at the bottom sections of the below three charts, inflationary pressures appear to be low to moderate. Low as measured by the Institute for Supply Management Price Index and moderate inflationary pressures as measured by the NDR Inflation Timing Model.
Trade Signals – Cyclical Bullish Trend for Stocks Remains – 08-20-2014
Despite my personal feelings that:
- the cyclical bull market is aged,
- profit margins have likely peaked (and will likely mean revert),
- the market is meaningfully overvalued and over-owned, and
- margin debt is high and cash low
… price momentum (as measured by Big Mo) remains bullish and don’t fight the Fed or the Tape remains the important theme.
Big Mo remains in a cyclically bullish buy signal for equities. The last buy signal was October 14, 2011 when the S&P 500 Index was at 1224.58. As for the bond market, the Zweig Bond Model remains in a cyclically bullish buy signal for bonds and our 20-plus year old high yield tactical bond strategy moved back to a “buy” signal early last week.
Note too, after the recent correction, that short-term Daily Investor Sentiment is now reading extremely pessimistic – which suggests a “buy”. While risk remains high, the weight of technical evidence supports a continuation of the current cyclical bull market in both stocks and bonds.
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains (as measured by Big Mo and 13/34-Week EMA S&P 500 Index chart)
- Weekly Investor Sentiment Indicator – NDR Crowd Sentiment Poll: Neutral (Not Yet Bullish)
- The Zweig Bond Model: Cyclical Bullish Trend for Bonds (supporting bond investment exposure)
What we know today is that valuations are high and the markets are highly leveraged. Similar to mountain snow, we can measure the stability but we can’t predict which snowflake will cause the snow to fracture and slide nor when. Today, risk is high and the system unstable. The markets can continue higher. Thirty plus years and some hard knocks has taught me that nobody can forecast the future perfectly every day. It is simply not humanly possible. What can be measured is the degree of risk and today risk is high. The tools to manage risk are abundantly available and are highly liquid but risk measures should be taken prior to the slide; for when it does slide again, it will be too late to protect your investments.
The U-Haul is rented and it’s time to load the stored couch, bean bag chair and other miscellaneous pieces of old stuff. I’m heading to Penn State early tomorrow morning to move my beautiful daughter into her rented house for her senior year. She left yesterday – my job, of course, is the heavy stuff.
Do you remember back then (32 years ago for me – ugh) how you and your friends would fight for the best room positioning, figure out groceries and surely not tell mom and dad about the beer budget. It has been a great three years and Brianna is already wishing for time to slow down. It has gone by too fast, she said.
I hope to really be present in my time ahead. Sometimes that is hard to do… and I hope for you too for time to slow down.
Wishing you a wonderful “slowed down” weekend!
With warm regards,
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
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