Fed Policy Confuses & Markets Throw Tantrum
Equity markets have not taken kindly to current Fed policy and the broad index is down about 10% from January 4th highs. We believe that things are somewhat similar to the last time the Fed announced the end of quantitative easing, and yet, some things are different. Regardless, the market is akin to a child that has been given candy for days on end and is not being denied candy. Equity markets have laid face-first on the floor and are throwing a temper tantrum. On top of that, the Fed is struggling with messaging and that is adding to market confusion. Let's get into what we're seeing so far this week...
How QE's End Is The Same As Last Time. in 2014, the Fed announced the end of Quantitative Easing and the market reacted then just how it's reacting now - like a petulant child. From September 19th, 2014 to October 16th, the S&P 500 Index sold off 7.5% in response to the Fed's announcement of the end of Quantitative Easing.
The "easy money" train was over and the market responded with a sell off. Approximately 15 days later, the market had recovered all of those losses. Can we expect the same this time around? Only time will tell. However, we do seem to have established a key holding pattern this week. The S&P 500 Index reached a low of 4,278 on October 4th. We tested that low on Monday of this week, but ultimately closed well above it. While we have come close to testing that October 4th low, we have remained above it and look poised to close above it today. This means a floor could have been reached, for now. The other good news is that, historically, the index has moved higher when exceeding it's 200-day moving average.
The S&P 500 Index has broken below its 200-day moving average 34 times in modern history. In the 1-month, 3-month, 6-month, and 12-month periods following the 200-day violation, the index proceeded higher at least 74% of the time. In the 12-month period, the index was higher, on average, by 9.9%. In our opinion, the timing and communication of the Fed's policy has been a primary factor in the market's response.
How QE's End Is Different This Time. The last time the Fed ended QE and started tightening, the macro situation was different. Inflation was at 1.7%, year-over-year in 2014. Today, inflation stands at 7.1%. The yield on the 10-year Treasury was 2.62% and falling from a high of 3.01% just 9 months prior in 2014. Today, the 10-year Treasury Bond is yielding 1.78% and coming off a 1-year low of 1.19% back in August. We are still in the throws of a shipping crisis and labor shortages in key sectors.
The timing of the Fed has not been the best on this announcement of QE. However, to put this most recent pullback into perspective, we experience intra-year pullbacks of at least 8% in 76% of the calendar years of S&P 500 performance, going back to 1980. In 32 of those calendar years, the S&P ended higher by year-end. The last time the S&P 500 had a 10% pullback was 2012. At the end of that year, the index finished up 13%.
Time will tell where we finish this year, but with the floor the index seems to have established, perhaps the worst is over. What is of concern however, is the Fed's current balance sheet and inability (or, unwillingness) to let the balance sheet decline substantially. Again, back to the spoiled child analogy, the faucet of "easy money" is being turned off and now economic fundamentals matter more than ever.
Where Do We Go From Here? This recent pull back doesn't feel like the beginning of the Pandemic in 2020, nor the 2008 Financial Crisis. First, when we look at our Wealth Protection Signal, it has not even come close to triggering during this recent pullback. The TED Spread - an indication of panic or fear among traders - has not increased during this recent pullback, but rather, has declined more than 50%!
In other words, the "smart" money (institutional traders) have not panicked at all over the last few weeks. In 2007, our Wealth Protection Signal increased 145% in just a few days in August of that year and triggered, before equities made their ultimate highs in October. In addition, the TED Spread spiked nearly 300% in the month of August, 2007. By comparison, the Wealth Protection Signal spiked 226% in just under two weeks after the market made its ultimate high in February of 2020 (early days of the pandemic). During that time, the TED Spread showed plenty of panic among institutional traders as it increased more than 200% over that same time period in February of 2020. So, this time does definitely feel different. We would expect weekly economic releases and corporate earnings to matter more going forward.