Follow The Yellow Brick Road
This week all eyes have been on the Fed, and the Fed didn't disappoint for drama. For the past few months, the Fed has downplayed inflation concerns and labeled the current rise in inflation as "transitory." I love how policy-wonks and the so-called "experts" create new words or phrases to throw people off the trail or confuse the public at large - but, I digress.
The fear over the recent Fed minutes shouldn't be taken as a signal to get out of the market. The book "The Wizard Of Oz" famously brought the debate about monetary policy into the mainstream. From the 1890s until the Great Depression, the debate over U.S. currency being backed by the amount of gold in the Federal Reserve raged on in politics and financial circles. In the book, written by Lyman Frank Baum in 1900 and adapted into the famous movie in 1939, the yellow brick road represents the "gold standard" (hence the name of the book's elusive character Oz, or ounces). The story involves the different groups in American society (scarecrow - farmers, lion - William Jennings Bryant, and the Tin Man - industrialists) and their struggle to make sense of their environment - i.e., coming off the gold standard. On June 5, 1933 the U.S. officially came off the "gold standard." It would appear that the book is nearly as applicable today was it was in the early 1900s as we continue to struggle with monetary policy. Here's what we're seeing so far this week...
Fed Rate Decision Full of Drama. As expected, on Wednesday the Fed kept interest rates and monthly bond buying steady. What was unexpected was the fact that the Fed changed their forecasts. First, the Fed raised their interest rate forecast in 2023 from 0.1% to 0.6%. This indicates two interest rate hikes of 0.25% in 2023, a fairly significant departure from previous Fed projections of no rate hikes until 2024. Second, the Fed increased projections for economic growth (GDP) from 6.5% to 7.0% for 2021, 3.3% for 2022 (unchanged), and up to 2.2% in 2023 from 2.1% originally. Third, the Fed increased Inflation expectations to 3.4% from 2.4% this year (1 full percentage point), 2.1% from 2.0% in 2022, and 2.2% from 2.1% in 2023. Lastly, the Fed lowered Unemployment forecasts to 3.8% in 2022 from 3.9%, while leaving this year's forecast unchanged at 4.5%. These changes sent the market into a tizzy. The expectation is that tapering discussions will heat up and could play into an announcement for the official end to bond buying by August. The S&P 500 Index was trading down about 13 points before the news broke concerning the Fed's changed projections. The Index proceeded lower by 1% after the changes were revealed. Markets nearly reversed by the end of trading and the S&P 500 ended Wednesday down only 0.54%. In our view, the Fed's recent hawkish tone reveals a healing economy and a better overall environment for consumers. This will drive earnings, and therefore, stock prices higher. As we have stated before, the market needs to come to grips with the reality that Fed-fueled liquidity is no longer needed. Investors should remain calm. As we pointed out earlier this week, the last time the Fed tapered bond purchases (2013-2014) the S&P 500 Index was up more than 40%! Our Wealth Protection Signal is still at such a low level that it would have to increase more than 200% to reach the 1st trigger point for raising cash. As investors' stress levels increase, their cognitive ability to make rational decisions decreases (see chart below). Hence the reason for the creation of the Wealth Protection Signal. Sometimes we need to keep our emotions in check before we make investment decisions.
Economy In Adjustment Mode. The economic releases have not been great this week as the U.S. economy continues to battle supply chain issues and labor shortages. The Housing Market has clearly adapted to higher construction costs (due to inflation) and a lack of available workers. Both Building Permits and Housing Starts were lower month-over-month. Retail Sales dropped for the 1st time in 3 months. Manufacturing is clearly in adjustment mode, as well, as both the Philly Fed Index and the NY Empire State Index slightly declined month-over-month. This morning, Weekly Jobless Claims disappointed by rising for the first time in 7 weeks. After the steady march lower, it's not surprise that Claims would reach a respite level. A lot of the disappointing news is centered around inflation and earlier this week more evidence of higher inflation was seen in the higher-than-expected increase in the PPI (Producer Price Index). All-in-all, not a good week for economic updates. However, the conditions for continued growth still look good as the NFCI remained steady.
Markets in Adjustment Mode. As we stated in last week's Market Musings, "the Summer Doldrums don't allow for much market activity, so any slight news - positive or negative - could move the markets one direction or the other." I think it's fair to say we got our news item in the Fed's latest change in stance from dovish to hawkish. I noted last week that a Summer pullback was certainly possible. However, if we look at the pattern the market has followed for the past 7 and 1/2 months, every time the S&P 500 Index reaches or slightly violates its 50-day moving average (solid blue line), the market quickly makes new highs within a two-week period. If we go back 12 months, the S&P 500 exceeded the 50-day moving average by 3% or more on September 24th and October 30th of last year. It would appear that markets are set to open lower this morning and could put June's positive return so far in jeopardy. The VIX has not closed above the 50-day moving average since May 21st. If the VIX closes above the 50-day MA today, we could be in for some volatile trading here in the short run. The VIX is still on a good trend of making lower highs and not exceeding the floor of around 16.4. As long as the index stays in that range and continues making lower highs, markets shouldn't trade off too much.