The Next Stock Selloff Could Lead To a New Buying Opportunity

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This week is a pretty big one for financial markets. Both the US Federal Reserve and the Bank of Japan (BOJ) have interest rate meetings scheduled.

It could prove to be somewhat of an inflection point. My feeling is that both central banks will try and ease off their perpetual promises of unlimited and undying support for financial markets.

Because if they don’t do it now, they may never get another chance.

Let’s look at the BOJ first. The Japanese economy is far and away the world’s biggest basket case. Absolutely nothing that the BOJ does has any lasting effect on the economy. That’s because the Japanese simply refuse to genuinely reform their economy. They simply expect monetary policy and government spending to do the job.

At their last meeting, in late July, they disappointed markets by not pushing interest rates even deeper into negative territory. This lack of action got the market thinking that the BOJ was out of ideas.

In February, the bank made interest rates negative on some commercial bank deposits, and its ongoing buying of Japanese government bonds (JGBs) pushed yields into negative territory, too.

The BOJ now owns over one third of the JGB market. It is the market. This action led to some criticisms about the effectiveness and unintended consequences of negative interest rates.

Against this backdrop, the BOJ comes into this week on a hiding to nothing. They either have to come up with something new and audacious, or they will disappoint the market.

The US Federal Reserve is also in a spot of bother. They desperately want to raise rates. They want to move interest rates higher before the next economic slowdown hits…but they don’t want a rate rise to cause the slowdown!

Recent economic data released in the US has been weaker than expected. But the labour market remains healthy and there are signs of a pick-up in inflation. This gives the Fed the ammunition it needs to raise rates.

While I doubt the Fed will raise rates this week, I think it is more likely that they will prepare the market for a definite move in December. It really is now or never for the Fed.

They’ve been threatening ‘interest rate normalisation’ for years. All they’ve managed so far is one 25 basis point hike, in December last year. And look what happened after that…

The US dollar surged, China and emerging markets came under heavy pressure, and global stock markets crashed. It was only when the Fed took consecutive rate rises off the table, and China injected more stimulus, that markets stabilised.

This gives you a few clues as to what the Fed will do now. That is, if they do communicate that a rate rise looks likely for December, they should emphasise that they will do nothing for a while thereafter.

If they have any brains, or a feel for the market, there should be none of this ‘three rate hikes in 2017’ business. That will put the fear of God into the market, and you’ll likely see some pretty heavy selling.

As it is, I think you’ll see some selling over the next few weeks anyway. The Fed has lured global markets into a false sense of security. The prevailing view is that the Fed has a triple — and not a dual — mandate. That is, they’re concerned about the labour market, inflation, and asset prices.

While that certainly seems to be the case, it’s not. Because if the Fed ignores a tightening labour market and rising inflation, and shows too much concern for maintaining high asset prices, the market will have contempt for it, and that is something the Fed will not allow.

As I said, it’s now or never for the Fed to hike. This business cycle is already mature in terms of historical economic expansions. The probability is increasing that a slowdown is approaching, no matter what the Fed does.

They surely know this. They don’t want to be the Fed that stood there, mouth agape, holding interest rates down through a whole business cycle, leaving absolutely nothing in the tank to fight the next recession.

At least, I’m pretty sure they don’t want this reputation. So this week isn’t looking like it will be a good one for markets. And that goes for the next few weeks. Markets are simply not positioned for a tough-talking Fed.

The good news is that any sharp selloff will more than likely be a buying opportunity. Because, as much as the Fed doesn’t want to be influenced by the market, a 10–20% decline in the S&P 500 would certainly get them sitting up and taking notice.

As I’ve written before, the Fed has created a monster, and it can’t go from feeding it to letting it starve in a matter of months. So have some cash waiting on the sidelines, you may get a chance to deploy it profitably in the next few months.

If you’re after some investment ideas, check out the latest presentation from my mate Sam Volkering. Sam is the editor of Australian Small-Cap Investigator, which focuses on stocks at the smaller end of the market offering big potential rewards.

Sam has been in cracking stock-picking form this year, so I strongly suggest you have a look at his latest idea.

Cheers,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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