Is the Stock Market Going Through A Sucker Rally?

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‘We judged that the case for an increase has strengthened, but decided for the time being to wait for further evidence of the continued progress towards our objectives. Our current policy should help move the economy toward our statutory goals of maximum employment and price stability.’

So said Fed boss Janet Yellen at the start of her press conference overnight.

Not surprisingly, the market liked it. Stocks were up, bonds rallied, precious metals and commodities rose too, and the US dollar tanked.

Yet the decision to keep rates on hold was largely expected, wasn’t it? And there were three dissenters amongst the Fed committee, who disagreed with the decision to keep rates on hold…again. Clearly, momentum is building for a December rate hike.

So why the broad rally?

Well, the first explanation is that a rally after a Fed decision that keeps interest rates on hold is the standard Pavlovian response from the market. It’s a pretty easy short term trade if you’re betting big and with leverage.

I’m sure many short term traders have done the research and have the stats that show markets mostly rise in the aftermath of a Fed decision to stay on hold. The odds are simply on your side if you’re a short term trader.

The other thing that would have buoyed the market was the Fed downgrading their long term economic growth forecasts for the US. That sounds weird, I know. But it tells the market the Fed is less optimistic about the economy’s long term growth path, which in turn means less scope for interest rate hikes.

Having said that, the Fed’s forecasting record is horrendous, so I’m not sure that really tells you too much. The market already knew the Fed was overly optimistic about future economic growth.

Perhaps more simply, the fact that the Fed won’t be raising rates for at least another three months is a green light to party. It’s highly unlikely the Fed will do anything at its November meeting, which occurs just prior to the US Presidential election.

Although, in response to a question concerning the politics surrounding the November meeting, Yellen did say that all meetings were ‘live’. That is, if the economic data continues to come in in line with expectations, the Fed will not be influenced by the upcoming election, and could hike in November.

Although I’d take that assurance with a grain of salt…

That means December is most likely the next date to move, and that will only happen if the economy continues to expand at a reasonable rate.

The upshot of all this is that if the Fed attempted to prepare the market for a rate rise before the end of the year, they did a pretty poor job of it. The market’s response was basically one of contempt.

As in, ‘Yeah, sure you’re going to raise rates. You say the same thing every time. And you always come up with a reason to hold off. So we’ll believe it when we see it. In the meantime, we’re going to party!’

Or something like that…

In the very short term it looks like US stocks might have another crack at the all-times highs. In the case of the NASDAQ, it actually made a marginal new high overnight. But the Dow and the S&P 500 still have a bit of work to do.

The chart below shows the S&P 500 index. Following the sharp but short sell-off earlier this month, the benchmark US index has pushed higher. Another attempt at the highs looks likely.


Source: Bigcharts
[Click to enlarge]

But I’m not convinced it’s all clear sailing from here. If the index can’t push on to new highs, it will signal an exhaustion of buying power. That is, everyone who is bullish is already in, meaning there’s no one left to push prices higher. That will leave the market very vulnerable to a sharp decline.

Related to this is the potential post-meeting response from the Fed. If they think the market’s response is ‘disrespectful’, and not taking the prospect of a near term rate rise seriously, you’ll see a bunch of voting members on the speaking circuit talking up the prospect of a rate rise.

The point is, I’m not convinced about the market’s knee jerk reaction to the Fed’s statement. A near term rate rise is a much higher probability than the market is pricing in. That creates risks to the downside. You might not see these risks for a few days or weeks yet, but I think you’ll see them soon enough.

I haven’t even mentioned yesterday’s Bank of Japan (BOJ) statement. It’s worth having a brief look at too. The market responded positively, but again, I’m not sure how long the positive response will last.

As you probably know, the BOJ has spent years trying to create inflation above 2%. They have failed miserably in trying to achieve this objective. Yesterday’s change in policy direction was an admission of this failure.

While they kept the short term interest rate at -0.1%, and pledged to maintain their current amount of asset purchases, they managed to come up with another crazy scheme. They call it ‘QQE with Yield Curve Control’.

In effect, the BOJ is trying to steepen the yield curve, which usually happens naturally in a healthy economy with a bit of inflation. But because Japan doesn’t have a healthy economy or any inflation, the yield curve isn’t steep (much to the detriment of banks and insurers who profit from such financial conditions).

The solution, as far as the BOJ is concerned, is to unhitch the cart and put it before the horse. Create the steep yield curve, they mindlessly think, and watch the economy take care of itself.

The only comforting thing about this is that the BOJ is as hopelessly lost, as they always have been. Clearly, there are no new insights coming out of this institution.

What isn’t too comforting is just how they plan to steepen the yield curve. They said the plan is to hold the 10-year bond yield at 0%, while keeping short rates at -0.1%. I don’t know about you, but to me, that sounds like a pretty flat yield curve.

But who cares what I think?

The market liked it. In yesterday’s trading session, Aussie banks moved higher in anticipation of receiving yield hungry Japanese capital. Following the US reaction to the Fed’s overnight statement, Aussie stocks will probably have another good day today.

But as I said, don’t get too carried away just yet. This could well be a suckers’ rally.

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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