Down is the New Up

PaulNolte-2“Should I stay or should I go” may be the rallying cry for the Fed this week. Should they raise rates after eight years of maintaining a zero rate policy or just leave them alone for yet another meeting? The “consensus” opinion on what the Fed should do is split between the two camps. One argues the employment situation is very healthy and should warrant the slow process of “normalizing” interest rates over time. The other says the global economy remains fragile and with central banks around the world still cutting rates, a rate hike in the US will hurt our economy. In either case, about a minute after the decision, investors will be fretting about the next meeting and what they will do then. It is a never ending cycle of worry that fills up investment columns and pushes stock prices around. Expect another week of volatility from the markets, no matter the decision. Using short-term rates as a guide, the bond market seems to be leaning toward a rate hike this week. Inflation remains non-existent, so quelling inflation fears will not be part of the decision process. “If I go there will be trouble, an’ if I stay it will be double”. Such is the conundrum for the Fed this week.

The 2% gain for the week is actually the best in six months and gave investors some hope that the markets will react kindly to whatever the Fed decides this week. Many of the momentum indicators we regularly review are very near levels of prior bottoms in ‘08/’09 and fall of ’11. Investor sentiment, usually a contrary indicator, is bearing – meaning investors expect the markets to continue their decline. From strictly looking at the price action of the past few months, the SP500 has settled down some from a volatility perspective. But, the pattern of both higher lows and lower highs usually precedes a big move in prices. Of course the set-up is perfect for the hugely anticipated rate decision this week. One other “line in the sand” that the SP500 needs to cross is the 2000 level. This marks the price at which stocks declined hard in August. A retracement of the decline is expected and is nearly complete. If the SP500 gets above 2000, then we may be done with the corrective process. If the SP500 turns tail this week, another decline could ensue, taking the SP500 back toward the lows of August. A Fed hike in rates should not force investors to the sidelines, as interest on money market accounts will remain near zero and to gain “a return” of any consequence will still require risk-taking. The tea leaves say a strong rally could begin this week, but with such opposing views, we are likely to allow the dust to settle later in the week before making major investments.

The bond market has been just as rocked as the stock market over the past few weeks. As mentioned above, the short-term yields have gone up (and prices down) as investors expect the Fed to hike rates. However the long-term yields have not budged too much as they track inflationary expectations which remain relatively low. One of the concerns within the bond market is the relationship between “riskless” treasury bonds and “junk” bonds. If treasuries are doing better, investors are looking to shed risk and it creates a “flight to safety”. If junk is doing better, investors are willing to take on risk to achieve higher returns. Until the middle of the year, junk was consistently beating treasuries. Since that time, investors have begun to run to the safety of treasuries. Much of the high yield area is within the energy sector, but it also began throwing up warning signs to equity investors as well. The SP500 is almost exactly unchanged since 6/30/14.

In a market such as we have had over the past two months, everything declines. It is instructive to see where opportunities lie by looking at how various sectors are doing relative to the SP500. If they are falling less than the market, it may be expected that when things turn around, they will rise first/faster than the market. The usual “safe” investment havens, like utilities and consumer goods have gone down less, but so too have industrials and consumer goods, such as retail, shoes and restaurants. What the markets may be pointing to is some strength within the US economy that could indicate a willing Fed to raise rates this week. However, what have been extremely weak are the basic materials and energy sectors, the building blocks for the economy. How the Fed moves this week will truly be anyone’s guess.

We remain cautious toward stocks, holding a bit more cash than usual. As the markets declined, we have found a few parts that have held up well and are looking to deploy some additional funds once past the Fed meeting on Wednesday. Volatility is likely to remain a part of the market through October. Bond investors should continue to be immune from much of the large daily swings experienced by stock investors.
The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.