Caution: Fed Meeting Dead Ahead!

PaulNolte-2Everything from the bazooka to the pea-shooter were used on the European monetary system on Thursday. Interest rates were pushed down to zero (from the dizzying heights of 0.05%). The central bank is going to pay banks to make loans on funds held. They are also buying up $80 billion in euros of bonds, including corporate and non-financial investment grade bonds. This flurry of activity was viewed by the financial markets as huge and rallied strongly until the press conference that followed. In it, the ECB president Mario Draghi indicated that interest rates would not be pushed lower at subsequent meetings. Markets turned lower, finishing Thursday unchanged. Friday investors had slept on it and decided the amount of money flowing would be good for financial assets and pushed the markets higher by nearly 1.5%. Looking forward on this side of the pond is a very different scenario. When Ms. Yellen speaks on Wednesday, she will be evaluating the better looking US data and financial markets. She will likely signal the Fed’s desire to keep up the rate increases, although not beginning until late Spring at the earliest. Of course all her comments will be parsed very closely for any additional clues as to the Fed’s intentions.

The stock market continues to rise, supported by global easy money and better than expected economic data. Energy prices have helped, now starting their own bull market (over 20% gain from the lows) and commodity prices as a whole are getting a bit stronger. The main question is whether this is the beginning of a new leg higher or just a furious rally to be reversed in a month or two? There are a few indicators that point to “just” a short-term rally. The good news is that the net number of advancing to declining stocks has make a high for the year, but sadly the performance of small and midcap stocks are not at new highs for the year vs. their large peers. Volume has expanded nicely on the rally days vs. the declining days, a win for the bullish camp as well. What still lingers in the background is the persistent thought that earnings and margins for companies is contracting at a time when earnings are also slowing. This double-whammy could keep corporate profits depressed, which in turn keeps a lid on stock prices through the year.

When talking about “the bond market” investors may believe it is one giant monolith of debt. In fact, there are nearly as many sectors within the market as there are within the stock market. When the markets get scary, stock investors flee to the safety of utilities and consumer stocks and bond investors flee to government bonds. When the markets get bullish, stock investors look to energy and technology stocks to boost returns. For bond investors it is high yield (junk) bonds. Early in the year investors fled any type of bond that had default risk and ran to government bonds. Since stocks began their run over the past few weeks, that trade is reversing as investors are again OK holding higher risk bonds. Bonds tend to lead stocks and did so before the market decline, but everything seemed to bottom at once in mid-February, leading
toward some suspicion of the longevity of the rally.

Sharp rallies, followed by breath-taking declines and sharp rallies again have made investors a bit skittish about committing more money to what is looking more like a casino than a stock market. Do the values of companies change so quickly that we can experience two 10% declines and a nearly 10% gain within a six month period? Unfortunately all the various QE policies of the Fed and easing policies of central banks do not generate more sales or earnings for companies. What Draghi alluded to in his press conference was that governments will need to adjust fiscal policies to better address investments in new plant, equipment and long term investments in building “stuff.” There is only so much central bankers can do: provide liquidity and make it easy to borrow. But they cannot create value on the asset side of the balance sheet. It is that part that has been missing since the housing collapse. All that has been done so far is shifting the debt structure from one entity (individuals) to another (government) without addressing the need to provide economic growth to help service that debt. There are long-term values in parts of the markets, but finding them is getting tough. As depressed as investors were in early February, they are getting just as euphoric with the recent rise in stocks. Just as we thought stocks “should” bounce in February, they should decline some now, if only to take off some of that euphoric high. As usual, the Fed meeting and press conference that follows will provide investors fodder for buying or selling
stocks. We do not expect to see a rate hike at this meeting, but would expect the Fed top pave the way for another increase by summer. Investors may not be thrilled, but the Fed is very interested in getting back to what passes for normal very soon!

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.