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Has Fed distanced itself from the stock market?

Posted on Fri Jan 28 2022, 18:56
Historically, FOMC has acted to suppress the volatility in stocks. This time VIX has remained elevated. What does it mean for investors?
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2018 2019 2020 2021 2022 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 1 3 5 Fri Thu Wed Tue Mon Fri Thu Wed Tue Mon Fri Thu Wed Tue Mon Fri Thu Wed Tue Mon Fri Thu Wed Tue Mon -3 -2 -1 0 1 2 3 No. of Std. Deviations Days of Big Price Changes in S&P 500 Index 1 standard deviation = 1.27% up or down for S&P 500 Index

So far, there have been four days in January when S&P 500 saw more than one standard deviation of percent change. The market fell in all of the four days. Most market participants were hoping for a benign language from Powell so that they could "Buy The Dip" again.

Post FOMC market volatility has remained at an elevated level. Which is very unusual. Historically, FOMC has acted to suppress the volatility in stocks. VIX usually falls post conference. But not this time. So, what does this mean?

Has Fed distanced itself from the stock market?

Yes, Fed has temporarily distanced itself from the market. No point to be in denial. Why? because Inflation. Temporary or not, till inflation shows some signs of easing, stock market will remain a second priority for Fed. Here, are few signals which clearly show shift in Fed's strategy.

Firstly, consider the following paragraph in FOMC letter.

"With inflation well above 2% and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate."

It clearly states that Fed's main concern is inflation. Current inflation is running at 7.12%. Which is quite a distance away from 2%. Till this falls below 4% it will remain a big source of stress for Fed.

Secondly, Fed did not budge from its commitment to stop asset purchases.

"The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March."

In other words, Fed feels strongly about reducing liquidity from markets.

What does this mean?

Fed 'Put' has a lower strike price now

Fed Put is a fictitious level of S&P500 index below which Fed gets worried and begins to announce easing of policies. Now Fed cares less about markets. In fact, it considers current market prices to be elevated. We believe that new Fed Put strike price is around 4000. So, market can fall another -7% and still Fed won't change it's stance.

Interest rates are going to rise

Now that the Fed asset purchases are coming to end, the rates will be decided by market forces. With inflation at 7%, there will be a big pull for bond yields to rise.

Money will chase slightly safer assets now

With no short term hope of money printing (free helicopter money for consumers and businesses), the crazy valuations will start looking crazier and investor psychology will continue to shift towards assets that generate earnings (note, bonds are not safe).

VIX will come down

Yes. It will come down. It always come down. We will discuss VIX in a separate article.

What steps should one take?

Now is the time when asset managers will start changing their asset allocation. They move from growth to value. Moving before big investors move will be rewarding. In short, here's what most investors will think will happen, and that is all that matters.

  • Rising interest rates make a big dent on consumer savings. As mortgage payments go up, there is less income to spend.
  • Inflation increases costs of goods and services for consumer, so they postpone purchases.
  • Rising rates increase cost prices for businesses, so services and goods become expensive. So, profit margins become tighter. Which especially hurts high PE valuations.
  • With lower Fed Put, "Buy the dip" mentality softens. Investors will not rush to buy risky assets (non-earning, high PE) every time they drop.

What to avoid?

  • Bonds - Rising rates are toxic to bonds. Longer the duration, the bigger the loss on bonds.
  • High PE stocks - Low consumer spending power impacts sales growth of companies. So, high growth softens and has big impact on valuations.
  • Loss making stocks - This is the time of shrinking profit margins. So, the date of turning positive earnings goes further away.

So what to buy?

The best bets are low PE, profit making, growth stocks. Do such things exist? Yes. GOOG is an example. Such stocks will rise when market rises but will fall lesser when market falls.

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