by Brooke Thackray, Horizons ETFs
Some investors are buying the dip (BTD), expecting a massive “V” shaped recovery. Good luck. The stock market may rally, but it probably will not zoom to all-time highs in the near future.
The S&P 500 may have a strong rally, or two, and increase in value over the next month or two (in the favorable period for stocks), but it is unlikely in the near-term to rally 20% above the all-time highs that it set less than two weeks ago.
Over the longest bull market in history, investors have become accustomed to “V” shaped recoveries as central banks have come to the rescue adding more liquidity into
the markets. The monetary policy was initially effective in helping the financial institutions and definitely helped to prop up the stock market. Increased monetary liquidity has helped the overall economy grow a bit, but not by a large amount.
Previous corrections have been caused by the perception that monetary policy was too tight for the existing circumstances. The coronavirus is presenting a structural supply and demand problem. Compared to previous corrections, “this time is different.”
China’s manufacturing has fallen sharply as factories have been closed. China is attempting to restart production, but is having trouble. The recent Chinese Manufacturing PMI registered 35.7, an unprecedented low, and indicating further weakness. Demand in the economy is weaker as people are quarantined and cannot get out to spend any money they may have. Even if they were not quarantined, if they are not working, the Chinese are not spending money they do not have.
Italy is also having its troubles. Their problem is more of a demand problem. Italy has banned attendance at large sporting venues due to the possibility of the virus spreading. As people restrict their travel and attendance at events, demand for goods and services will contract. Lowering interest rates and embarking on another round of QE will probably only have a negligible effect on the economy.
Powell Panic
Powell panicked on Tuesday, March 3rd as the Federal Reserve initiated a surprise non-meeting 50bps rate cut, which is equivalent to two regular cuts. Powell would have been better off cutting rates in an orderly fashion on the FOMC meeting dates, saving bigger cuts until the US was further along in the coronavirus cycle.
The Federal Reserve has now created the expectation that it will continue to cut aggressively. As of this writing, according to the CME FedWatch Tool (https://www.cmegroup. com/trading/interest-rates/countdown-to-fomc. html), investors now expect the Federal Reserve to cut at least 50bps at their next meeting on March 18th.
So far North American economy has not been dramatically affected
So far, North America has not been affected in a material manner by the coronavirus. Both companies and people are starting to become concerned and are changing their behavior, reducing activities that increase the risk of transmission. Companies are cancelling conferences and banning all non-essential travel. Individuals are flying less and starting to reduce activities that involve close proximity to large groups of people. Nevertheless, the impact on the North American economy has so far has been relatively small both on the supply and demand side.
Cutting the short-term rate will help the economy somewhat, but it is doubtful it will have much of an impact. The problem is that the current situation with the corona- virus is a not a monetary problem. If people are not working, reduce their travel and refrain from group activities, it will effect the economy regardless of how low the interest rates are for companies and individuals.
Federal Reserve thinking of over reaching
The Federal Reserve and other central banks are confident that they can handle the situation (what do you expect them to say). Currently, the Federal Reserve has limited tools in implementing monetary policy. According to Section 14 of the Federal Reserve Act, the Federal Reserve is limited to open market operations in dealing with securities issued by or guaranteed by the Federal government. It is interesting to note that Boston Fed President, Eric Rosengren recently stated that the Federal Reserve should be looking at other types of asset purchases that would require Congress approval. This will be a disaster, as it has been in Europe with the EU buying junk debt, creating zombie companies (companies that are only able to pay the interest on their debt, and not the principal). The EU is currently supporting many companies that should be out of business. Buying non-government assets has also been a disaster in Japan, where the BoJ owns a substantial portion of the ETF market. A topic for another day.
Previous “V” shaped bottoms saved by the Fed
Previous “V” shaped bottoms in the stock market during this ten-year plus bull market have bottomed on a major shift in investor sentiment from negative to positive, based upon a narrative that the central banks were committed to “goosing” the stock market higher.
In early 2016, the stock market stopped its correction and rose sharply higher when Janet Yellen (Chairperson of the Federal Reserve at the time), placated investors saying that the Federal Reserve was going to be cautious in its policy to increase interest rates.
In late 2018, the stock market corrected sharply and in the final days of the year, rallied sharply and went on to set all-time highs in 2019. The “V” shape bounce was the result of investors reaction to Powell’s pivot from raising rates in 2018, to committing that the Federal Reserve in would back away from its tightening policy.
In both recent “V” shaped bottoms, investors have reacted to the belief that the Federal Reserve actions would stimulate the economy. The irony is that the economy has had fairly muted growth despite the Federal Reserve stimulus.
After many QE’s and interest rate adjustments, investors have now been conditioned to invest based upon possible Federal Reserve action. And over the last ten years investors have been rewarded for implementing a Federal Reserve based strategy. The danger is that this time, investors may not believe that monetary policy can be effective in battling a slowing economy based upon weaker demand and supply caused by the coronavirus.
It appears that “Pavlovian” link between Federal Reserve policies and stock market rallies may be breaking. On Tuesday March 3, when the Federal Reserve announced its surprise 50bps cut, the market declined. The next day, the market rallied as more central banks cut their rates, but the rally did not last long. It is also interesting to note that the stock market corrected on Friday March 6, despite a very strong Nonfarm payroll report of 273k. As I have stated before, when the stock market drops on positive news, it tends to be a bearish signal.
Federal Reserve actions less important
Investors are now adjusting their investment thesis not on central bank intervention, but on their expectations of the spread rate of the coronavirus. Sure, if the Federal Reserve cuts its federal funds rate at its meeting on Wednesday March 18, investors may prop the market up in the short-term, but the big question will be, how long will it last?
If the new confirmed cases of the coronavirus start to drop on a per day basis, US investors may breathe a sigh of relief and push the stock market higher and vice versa.
Stock market can still rally
Can the stock market move higher - absolutely. Can it put in a sharp bottom bounce? At some point. Will it have “V” shaped recovery and roar to all-time new highs in the near future? Probably not.
From a seasonal perspective, the stock market is in its six- month favorable period (October 28 to May 5) which has historically been a much stronger time to be in the stock market compared to the other six months of the year. March and April tend to be strong months for the stock market, particularly the first half of April. A strong seasonal trend does not imply that the stock market cannot go down, but it has historically helped increase the chances for success.
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