by Brooke Thackray, Horizons ETFs
FED FOMO is the Fear of Missing Out (FOMO) on a rally in the stock market that is believed to be substan- tially supported by the actions of the Federal Reserve. It is the belief that if anything bad happens to the stockmarket that the Federal Reserve will be forced to provide stimulus to once again drive the stock market higher. FED FOMO is largely based on the concept of the “Fed Put.”
A put option is the obligation of the put seller to sell a security if the buyer “puts” his right to buy the underlying securities at a specified price. The colloquial term “Fed Put” is used to refer to the ability of investors to put their right for stock market support to the Federal Reserve, forcing them to act if the stock market has declined.
The term “Fed Put” was started back in the Greenspan era, when Greenspan bailed out the markets after the Long Term Capital Management fiasco. Successive central bankers have followed suit and have continued to ferment the belief of a Fed Put with loose monetary policy actions.
Powell has established his own version of the Fed Put, with strong policy statements, stating that he will do whatever is necessary, and the Federal Reserve is not thinking about raising rates. In addition, the Federal Reserve has embarked on novel programs such as buying junk and corporate bonds. Investors have cheered the actions of the Federal Reserve and pushed the stock market higher, creating a moral hazard with investors believing that the Federal Reserve has no choice but to support the stock market.
Download the complete September 2020 Thackray Newsletter here..
Investors such as Dave Portnoy, aka the guy from barstool sports, is telling everyone that stocks never go down. Sometimes it seems that way, but we all know that is not true. Nevertheless, investors are acting as if Portnoy is right.
There is a growing number of investors that fear that they are missing out on stock market gains that are backstopped by the Federal Reserve. Valuations do not seem to matter. The feeling is that if the Federal Reserve is supporting the stock market what difference do valuations make?
The problem is that investors are acting as if the Fed Put is “at the money” and the Federal Reserve will come in and support the stock market if the stock market drops a few percent. Ironically, the Federal Reserve has helped to support this belief through its actions. In a way, the Federal Reserve is its own worst enemy.
The level of the Fed Put is probably much lower than most investors anticipate, but the mere fact investors believe it the Federal Reserve will step in if the market only declines a few percent is helping to support the markets.
The danger is obviously that if the stock market moves lower and the Federal Reserve is not there to step in and support the market, the stock market could move decisively lower. What if the Federal Reserve sat on the sidelines while the stock market corrected? It seems that many investors do not believe that this is possible, but it is totally conceivable.
As investors are starting to realize, the economy and the stock market are not related in the short-term. In the longterm, they are absolutely related. Currently, the stock market is at all time highs and the economy is far below the level that it was at the beginning of 2020.
Yes, I agree that the Federal Reserve has an unofficial third mandate of supporting the stock market to indirectly support the economy through the wealth effect. But it is a stretch to believe that Federal Reserve is going to stop every correction. I know that it is hard to believe, but it used to be quite common for the S&P 500 to have one or more 10% corrections in a year...in a positive year for the stock market.
Investors may be in for a surprise if the stock market corrects and the Federal Reserve sits on the sidelines.
Blackout Period - It Has Started
In my newsletter last month, I stated that ”once we slip into September, the odds of large Federal Reserve actions decreases substantially.” In essence, we are now getting too close to the election for the Federal Reserve to initiate major actions unless very unusual circumstances develop. We are now in the “unofficial” blackout period for the Federal Reserve.
The next Federal Reserve meeting is on September 15 and 16 with its interest rate announcement being made at the end of its meeting on the September 16. Currently, investors are expecting the Federal Reserve to leave interest rates unchanged. It is highly unlikely that the Federal Reserve would move into negative interest rate territory just before the election.
In addition, the Federal Reserve is probably not going to make any large changes to its quantitative easing policy. First, it appears that the economy does not need to be artificially manipulated at this time as it is plodding along on its own. Second, it is unlikely that the Federal Reserve would make any large policy decisions before the election unless absolutely needed.
So what might the Federal Reserve announce on September 16?
The Federal Reserve could give more of a description of how the Average Inflation Target (AIT) policy is going to work. It is also possible that they might hint at Yield Curve Control (YCC). It will probably continue to talk about how the Covid-19 pandemic can still have large economic consequences and how the Federal Reserve will be supportive and it has a lot of tools that it can use if needed. But there probably will not be a dramatic new policy announcement.
The November Federal Reserve meeting falls on November 4 and 5. Although this meeting is not associated with a summary of economic projections, in the past, Powell has made comments after this type of meeting.
The Federal Reserve meeting falls right after the US election on Tuesday November 3. I wonder if this was an oversight by the Federal Reserve committee. Regardless, it is possible that a winner of the election will not be declared until some time after November 3, and even if a winner is declared, there is a possibility that it will be contested by the other party.
It is going to be hard for the Federal Reserve to announce any large moves right after an election. If it were to make a large announcement, being so close to the election would certainly cause many people to openly question if the Federal Reserve is truly independent from the government. It is all about optics.
The next Federal Reserve meeting, after the November meeting, takes place December 15 and 16. This is the time period when the Federal Reserve is more inclined to take action. December is also the preferred month of the Federal Reserve to take action. Both Yellen and Powell have previously pivoted in December.
The point is that for the next few months, the Federal Reserve will probably not step up to the plate with new and large programs, even if the stock market goes through a moderate correction.
Gamma not for your Grandma
Recently, gamma has been pushing the stock market. When an underlying stock increases in value, the corresponding option contract also changes in value. Gamma is the rate of change of delta on an option’s contract.
Recently, a lot of novice investors have been buying call options, speculating that stocks and the stock market will continue to rally. The amount of call options being purchased is setting records due to a huge amount of speculation. Market makers, taking the other side of the contract, typically hedge their position, buying the underlying equity. As the stock market moves higher, market makers are forced to buy the underlying securities to cover increasing gamma, thus pushing the stock market higher. This circular relationship has kept upward pressure on the markets.
The bad news is that if the stock market starts to turn down and investors buy puts, the whole process could work in reverse and market makers could be forced to sell underlying holdings, putting downward pressure on the stock market.
Seasonally - Not a good time
On a seasonal basis, we are in the weakest period of the year. In fact, the last two weeks of September over the long-term has been the weakest two weak period of the year over the long-term. To top things off, we are heading into a very polarized election. On a seasonal basis, the market tends to be weak before the election as investors shy away from risk in an uncertain environment. The result over the long-term on average has been a declining stock market into late October.
Above is a graph that I included in my last month’s newsletter. It shows that on average the stock market tends to decline at this time of the year into late October, in election years. Of course, the S&P 500 does not have to follow its previous election trends, but given the amount of polarization in the US and uncertainty around the election, the possibility of a declining market into the election should not be dismissed.
Copyright © Brooke Thackray, Horizons ETFs
