The stock market kicked off March 1st with a new high in the Dow, S&P 500 and NASDAQ but has been losing steam the rest of the month. Since the presidential election, investor optimism has been driving stocks higher. In fact, a recent analysis by Bloomberg found that mom and pop investors have been a major force in this rally. More sophisticated investors, on the other hand, have been a little more cautious.
The market is still trending up even with its recent wavering, but a few cracks are starting to show. One worrisome sign is investor sentiment indicators are getting stretched. These are usually early indicators that point to short-term weakness, but not a serious pullback, correction or something greater than 5%.
The Fed Still Matters
President Trump’s tweets have taken center stage for the market since he was elected. But there is still another 800-lb. gorilla in the room—the Fed. Janet Yellen has signaled to the market that rates will go higher by 0.25% when they meet next week. She has also indicated that the Fed may switch monetary policy from “accommodative” to “neutral” moving forward. This would be a significant change to policy as they’ve been “accommodative” since 2008.
So far, the market has shrugged at a March rate hike. Its hopes are pinned on Trump’s proposed tax cuts and deregulation to drive the market higher. If they go through, great. If they don’t occur in a timely fashion, then the Fed will be back on center stage.
The QE Factor
But can three rate hikes totally 0.75% in 15 months derail this market? It doesn’t sound like much, but if you factor in the prior quantitative easing (QE), it looks more significant. Samuel Reynard from the Swiss National Bank estimated that QE was the equivalent of a negative 4% federal funds rate. Others think negative 3% is a better estimate. Either way, we’re looking at a 3.75% to 4.75% move up, which is historically when things can start to go haywire.
When the Fed started to unwind QE in late 2014, they essentially started tightening. And tightening generally leads to recessions according to the 2016 analysis by Goldman Sach’s David Mericle. What makes that more problematic are the market’s high valuations. High stock valuations and recessions have historically ended poorly for investors.
But this doesn’t mean now is the time to move out of stocks. Our models are still positive, so we’re overweight stocks. There will come a time when it does make sense. Just not right now. Until then we’ll be carefully monitoring the stock market for indications of further strength or weakness and adapt.