US Stocks: Why The Markets Don’t Need To Fear The Fed

The S&P 500 fell sharply last week, dropping to its lowest level in 2 months. It sliced through its 50-day sma, usually a significant support zone, and as we wait for markets to open on Monday it is hovering above the 100-day sma, which comes in at 1,910. But is the sell-off justified?

To answer this question we need to look firstly at why the sell-off happened in the first place. Secondly, what the corporate earnings picture looks like. And, thirdly, what the Fed is doing and how this may effect stocks.

Why the sell-off happened:

The market seems to be in unison about why the sell-off happened and the culprit is the better tone to last week’s economic data, including the US GDP print for Q2 and another +200k reading for July’s payrolls. This has focused the market on the prospect of tighter monetary policy from the Federal Reserve. The market is scared that tighter policy could choke off the economic recovery, so good news is actually bad news for the markets right now.

But should the markets be so worried?

We think not, for a couple of reasons that we will outline below:

1. A healthy corporate picture:

The Q2 earnings season is virtually complete with 380 of the 500 companies on the S&P 500 already announcing their results. So far, the news is positive on the growth front. All sectors have reported an increase in sales and earnings growth. Sales growth was particularly strong in the consumer services sector, which bodes well for overall GDP. Technology also saw sales growth rise more than 8% last quarter.

On the earnings front, telecommunications and healthcare led the way. In terms of sales and earnings surprises, all sectors of the S&P 500 beat forecasts on the earnings front, with more than 70% of sectors registering positive surprises on the sales front. If this trend continues then Q2 will have been a solid earnings season.

Looking ahead, the market is forecasting strong sales growth for the next 12 months, although a slight dip in earnings growth is expected for Q3, this is expected to bounce back by the end of the year, which could support another hurrah for the stock market rally going forward.

2. Don’t be frightened of the Fed:

The big bad Fed coming to ruin the party in the stock market is perhaps the biggest misconception in the market right now, for two reasons. Firstly, don’t bank on an early rate hike from the Fed. The St. Louis Fed wrote a paper at the end of 2012 that looked at policy decisions of central banks that engaged in forward guidance. It found that the majority of these banks kept monetary policy loose even though the economic data supported tighter policy.

Secondly, as you can see in the chart below, the S&P 500 has, in fact, risen when the Fed has embarked on its last two rate-hiking cycles in 2000 and 2004. Over the last 15 years, the S&P 500 has tended to follow the Fed’s rate hiking cycles fairly closely, rising when rates rise, and falling when rates are cut. The anomaly has been since 2009 when stocks have risen but rates have stayed the same.

Of course, just because stocks have performed well during previous rate hiking cycles does not mean that history will repeat itself; however, it does suggest that rate hikes don’t have to be the nail in the coffin for this stock market rally.

Figure 1:

Fed Funds versus S&P500 Chart

Source: FOREX.com and Bloomberg

Takeaway:

• • Stocks have sold off sharply as the focus has shifted to the Fed tightening monetary policy after some strong US economic data.
• • We think that the stock market rally could have further to go.
• • Q2 earnings have been strong and expectations are high for continued sales growth for the rest of this year.
• • As you can see in figure 1, the S&P 500 has tended to perform well when the Fed has raised interest rates.
• • Looking ahead, it will be interesting to see if US markets follow Europe’s lead and bounce back. It is also worth watching the reaction to Tuesday’s non-manufacturing ISM for July. If it beats expectations and stocks rally, then the market may start to calm down about the prospect of better data leading to tighter policy and crushing market sentiment.

Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient.

Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

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