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The Fed Killed It

Submitted by Lance Roberts via STA Wealth Management,

I had previously discussed the impact of Fed meetings on the markets stating:

"With markets oversold on a short-term basis combined with a spike in volatility and bearish sentiment, a "punt" by the FOMC will likely spark a short-term rally in the market. Such an outcome would NOT be surprising by any means since the market has rallied the week of an FOMC "no hike" meeting since 2013."

If you look at the chart again, you will notice that while the markets have tended to rally in anticipation of the Fed meeting announcement, in many cases the market fell following the announcement. The "buy the rumor, sell the news" effect is definitely apropos in this case. 

I began addressing at the end of August that the market collapse had gotten extremely oversold. As such, that set up the probability for a reflex rally back to previous support levels. 

"While the volatility index (VIX) is still suppressed relative to historical corrections, it is at the highest level since 2012. When combined with the most bearish sentiment reading we have seen since the summer of 2011, and a currently oversold market condition, the ingredients needed to fuel a short-term rally are present.


The chart below shows this oversold condition, and is the same "potential reflex rally" chart I have posted for the last three weeks. The dashed blue line, which I drew immediately following the initial slide, has marked the exact 'reflex rally' to date."


The Fed Killed It

Not surprisingly, the failure of the Federal Reserve to hike overnight lending rates sent a clear message to the markets that the economy was simply not strong enough to withstand tighter monetary policy.

While Chairwoman Janet Yellen did her best to pass off the recent disinflationary trends as transient due to the decline in oil prices, the discussion of the potential for negative rates sent a very different message. From the WSJ:

"Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.

One official called for a negative interest rate in 2015 and 2016, something that has been tried in several European countries to boost growth and inflation. The Fed doesn't identify which officials make specific projections.


One reason for the shifting outlook: Officials have become a bit less optimistic about the economy's long-run growth potential. They projected the economy will grow at a rate between 1.8% and 2.2% in the long-run, down from their June estimate of growth of 2.0% to 2.3% in the long-run. A more lumbering economy has less capacity to bear much higher rates."

With earnings growth already weak, the recognition that the Federal Reserve is likely trapped at lower rates is problematic. It also brings into question the current valuation multiples being sported by the markets currently. 

While it is often noted that "low rates suggest higher multiples," it should be remembered that ultimately earnings growth, outside of accounting manipulations and stock buybacks, is dependent on economic growth. Therefore, low rates also suggest economic weakness which will cap organic earnings growth over time. This makes high valuations problematic longer term. 

It was this realization, and disappointment, that likely killed the rally that began in earlier this month.

A Retest Of Lows?

The failure at overhead resistance, combined with a continued weak technical backdrop of momentum and relative strength, suggests that a retest of lows in the weeks ahead is a likely probability. As shown in the chart below, the deviation from the long-term bullish trend line was greater than at the previous two bull market peaks. In both previous cases, a break of the market below the shorter-term moving average (red dashed line) subsequently led to a least a test of the longer-term bullish trend line. However, a "test" would assume that the current cyclical bull market is still intact. 


If the market fails to hold support at the long-term bullish trend, such a failure will dictate a fully completed transition into a more destructive cyclical bear market. 

As I addressed last time:

" do not rise or fall in a straight line. During bull markets, there are declines to previous support levels and during bear markets there are rallies to resistance."

"Notice that at the peaks of previous bull markets, the initial correction looked much like all previous corrections during the bullish advance. The problem is that many failed to recognize, until far too late, the technical trend had changed for the worse.


Currently, it is being argued that this correction is just a blip in an ongoing bull market. However, there are plenty of markings that suggest that the current correction may have been the start of the next cyclical bear market."

While the mainstream analysis remains quite bullish on the underpinnings of the market, the ongoing deterioration of market internals and fundamentals suggests something more pervasive.

Market topping processes take quite some time to develop fully and, unfortunately, are only fully recognized in hindsight. The problem in waiting for "recognition" is that the destruction of capital is already far larger than previously expected. This leads to a series of "psychological" responses that exacerbate the problem such as "hoping to get back to even."

The last point is critically important. In the world of investing, "hope" has never been an investment strategy that one could profit by. It likely won't be successful this time either.