Friday’s Stock Market Decline: Complacency vs. New Fed Policy?

the Curmudgeon with Victor Sperandeo


US stock indexes and sectors suffered their biggest losses in two and half months Friday, as bullish traders and financial institutions suddenly and unexpectedly became uncertain and unhinged after months of calm, upward bias trading, despite deteriorating economic fundamentals. 


The NASDAQ and S&P 500 each lost 2.5%, while the small cap S&P 600 shed 3% and the Russell 2000 index was down
3.11%. Popular sectors were equally hard hit.  The Dow Jones Utility Average dropped 3.8%, while the Philadelphia Semiconductor Index lost 3.7%. 


Declines led Advancing issues by a roughly 15-1 ratio on the NYSE and 6-to-1 on the NASDAQ.  Volume rose solidly across the board, leaving no doubt about institutional selling (most likely hedge funds and computerized traders with quick trigger fingers).


Traditional stock market hedges, like Gold stock ETFs, lost even more than the popular averages or sectors.  

·       Market Vectors Gold Miners ETF (GDX) dropped -5.34% [Curmudgeon owns several hundred shares and is not selling]   

·       Market Vectors Junior Gold Miners ETF (GDXJ) cratered by -7.09%

·       Direxion Daily Junior Gold Miners ETF (JNUG) was down -21.00%


The Curmudgeon and Victor provide their different market perspectives on Friday’s decline in this article.  Fasten your seat belts!


Curmudgeon Comments:


Many attribute Friday’s stock market sell-off to a speech that same morning by Boston Fed President Eric Rosengren who (like so many other Fed officials) hinted at a rate increase.  The Curmudgeon strongly disagrees!!!  


First, the Financial Select Sector SPDR Fund (XLF) declined 1.80% along with banks shares (e.g. Wells Fargo lost 2.36%; CitiGroup was down 1.30%).  A Fed rate increase would benefit financial and bank stocks, which should have rallied if investors were so confident of a rate hike this September.


Second, the Saturday NY Times published a Reuters article which mostly attributed the stock sell off to North Korea’s nuclear test. 

“Shares fell on Friday as investor nervousness increased after a nuclear test by North Korea, and comments from officials at the Federal Reserve led investors to think that interest rates might be raised sooner. North Korea conducted its fifth and biggest nuclear test and said it had mastered the ability to mount a warhead on a ballistic missile, increasing a threat to its rivals.”


Instead of fixation on the Fed, we think that investor complacency was so prevalent and sentiment so bullish that any excuse could be used to trigger a sharp market decline. 


We warned in a blog post earlier this week that the disconnect between all-time high stock prices and the weak real economy/negative profit growth/declining earnings estimates/negative corporate guidance, etc. would end very, very badly.  While the timing of what we perceive as an “all assets decline” is uncertain, it could start any day with no warning flags. We believe such a decline is way overdue in bonds, stocks, REITs, and residential real estate (especially in the SF Bay area).


The Fed has repeatedly alluded to interest rate hikes so many times this year that it’s now perceived as “the boy who cried wolf.”  Most recently (August 26th) Fed Chair Janet Yellen shouted “The case to raise rates has strengthened in recent months.” US equity markets yawned.  The NASDAQ 100 and Russell 2000 made new all-time highs this past Tuesday and Wednesday while the S&P 500 < 1 point from a new all-time high.  All on continuing earnings guidance downgrades as reported last week.


The Fed’s own internal forecasts vary so widely, they’re useless for accurately assessing where rates may be in the future.  That’s shown in this chart, which was shown by Doubleline’s Jeffrey Gundlach on a webcast last Thursday:



That “lack of faith in the Fed” is depicted in the chart below, which is a response to the question:  How much confidence do you have that the Fed leader will do the right thing for the economy?  Only 8% of current respondents have a “great deal” of confidence in the Fed vs ~28% in 2001, when the survey first began and “maestro” Alan Greenspan was Fed Chairman.


Courtesy of Wall Street Journal

As a result, no one really takes the Fed seriously anymore, especially when a Fed official says or hints they’re going to raise rates.  Traders may jump on that news, but longer term investors seriously don’t believe the Fed will raise rates anytime soon.


The CME Fed Watch Tool, which is based on CME’s 30-Day fed-fund futures prices, did have an uptick in the probability of a 25 bps Fed Funds increase at the September FOMC meeting.  It’s currently 24% vs 18% the previous day.  The Fed Watch tool probability should be more like 75% for a rate hike to actually occur at the Fed’s September meeting.


What Rosengren Really Said (Curmudgeon):

Mr. Rosengren only mentioned that asset markets COULD become too ebullient IF the Fed waited too long to raise rates. He later softened that remark by saying the risk of raising rates is two sided.  Here’s what he actually said, according to the Boston Fed’s website summarizing his speech (there’s also a video replay option on that website).


Rosengren noted that waiting too long to tighten could lead to conditions that require more rapid increases, risking a more pronounced slowing of growth and rise in unemployment.  It may also allow some asset markets to "become too ebullient," and he reiterated previous concerns over commercial real estate prices.


"The risks to the forecast are becoming increasingly two-sided, in my view," Rosengren explained. "Weakness emanating from abroad poses short-term downside risks to the domestic U.S. economy," yet there are also "longer-term risks from significantly overshooting the U.S. economy's growth."


Victor’s Comments:


I believe that traders reaction to Rosengren’s remarks caused the markets to drop on Friday – the biggest fall since June 24th - the day the UK voted to leave the EU (BREXIT).


The Fed has never said before that assets had "become too ebullient." Instead, the Fed has said over and over, that interest rate increases they control (Fed Funds and Discount Rate) were "DATA DEPENDENT."  That means a Fed rate rise is dependent on data showing the economy is strengthening and inflation is at or above the Fed’s 2% target rate.  Do you really think either of those is happening?


To bring the obvious into the policy mix – that asset bubbles have been created and could get bigger-  throws out the data dependent or weak economy EXCUSE that keeps the Fed from raising rates and thereby props up the markets.  It puts into play "a new REAL reason" to raise rates: to prevent asset bubbles from getting bigger.                              


This shock and awe surprise statement is substantial. If the Fed decides to raise rates to prevent asset bubbles from getting bigger, it’s over for all assets, except gold and cash.  The greatest bubble is in bonds/debt; then equities, then real estate.


If the equity markets are down on Monday by over 2% and volume expands above Friday's NYSE 1,080 billion shares this is likely the beginning of the end for the huge bubbles in so many asset classes.


THE BELL IS RINGING AND THE FAT LADY IS SINGING!  Until the Fed realizes it shot itself in an artery before the election, changes its tune and retracts the Rosengren remark that assets had "become too ebullient."

Good luck and till next time...

The Curmudgeon


Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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