The Search for Equilibrium

May 2, 2013

Let's start with the FOMC statement:

Although the FOMC left policy unchanged after its Apr. 30-May 1 meeting, the FOMC statement added new language indicating willingness to "increase or reduce the pace of QE to maintain appropriate policy accommodation...."Minutes to the last FOMC meeting had put a bit more weight on the potential costs of continued asset purchases-seemingly increasing the likelihood of a sooner slowing in QE. With the new language that was added to this FOMC statement, Fed officials are attempting to again lessen anticipation of that tapering.Language on the outlook for growth and inflation was unchanged. "The FOMC continues to see downside risks." However, current assessments of the economy gave much more importance to the impact of the sequester on growth.

The March statement had said "fiscal policy has become somewhat more restrictive", but the May statement linked the sequester directly to slowing in growth: "fiscal policy is restraining economic growth".Other changes to the Fed's current analysis of growth and inflation were little different, and the FOMC still characterized growth as "moderate". Labor market improvement was recognized a bit less tentatively ("some improvement..., on balance..." rather than "signs of improvement"). Wording on consumption, business investment, and inflation was not altered.

The recognition of an increased drag from fiscal policy is probably linked to the Fed's new warning that QE could get larger or smaller. The Fed had already been indicating that it would size QE according to "efficacy and costs... as well as... progress toward its economic objectives." In that regard,  it seems that Fed officials found that the new warning was necessary mainly due to increased evidence that Congress and the White House are not reaching easy agreement to scale back the sequester.

In adding the warning on QE, Fed officials were also responding to the threat of disinflation. (The QE pace will be altered "as the outlook for the labor market or inflation changes".) The core PCE price index has slipped to 1.1%y/y as of March from 2.0% a year earlier. That threat would be clearer if the core CPI had followed the same path, but it has not, instead sticking close to 2%y/y. The emphasis on greater/lesser QE partly reflects FOMC uncertainty about underlying price pressures.

Thus, the underlying structure of the statement was unchanged but it put the FED moves in perspective related to the Congress moves, so to speak monetary policy are not substitute to economic policy but they need to work together to reach the economy's point of equilibrium.

An equilibrium that I did not find during my readings; while I was lost into the blogosphere I've found that more than 3/4 of blogs' post titles were:"Sell in May and go away", is this titles' convergence expression of a lack of imagination? or reflection of the actual market positioning?

What I have learned during the past 14 years is that sometimes we become trapped of the old sayings, and we loose our ability to read the market.

For sure if we look at the statistics we see that in the past 3 years May returns for the S&P were on average negative 8%. Will May 2013 follow the same return distribution?

I certainly do not know, because I'm a trader not a prophet. What I know is that returns follow a Markovian process:

A Markov process can be thought of as 'memoryless': loosely speaking.

A process satisfies the Markov property if one can make predictions for the future of the process based solely on its present state just as well as one could knowing the process's full history. I.e., conditional on the present state of the system, its future and past are independent.

Therefore if the Future and the Past are independent we need to surrender to the ultimate force driving an asset returns: its price.