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No, the Fed is not driving the markets

Michael Santoli
·Michael Santoli

It’s not all about the Fed, and never really has been.

The market’s confused response and dramatic reversal following the central bank’s inaction last week has encouraged plenty of talk that the non-move was momentous.

Yet how to square that with the broad agreement beforehand that it was a very close call and a slight bump in rates would make little real-world difference anyway?

Fact is, the market has been struggling against plenty of swirling currents that aren’t directly about the Fed’s tenuous control of liquidity conditions. Here are a few:

-Credit conditions for companies have become less comfortable in recent months. The risk priced into junk debt has been rising, and not really because the Fed was thought to be nearing rate “liftoff.”

Sure, very low rates encouraged the multi-year debt-issuance binge that’s now causing market reflux. But the energy bust and stalling out in corporate cash flow growth have been hurting more.

Junk spreads have quit racing higher in recent weeks, which has allowed stocks to lift off their lows. They remain a bit too elevated to allow for much upside in equity valuations, though. Whether credit investors view current yields as cheap will be a key beacon for stock-market direction through yearend.

-The broadest take on this year - with the S&P 500 (^GSPC) down nearly 5% after tripling over the prior five-plus years – is that a mature bull market has been re-priced for an earnings lull. Makes sense, right?

For the third quarter, S&P 500 companies outside of energy are forecast to show a 3% rise in profits. We’re months away from lapping the steep collapse in oil prices and run-up in the dollar, but the market will likely sniff out this shift before too long.

It’ll be noisy, but domestic companies are growing pretty well while globally focused ones are having well-understood trouble. Everyone should be watching how stocks trade off preannouncements in coming weeks for a clue about whether the bad news is largely in the market already.

-Seasonal factors are challenging.

It’s maddening that whatever month of the year it is continues to be viewed as an important driver of markets (which supposedly reveal the collective wisdom of the world’s investors). But there it is, seasonal patterns repeating often enough to keep people focused on them, and seeming to “work,” even if by self-fulfillment.

This week starting now has been the roughest one for U.S. stocks in the past decade. When a six-month low has been made in August, as happened this year, the S&P has tended to break that level more often than not in subsequent months. But then a fourth-quarter rally usually followed.

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Set against these stiff headwinds, a few factors suggest that the bearish case shouldn’t be considered a lock.

-Investor sentiment remains the most consistent factor cautioning against getting more negative on stocks. Surveys, fund flows, short interest, hedge-fund positioning and demand for protective options all show the crowd leaning rather hard against stocks. One might add to this the fact that equity markets never quite got into the silly zone, either in valuation or public attitudes, near the record highs. Global stock-market capitalizaiton as a percentage of world GDP, for instance, is near 2004 levels, well below peak readings from 2007.

This is no guarantee of an easy rally to trade, and crash-like scenarios are near-random and strike from the blue no matter what the prevailing mood.

But all else being equal, extreme pessimism typically limits further downside and at some point should set the stage for a bounce to knock the bears off balance.

-While vulnerable due to those sloppy credit markets and global growth worries, the M&A/stock buyback/activist investor theme of financial engineering isn’t quite spent.

August was another strong month for merger announcements, up 20% from a year earlier. Buyback volumes may well have peaked, but companies will keep trying to soak up shares in historically heavy volumes. Activists have got to most of the easy targets, but the selloff in many sectors is refreshing the supplky of potential targets.

Not reasons alone to get bullish, but this should be a net positive until proven otherwise.

Some people will place all these factors and everything else at the feet of an aggressive Fed now looking for the chance to undo years of stimulus efforts. But that’s far too simplistic, and unhelpful to investors looking to navigate the tape.

It remains difficult to view the conditions we’re seeing now and deciding with much conviction that it’s either a sharp correction in a bull market or the start of a cyclical bear phase.

But it’s not the Fed alone that will determine which of these paths the market takes.

 

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