The Fed Decision and the Market Reaction

The morning papers will tell you that the Fed made a decision and the market rallied by 4%.  Causation will be implied, even when not explicitly stated.

For most of the punditry the interpretation of these stories is seen through the prism of their opinions.  Forget the data!

The initial reaction to the Fed decision — for a heartbeat — was a rally based upon the apparent promise to hold rates low until 2013.  Then the critical commentary hit.  I watch a good group of sources via Twitter as well as the MSM commentary.  The Twitterati had an immediate negative reaction.  It is a tough audience that usually hates Bernanke and the Fed.  As the market sold off, the comments became more strident.  There was criticism of Doug Kass, who turned out to be the star of the day.  He explicitly stated that the Fed decision was favorable for risk assets.  No one agreed.  Financial TV started raising questions, like whether or not the 2013 date was a firm promise.

Kass called the rally in real time, and most everyone disagreed.

When the market rallied, suddenly things changed.  New explanations were needed.  Even tonight's Kudlow show involved as many interpretations as there were guests.

Too Many Explanations, Too Little Knowledge

Anyone experienced in analyzing causal relationships knows the difficulty when you have multiple variables and few events.  You cannot invoke the right statistical controls.

A pundit test would be great fun.  The "expert" is given a set of facts and must then predict the market reaction without knowing the real outcome.  (Please note the relevance to last week's trading).  Let us consider yesterday's huge decline, widely attributed to the S&P debt downgrade.  There were a number of possible sources of selling:

  • The debt downgrade.  One would expect to see this reflected in higher interest rates, but rates moved lower.
  • The European crisis.  The ECB  bought bonds and the interest rates of Italy and Spain moved much lower.  Even those who did not see this as a complete solution had to be impressed by the result.
  • Margin calls on various market participants.  We do not have precise information on this, but I think it was important.
  • Momentum trading.  One of our programs is a momentum model, and it did very well — even signaling an exit late in the day.  While our technology is very good, others do similar things.

My own explanation includes all of the above, not a single cause.  The apparent anomaly on the downgrade requires a deeper look.  Between the Tea Party and the S&P, the market believes that the US must now focus on immediate deficit reduction.  I disagree — a story for another day — but that is the market perception.  I commented to my team that this idea would turn up somewhere, and sure enough, I see that David Rosenberg has that viewpoint.  It is one of the few good explanations of why bonds rallied on the downgrade while stocks tanked.

The Fed Decision

Let us now turn to today's action.  Let me start with my interpretation of the Fed move.  I am not going to do a detailed analysis, assuming that readers of "A Dash" have a basic understanding from primary sources.

  • The 2013 date is a promise, but not a contract.  The language is not definitive, but is open to interpretation.  I think that this is intentional.  The specified date is stronger than the "extended period" language, which implied two or three Fed meetings.  If the economy improves a lot, this is going to change.  Having said this, it will be difficult to revoke the promise without a major change in conditions.  Eventually market participants will come to this viewpoint.
  • The economic outlook was downgraded realisitically.  This was not the meeting to report a formal change in estimates, but obviously the change is there.  The Fed explicitly acknowledged the weaker data, even worse than the Japan/soft patch thesis would suggest.
  • The door is ajar on balance sheet management.  "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate."  This is better than announcing a QE3 program.  Most market participants still do not understand QE2, including the fact that it has not ended.
  • The three dissents.  While this is still a 7-3 vote, it is far from the typical unanimity.  The dissenters seem to have a more bullish view on the economy, with less need for long-term action.  The bearish segment of the punditry will see the dissenters as fearing inflation without growth, so this is more fuel for the fire.
  • An air of mystery.  Other options were considered.  Who knows?  Pundits are already speculating about a QE3, with the Jackson Hole annual speech only weeks away.

The decision gives plenty of room for interpretation, helping to explain the market confusion.

Market Interpretation

Here are several other interpretations for the market rally:

  • Realizing that interest rates will be low for years to come, the comparison to dividend and earnings yields in stocks (the widest risk spread in history according to some) suggests the need to reconsider asset allocation.
  • The "attack on the yield curve" stimulated short covering in Treasuries, as well as stocks.
  • The market was oversold and ready for a rally unless the Fed decision was something horrible.
  • Many were caught leaning the wrong way, so there was massive short-covering.

No wonder my twitter friends were so far off base.  Since the actual decision was not that dramatic, I favor a combination of the above causes.

Investment Implications

It is a mistake for the average investor to attempt to time these moves in a volatile market.  Having a price target for individual stocks that you want to own makes much more sense.

 

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