June 14, 2017

Stocks rallied yesterday as jitters created by the tech stock rout last Friday eased.  This morning futures are higher ahead of the conclusion of the two-day FOMC meeting this afternoon.

Let me start with a brief discussion of the action in the FANG and other high flying stocks.  As noted, they took a drubbing on Friday and continued to sell off on Monday morning.  In general, the stocks that took the biggest shellacking were the ones that had risen 30-40% or more just since the start of this year.  Taking nothing away from the corporate performance of companies like Amazon, Apple# or Nvidia, a 40% move in less than six months can easily be viewed as too far too fast.  Equity prices rarely move in a straight line.  After a move of that magnitude, some correction makes sense.  The fact that the declines were mitigated by modest recoveries late Monday and yesterday, the message of the market seems to be that further moves upward along the trajectory of the past several months are unlikely.  Indeed, for these stocks, which remain well above recent 50-day and 200-day trendlines, to move materially higher, they have to recover to highs set last week and cut through them like a hot knife through butter.   I am not predicting whether that will happen or not; I will wait to see what happens.  But until such an occurrence, I remain somewhat skeptical that these stocks can pull the entire market along while they continue on the same joy ride they enjoyed through the first 5 months of this year.

If the FANG stocks are not going to be the dominant market influence near term, where will leadership come from?  To figure that out, I combed the new high list late yesterday to see where leadership is now.  There were some tech names on it, companies with solid fundamentals and more down-to-earth valuations.  But the list included a significant number of multi-national industrials, as well as several homebuilders.  This coincides with solid corporate fundamentals in both sectors.  Some financial services stocks tied to the stock market were also on the list, not illogical with markets making new highs.  Other strong sectors include travel and leisure companies, electronic gaming stocks, and companies that derive a large part of their business in Europe and emerging markets.  In other words, there are still quite a few pockets of leadership around that can carry stocks higher if the high flying tech companies take a breather.  One probably should expect a bit more volatility over the summer when news flow tends to be light, and trading volumes lower, thanks to vacation season.

Now let me switch to the Fed.  There is an almost universal expectation that the Fed will raise short term rates 25 basis points this afternoon.  Despite another soft report on retail sales this morning that shouldn’t be enough to sway opinions, the Fed almost always does what markets expect.  After all, expectations are built on a base of comments Fed officials make in front of their meetings.  That means the real focus today will be on comments made both through a press release and a news conference hosted by Janet Yellen after the meeting’s conclusion.  Traders will want to know what comes next.

There are several options.

  1. After three rate increases in a six-month period, the Fed can pause for some time and do nothing.
  2. With two increases under its belt this year, assuming an increase today, the Fed might signal just one more this year and then shift to an effort to reduce the size of its balance sheet.
  3. The Fed can stick to raising rates persistently until it gets the Fed Funds rate back to a neutral level, estimated by various economists as somewhere between 2% and 3%.

By all accounts, the direction the Fed seems to be heading towards is option 2.  There are several reasons.  First, while there are some who want to see rates get back to normal as quickly as possible, taking the necessary steps at a time when other central banks around the world are still keeping their own rates near zero may prove counterproductive.  The impact of small rate increases or a steady reduction in the size of its balance sheet is roughly the same.  Both are tightening steps.  As long as rates remain below normal, tightening takes the form of applying less pressure to the accelerator, versus stepping on a brake.  No one suggests the Fed needs to try and slow our economy down.  At the same time, ultra-low rates have created some distortions that can be corrected by the normalization process.

When the Fed was enlarging its balance sheet by buying bonds in the open market, it did so by buying about $80 billion in bonds every month.  As it moved, it hardly created a ripple in the long term bond market or the rate of inflation.  Initially the Fed is likely to simply let maturing bonds mature without going into the open market to replace them.  If that step doesn’t rattle markets, and it shouldn’t, the next move will be to actually sell some bonds in the open market.  The pace will be dictated by market reactions, but given that interest rates in the U.S. are already higher than in the rest of the developed world by a large margin, I don’t see a spike in interest rates occurring if the Fed sells bonds at a moderate clip.  At some point, a combination of bond sales and further interim rate hikes are quite possible, but that is a story for next year.

It is reported that Gary Cohn is going to begin a search process for the next Fed Chief.  Janet Yellen’s term is up in the first quarter of 2018.  Both Ms. Yellen and Mr. Cohn will undoubtedly be on the short list.  While President Trump berated Ms. Yellen on the campaign trail, the two have gotten along well so far.  If the Fed holds a steady hand through the rest of this year, and markets act well, the case to retain her will rise.  Otherwise, look for a conservative economist to take the helm, or Mr. Cohn, who would probably like the job.  Markets are not likely to react unless a candidate with unknown or dubious credentials is named, an unlikely occurrence.

With that said, as I have often noted, stocks are ruthlessly unemotional.  They react to earnings and interest rates.  Thus, today’s meeting and the ensuing comments matter.  That could lead to volatility today and tomorrow.  Modestly higher rates may be good for sustaining an economic recovery and keeping inflation under control, but higher rates rarely are a good thing for stocks.  With that said, the consensus view built into the market today is that there will be one more rate increase this year and then steps taken to reduce the size of the balance sheet modestly starting this fall.  Next year will probably see another 3-4 rate increases.  As long as today’s conversation validates that path, any significant reaction beyond short term volatility as traders unwind short term bets is unlikely.

Today, Boy George is 56 and Donald J. Trump turns 71.  How’s that for a duo!

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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