The Fed Pivots And The Party Starts. Will It Continue? -

The Fed Pivots And The Party Starts. Will It Continue?

Dec 17, 2023Jeremy ParkinsonFinance0

By now, you’re probably well aware that Jerome Powell and the Fed became “dovish” on Wednesday and pivoted to a stop on interest rate hikes. More importantly, the Fed Chairman stated that the Committee could see as many as three rate cuts in 2024.Most analysts had suggested (or predicted) that we would see only two rate cuts next year, but Jerome Powell gave an indication that we could see as many as three 25 basis point reductions in the Fed Fund rate during 2024. The markets reacted favorably, and the party (which may have begun in early November) kicked into high gear.For the week, the major markets were up between 2.5% (S&P 500) to 2.9% (QQQ). Small-cap stocks (IWM), which had been trending sideways for most of the year (due to higher borrowing costs, which affect smaller companies more than the big, rich companies), rallied 5.8%. This placed the Russell 2000 index in double digit returns for 2023.The Dow and the Nasdaq 100 both made new all-time highs and have been on a seven-week winning streak.

The Bull Market of 2023 Continues
We will now provide a few charts illustrating the new all-time returns of the Dow and the QQQ. See below:The S&P 500 is also a whisker away from hitting a new all-time high. In bull markets, old highs often act as magnets and attract the indices to them, as do whole numbers like 4800. We are optimistic that the S&P 500 will soon pierce its old number. See chart below:Not only is the S&P 500 about to post new highs, but it is now surprisingly 8% higher than when the Federal Reserve began its hawkish hiking campaign. See chart below:

Small-Cap Stocks
While the Russell 2000 small-cap index is nowhere near its all-time high, it did make a new 52-week high, and it has picked up momentum that may help provide a tailwind for this market capitalization segment of the market.Many of these companies depend on financing and carry a higher percentage of debt on their balance sheets, especially as their businesses are growing rapidly. So, the fact that interest rates have come down markedly implies that smaller companies may feel the benefits more quickly. See IWM chart below:From these various charts, it is important to stay aware that the indices (SPY, DIA, QQQ, and IWM) are comprised of a large number of stocks. While these are all cap weighted indices, the equal weighted S&P 500 (RSP) and the QQQ (QQEW) have both begun to rally impressively. Meaning, many of the average stocks are breaking out. This explains why the indices are hitting new all-time or 52-week highs.See chart below:You may note above that the 50-day (blue) moving average may soon go through the 200-day (red) moving average, which is called a positive Golden Cross. Also, it is not lost on us that the RSI (Relative Strength Indicator) is well above the 70 number, which typically marks the beginning of an overbought move.While this can go on for a lengthy period, a reversion to the mean typically takes place at some point when investors capture gains. However, in this case, it may not occur until after the beginning of the year, and we welcome a new tax period for capital gains.Below, you can see that the 93 lower capitalization stocks (ex-magnificent 7) have perked up and are beginning to look more positive. See chart below:2023 has rewarded high growth stocks. These cash-rich companies have been the biggest beneficiaries from earnings growth, and the lower volatility/high beta stocks have mostly gone sideways. As shown above, through the RSP and the QQEW, these stocks have now joined the party. See chart below:Speculation through new initial public offerings (IPOs) has also been seeing a major rebound recently. See chart below:

The Fuel that Created this Push Higher
The Fed poured fuel on the fire that had started in late October when inflation numbers came out below expectations and interest rates backed off. When the Fed recently indicated that interest rates could come down over the next year, this was additional rocket fuel for the stock market party.According to the Fed’s new posture, which began last Wednesday, they are starting to see many economic indicators showing a weakening economy. These include a recent slowdown in job creation, struggling consumers, a record amount of credit debt, a screeching halt to mortgage demand and new home purchases, and other weak forecasts — all a direct result of their hawkish stance and numerous interest rate hikes these past two years.Couple that with recent downward moves in oil and commodity prices, and the US dollar declining sharply, and this all helped to kick the stock market rally (party) into celebration mode this past week.We have continued to provide many of these slowing economic charts over the past few months. Below, we provide a few charts that show signs of a weakening economy:

Positive Investment Sentiment is Also Helping
When investors are more positive about the future of the stock market and are contributing new inflows into their investment accounts, this always proves to be the wind at the market’s back. This measurement always shows up in positive investment sentiment readings.The recent readings on investor sentiment show individuals and institutions are rotating invested cash (having recently come down from 5% on the 10-year Treasury to 3.9% this week) into bonds and equities. These investors have pushed up the bullish-bearish sentiment readings to new highs in the bullish bias. See chart below:The Fear-Greed chart (published by CNN) below shows that investors now sit firmly in a greed reading. We have shown this chart many times before. Our friend Jeff Huge at Alpha Insights shares his insights that we are getting closer to extremes that would portend a trend reversal.

Past History Provides Evidence that this Positive Stock Market Momentum can Continue
The stock market is forward-looking.The Federal Reserve has quickly pivoted and proclaimed that they could see several reductions in the Fed Funds rate going forward. The risk markets, including but not limited to the above charts, market indices, as well as the fixed income markets, including other lower grade credit investments (high yield bonds), have already priced in that there will be more than 3 rate cuts next year and will begin as early as March of 2024.We are not so sure. Inflation remains elevated and may surprise to the upside in future months. Yet there is plenty of evidence that this period (stock market party) can continue into the new year. We remind you that we are in an attractive seasonal period for stocks. Plus, the Santa Claus rally typically doesn’t start until after Christmas. See charts below:

Does the Federal Reserve Know Something We Don’t? Why We Still Recommend Caution
The Fed pivoted very quickly. How fast?As recently as Nov. 1, the Fed stated: “Getting inflation to 2% has a long way to go.” And then again on Nov. 21, they said “No indication of rate cuts at last meeting.” On Dec. 1, they stated “Talking about rate cuts are premature.”They must know something that is coming. Personally, I remain of the opinion that residential and commercial real estate is in serious trouble and may be in for ongoing problems. Many owners of commercial buildings have not been able to conduct profitable businesses with the higher interest rates and have turned the buildings over to the lenders in lieu of foreclosure.It was these and other potential problem areas among US businesses that also gave the Federal Reserve the ammunition to stop raising rates. We are just not so sure that interest rate cuts are as close at hand, unless the economy really spirals out of control or that we enter a recession. One important note that virtually few analysts have mentioned since their meeting last Wednesday, is that the Fed stated that they were continuing with their campaign of quantitative tightening (reducing their balance sheet and selling their bonds).Reading between the lines of the Fed’s messaging, we believe it is wise to remain cautious. Here are a few other signs that provide additional caution to not get too aggressive:

Core inflation is still at 4%, double the Fed’s target.

They began to backup their pivot later in the week by discussing tightening their own balance sheet.

Markets are expecting 6-8 rate cuts in 2024 while the Fed expects 3.

The VIX is trading at its lowest since 2020. Very few investors are purchasing insurance, and that is usually a contrarian sign.

US interest expenses are on track to top $1 trillion in 2024, more than the defense budget.

The US is involved in major military incursions around the world, anyone of which could escalate.

We are financing enormous ongoing debt at significantly higher rates than just two years ago.

Less foreign entities are purchasing our debt, and recently the US Treasury auctions have had difficulties, which means rates may have to rise to attract buyers.

There are a significant number of unaccounted foreigners that have entered our country, and odds are going up daily that we can and will have a terrorist attack or disruption in the near future.

Please know that like you, we are enjoying the positive markets and are participating fully. Like you, we want this to continue throughout the coming year. However, we are realists. Now, here are some other factors that may have played a part in the week’s trading.

Risk On

With interest rates easing substantially, the markets exploded to the upside, with new high closes for the year in all indexes. They are running a bit rich, as led by the IWM, which is outside the upper Bollinger bands in price and real motion.

Volume patterns are positive, with the S&P 500 having the strongest pattern.

All sectors were positive on the week, led by Semiconductors, Homebuilders, and Retail, all up over +5%.

Solar and Clean energy roared this week, helping mitigate poor performance over the last six months.

The New High/New Low ratio remains intact, but it has been running rich with still more potential upside to come.

The Nasdaq Composite New High/New Low is in gear, with significant upside potential in store.

The Volatility ratio continues to show risk-on, though it has been sitting at high levels that should be closely monitored.

Interest rates dropped significantly back into an accumulation phase, running very rich, and subject to mean-reversion. Interest rates have come off their recent move, returning to levels we saw last summer. Lower rates are bullish for the market.

More speculative small- and mid-cap stocks exploded to the upside—a healthy rotation.

Growth continues its leadership despite the rally in value.

Risk Neutral

Risk gauges improved from risk-off to neutral.

The huge rally in bonds this week off of the Fed announcement has caused the traditional relationships between high-yield debt and the long bond versus the S&P to give a contradictory risk-off signal relative to the new highs in the market.

On a short-to-intermediate term basis, stocks over their key moving averages appear overbought and could have some short-term correction based on these numbers.

Both emerging and more established foreign equities are lagging the US market.

Soft commodities closed in a bull phase and looks poised to potentially test new highs for the year.

With interest rates easing, it’s not surprising that gold bounced and is holding in a bull phase.

Risk Off

Nothing noteworthy.

More By This Author:These Charts Clarify The Big Picture: See What They’re Telling You NowInvestors Were Thankful This Week After Cooling Inflation Data – Will We See Additional Follow-Through?Has The Fed Closed The Door To Future Rate Hikes, Or Does The Door Remain Partially Open?