The trading landscape has been nothing short of incredible over the last month, particularly the last 20 trading days. The S&P 500 has gone from 10% correction to new all time highs in the blink of an eye. When I last wrote, on 9 October, the market was in the midst of falling, but had been rescued by a bullish interpretation of the Federal Reserve minutes released the day before. I had speculated that the massive rally was a fake rally, and that the market would eventually go lower, to about 1900. The market went there, and beyond, in short order, breaking 1900 on the futures and going all the way as low as 1813. Even though I had been looking for such a move to occur, I had thought it would be more protracted, taking until the end of the year to play out.
The ferocity of the move was surprising, and more importantly, it created a condition in which momentum indicators were screaming oversold. Thus the stage for the violent rally which took place over the second half of the month. The ease with which 1900 on the futures was overtaken from the downside was a first clue that the bears were not so strong. Then 1920-30 and 1970-80 fell, which meant that a test of the all time high of 2014 was on the cards. That was breached yesterday, confirming that indeed the bull market that has been in place for upwards of 5 years is still on.
The Federal Reserve confirmed on Wednesday that it will allow the QE program to end, finishing the last round of ‘tapering.’ I remain of the view that this development is a negative for the market going forward. This doesn’t preclude prices from rising higher – in the 9 October post I posted the following chart of the S&P 500 when the last rounds of QE ended:
The white circles represent the days that the previous QE programs ended. In each case, the market went higher immediately following the ending of QE, by roughly 5% and 3% respectively. What followed that in each case was a ~20% correction.
The reason for this is that QE is a relative tightening of monetary policy. Consider the following diagaram:
From right to left are the various actions the Federal Reserve could take to affect the economy, from loose to tight policy. On this continuum, QE was the at the easiest end of the scale. In ending QE, the Federal Reserve has now shifted to the next step, titled ‘lowering short term rates via gov’t bond purchases.’ Given rates are already at 0, this shift is effectively Neutral Policy. However, it is less easy than QE, so it does represent a relative tightening.
Many commentators do not recognize this, and only believe that we enter the realm of relative tightening when we go one step further on the continuum, to the rate normalization phase, the last occurrence of which took place in 2004-2006. In that sense, they understand that the rate normalization period could have a negative impact on prices, as the explicit withdrawal of money from the system means there is less money coming into bid up prices.
However, the same impact is had when, as you go from QE to no QE, there is relatively less money coming in than before. Said differently, if you start with a base of 100, and add 50, then 25, then 10, then 5, then 0, each addition will have a less impact on the total figure than the prior round. When starting with 100, adding 50 was a boost of 50%. Adding 25 to the increased figure of 150 represents only a boost of 16%, and so forth down the line. This, in essence is what has happened with the tapering process. Its ultimate effect will not take place immediately, but it is inevitable that without the increased impact of QE, prices will fall significantly.
At the end of the day, this is the ‘fundamental’ that matters the most, trumping most traditional data points such as earnings. That is the reality of a market that lives and dies on the whims of central bankers.
In that vein, the early hours of Halloween, the BOJ came out with an announcement that they would increase their QE program. On a larger level, this presents an interesting situation in which the Federal Reserve is ending QE (for the time being), while the BOJ and ECB are moving in the opposite direction on the policy continuum. The yen took a massive plunge, as shown in the following USDJPY charts, the first showing the action over hte last year, and the second showing the action over the last 10.
The longer term chart suggests that 123 is on the cards, which is still miles away from its current levels at over 112. With the BOJ hell bent on destroying the value of the yen, shorting it against all pairs seems to be the no brainer trade of the next few months. Tread carefully of course. Until next time.