During the final week of the year, two things come logically for market commentators. One is to look back at the year that passed, another is to prognosticate about the year to come. While it is crucially important for investors to understand the conditions that brought us to their present situations, I find it more useful to have a plan for the days and weeks ahead. Here are some of the themes that I anticipate for the coming year.
The primary theme is for investors to expect more volatility than we’ve seen over the past year-and-a-half. The changing monetary environment should be the cause. At the risk of introducing an inconvenient analogy, investors have become addicted to ever-present monetary stimulus. Even under the care of a skillful clinician – or central banker – patients who are withdrawing from an addictive substance can suffer setbacks en route to a cure.
The Federal Reserve, along with several other central banks, has made it clear that they are reducing the amount of monetary stimulus that they will be exerting upon the economy in the face of rising inflation. After the most recent FOMC meeting, the Fed indicated that they will be reducing their bond purchases more quickly than they had indicated just six weeks earlier. They also released a “dot plot” with a median estimate of three rate hikes over each of the next two years. In theory, stock prices should be able to withstand short-term interest rates that are low by historical standards. In reality, change happens at the margin, and short-term investor behavior can take some interesting twists and turns. Those twists and turns are often manifested as volatility.
One reason for concern is that about one-third of investors are new. That is a good thing overall. We all want individuals to feel empowered about their personal finances. The problem is that those who began investing in the post-Covid environment have only seen an investing climate that was bolstered by unprecedented monetary and fiscal stimuli. It is said that placid seas make lousy sailors, and these new investors have only sailed through the calm seas with a steady tailwind at their back. Many will have to learn whether to adapt their strategies in a period that is likely to be less favorable to the speculative tactics that have worked for so many.
Extending that further, an entire generation of investors has come of age since 2009. In response to the global financial crisis, the Fed and other central banks began quantitative easing in addition to low interest rates as a means to resuscitate the financial system. Over the past 12 years we have seen markets hit significant air pockets each time the Fed has even thought about reducing stimulus. Think about the taper tantrum of 2013, the market swoon in the fourth quarter of 2018 and the repo crisis of late 2019. All were events that induced volatility.
Each time, however, the Fed blinked in the face of market tremors. Those actions reinforced the notion of the “Fed Put”, the idea that the Fed would come to the rescue of the markets with stimulus or other measures to ease financial stresses. A big question for markets always regards where that theoretical put is struck. The Fed has never actually acknowledged that a “Fed Put” actually exists, let alone its striking price.
History tells us that if there is a “Fed Put”, it kicks in about 20% below the prior level of the market. Stocks have typically self-corrected after periodic 10% dips without requiring anything more than verbal input from the Fed. Yet we have seen buy-the-dip activity kick in at ever smaller increments over the past 20 months. Because this has been a generally profitable strategy, undertaken amidst constant monetary stimulus, many investors have come to conflate the flood of liquidity with the “Fed Put”. And if the Fed is providing investors with a mythical put slightly below the market, fewer see the need to concern themselves with finding their own protection.
An accommodative Fed dampens volatility. The weight of money has been sufficient to embolden dip buyers to the point that a 2% dip is sufficient to attract fresh investment. But what if that flow of money slows, let alone ceases and even reverses? It seems reasonable to expect that the dips would be larger and more frequent.
Complicating matters is the concentration of market leadership in an ever-narrowing group of stocks. If we get a persistent drop in demand or outright selling in the cadre of stocks that has largely propelled the S&P 500 and other major indices, it can have an outside influence on the downside, meaning the index drop is worse than it appears. That can be great for stock-pickers who use disciplined investing fundamental or technical strategies, but less so for those who are indexers or trend-followers. It may behoove investors to amend their buy-the-dip strategies from simply buying favored stocks and ETFs to also buying protection when VIX or similar measures dip.
Meanwhile, it doesn’t appear that the Fed is in any rush to reduce liquidity at the pace they’ve indicated. According to Federal Reserve H.4.1 reports, their holdings of bonds has risen by about $129 billion between December 2nd and December 23rd. (November holdings rose by about the expected $105 billion.) The December rise is far more than the $90bn implied by the taper, and can only be resolved if they are pre-emptively replacing bonds that are set to mature at year-end. At least so far we haven’t seen anything close to the full effect of the Fed’s taper, which may explain why stocks have largely continued their upward trajectory since the December FOMC meeting. Let’s see what happens when and if tapering begins in earnest.
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