What if Markets Lose Faith in the Fed?

After one of the most tumultuous weeks in the stock markets (ever), the S&P500 managed to close down only 1.7%, after being down momentarily over 8% during the week.  Volatility jumped up again, this time 14%, but after touching multi-year highs during the week.  Volume surged, adding conviction to the direction of the price movement—down.

The economic data were generally negative.  The US trade deficit rose far more than expected; this will hit economic growth results for Q2 of this year.  While jobless claims dipped slightly below 400,000, they will almost surely be revised higher, as they have been virtually 100% of the time (how does that happen…..if the error is random?), next week.  Retail sales disappointed, as did business inventory build rates.  The highlight of the week was consumer sentiment, which literally collapsed down to levels last seen in 1980.  And since consumers make up 70% of the US economy, this does not bode well for future growth, if any.

Technically, the S&P is very oversold on a day-to-day basis.  In fact, by the end of the week, it started showing signs of making a short-term bottom and the makings of a bounce.  This bounce could last for several weeks and could cause the index to rise by 5% to 10%, but this would not break the overall downtrend that the S&P has established over the last month and a half.  Ominously, the 50 day moving average has finally crossed below the 200 day moving average, which is also known as the “Death Cross”.  While by no means a certainty, the odds of continued selling go up because other market analysts may decide to pull back on equity exposure as a result of this technical development.  In other words, another headwind for a sustained rise in market prices has been created.

So what will determine—on a fundamental basis—the direction of stock markets for the rest of the year?

As mentioned in prior posts, two major forces stand out.  First, is the fire that’s burning in Euroland. After getting hit by the news of Italy’s credit market stress (and after the ECB sent a fire brigade to manage this fire), the eurozone was hit with a new blow—emerging stress in France.  France’s major banks sold off badly last week, in some cases losing as much as 20% of their market value.  And this also put pressure on France’s sovereign credit which became more expensive relative to the European benchmark—German government bonds.

While the Euroland solutions, so far, have been nothing but fancy BandAids, they have over the last year and a half been able to kick the can down the road for months at a time.  So there’s good reason to believe that the European elites could plausibly buy several month’s (if not half a year’s) worth of time.  And during this time, most market participants would go back into Risk-On mode, bidding up the euro and global stocks in general, including the S&P.

But the second force could make or break the markets over the next several weeks.  And this is the policy response of the Federal Reserve.  Last August, when the last Death Cross just took effect, the Fed saved the day by pre-announcing QE2 at the Jackson Hole economic conference.  One year later, many market participants—having been conditioned by the Fed to always expect a rescue plan—are now beginning to price in another “surprise” announcement at this year’s Jackson Hole conference which begins in a couple of weeks.

So these investors and traders have begun to bid up the S&P (from its intra-week lows) in anticipation of some sort of QE3, or a variant of it.

But there are two major risks here. One, what if the Fed doesn’t come through this time? What if the Fed tells the markets that they’re on their own for a while?

Answer:  markets would go into a tailspin.

Two, what if markets begin to doubt the efficacy of the Fed’s QE medicine?  After all, it’s becoming obvious to anyone with half a brain that as soon as the Fed’s sugar highs wear off, the markets begin to plummet.  The markets, being so famously forward-looking, may begin to see through another QE program and price in the withdrawal of stimulus soon after it’s announced.  And what happens then?

Answer:  markets would go into a tailspin.

Once again, it’s becoming clear that the Fed is approaching the end game.  It is running out of bullets. While markets in the past trusted the Fed to always pull another rabbit out of its hat, the time is soon approaching when the markets will lose trust in the Fed.

What happens then?

Answer:  all hell breaks loose.

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