This week’s Federal Reserve Open Market Committee (FOMC) meeting has all the earmarks of a stock market correction trigger, just waiting to be pulled. Although it is widely expected that the Fed will reduce its bond buying by another $10 billion per month, which would be the fifth such reduction, investors may view this move as reason enough to begin selling.
It is not simply another notch down in the Fed’s quantitative easing (QE) that is of concern. The Fed’s economic assessment — which will be outlined in the Fed’s statement, the minutes of the meeting as well as in speeches given by Fed members — could end up dramatically realigning investor expectations about when, exactly, the Fed will begin to raise interest rates.
In the Fed’s previous statement, issued after the April meeting, the FOMC noted that “growth in economic activity has picked up recently, after having slowed sharply during the winter,” but also warned “labor market indicators were mixed” and “the unemployment rate … remains elevated.”
Although some economists believe the economy has improved since the end of the first quarter, and therefore expect GDP growth to rebound to as high as 4 percent annualized, I’m less enthusiastic. It is true that the last two employment reports showed monthly nonfarm payroll growth of 282,000 and 217,000. But consumer sentiment, as reported last week, showed a reading of 81.2, which is a three-month low for that indicator.
The Producer Price Index (PPI), a gauge of wholesale-level inflation, also fell unexpectedly by 0.2 percent from 0.6 percent in April and 0.5 percent in March. Although, at first glance, low inflation may seem like a positive, when it comes to a healthy economy, we need inflation to run at around the 2 percent annual rate. A negative inflation rate on PPI could indicate a lack of demand for wholesale-level goods and services, which is not a good sign for the economy.
Of major concern should be the Fed’s interpretation of this data. If it views the recent positive results for employment growth and other factors, the Fed may indicate that a rise in short-term interest rates is more imminent. The combination of another reduction in QE and an indication of the beginning of increasing short-term interest rates could certainly serve as a catalyst to send stocks into a severe correction, or even a crash.
Although investors have been extremely complacent about any negative news, as the market vaults ever higher, there is more motivation for investors to want to lock in profits. This past week’s developments in Iraq resulted in the worst weekly performance for the Dow Jones Industrial Average and the Standard & Poor’s 500 in the past three months. Still, the S&P 500 lost just 0.7 percent for the week and ended on a positive note.
We are now just two weeks away from the end of the second quarter. We won’t receive the first report on GDP growth for the second quarter until late July. In the interim several weeks, we’ll not only receive the Fed’s report from this week’s meeting, but we’ll have the opportunity to review and contemplate several other key economic reports.
If the Fed indicates that certain positive economic developments could serve as ample justification for moving up the timetable for the beginning of its rate increasing cycle, and some of the economic reports we receive are consistent with the Fed’s criteria, we could certainly see a negative reaction in the stock market.
Although the S&P 500 has made 19 new highs so far in 2014, this major market index has only risen 4.75 percent year-to-date. Volatility remains at extremely low levels, but given the lofty valuations for stocks, the downside risk in the market is substantial, and upside potential appears very limited. In other words, the risk/reward relationship for stocks is not favorable at present.
The situation in Iraq appears to be escalating. On Sunday, the United States evacuated its embassy in Baghdad. The day before, militants tied to al-Qaeda took control of Tal Afar — one more in a stream of northern cities overrun in the past week.
The vast majority of Iraq’s oil production is in the south and so far has not been directly threatened. Even so, oil prices have shot up to $107 per barrel and look to continue to rise as the violence in Iraq escalates further.
The presence of new U.S. military personnel and potential airstrikes in the coming days and weeks will certainly increase the uncertainty surrounding Iraq’s future. Uncertainty is not good for energy or stock markets.
In my experience, triggers that set off market corrections never appear to be significant enough — on their own — to cause the correction. Market pundits typically look for justification to explain why the trigger was, indeed, significant enough to warrant a correction after the fact — after the correction has run its course. Like many things in life, it will seem obvious once the correction has already occurred, but that doesn’t help us avoid the negative consequences of the correction. Assuming a correction comes, the truth will be that it wasn’t really the trigger that caused the correction at all.
The trigger will simply serve as an excuse for investors to sell because the stock market is overbought and ripe for a correction. Ultimately, it really won’t matter why a correction happened, other than for future reference. What will matter is anticipating the correction and taking appropriate steps to minimize its negative impacts.