Could This Fed Policy Error Lead to Further Lows in the Stock Market?


“Generals always fight the last war.” This quote is often attributed to Winston Churchill, and it certainly rings true with the Federal Reserve. By no means am I a Fed hater, I see it as the least bad option when it comes to managing the supply and striking the right balance between growth and inflation. Kind of like how Churchhill thought of democracy. I see the Fed as having erred in getting serious about inflation too late. Now, I see the economy sharply slowing down (which will do a better job of curbing inflation than rate hikes) which is negative for asset prices on its own, but the Fed’s hawkishness will exacerbate this condition. In today’s commentary, I will discuss this in more depth. I will also mention one specific scenario which could trigger a meaningful, counter-trend move in the stock market (SPY). Read on below to find out more….



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(Please enjoy this updated version of my weekly commentary published July 7th, 2022 from the POWR Stocks Under $10 newsletter).

As usual, we will start by reviewing the past week…

From last Monday’s close, the S&P 500 (SPY) is down by about 3%. We’ve given back about half of the advance of the last couple of weeks. As we’ve been noting, inflation risk is dropping, while recession risk is sharply rising.

This is evident if we look at sector performance. Areas like biotech/software/pharma are outperforming and putting in higher lows and higher highs, while cyclicals/energy/materials are falling to new 2022 lows.

A couple of months ago, we were noting that energy continued to hover near its highs even if it was becoming clear that the economic growth outlook was faltering. And determined it to be untenuous.

Fed Policy Error?

It also seems that these trends intensified in mid-May, when the Fed raised rates by 75 basis points and signaled that another hike between 50 to 75 basis points was likely.

This is possibly a good idea if economic growth was strong enough to handle this headwind like it was earlier this year or for most parts of 2021. Instead, the economy is slowing, with a large assist from the Fed, and the Fed continues to turn up the heat.

In my opinion, the Fed is making a mistake.

It’s like if you’re cooking eggs, and if you wait for it to be perfectly cooked in the pan before you transfer it to your plate and into your mouth…. then, it’s almost guaranteed to be overcooked and a bit dry and rubbery. You want to turn off the heat when, it’s a bit undercooked, because it’ll keep cooking even on your plate.

I believe the Fed should be turning the heat lower or even pausing for a bit to let the impact of this initial set of rate hikes play out.

But, maybe there’s a better explanation. Maybe the Fed is so scared about the prospect of inflation becoming entrenched and a long-term issue that it’s willing to engineer a recession.

Or, maybe the Fed deserves more credit, and it knows exactly what it’s doing. It simply sees this as the price to pay to regain its credibility with the market.

From this perspective, the worst-case outcome would be for the Fed to pivot too early, re-ignite inflationary pressures, and then again have to initiate another series of hikes.

We’ve talked about past recessions to help us understand what is happening now. I continue to think that there is some merit in the 2000 to 2002 analogue as we had multiple shocks which caused the initial move lower in stocks.

Then, stocks sank even lower as these shocks led to a drastic turn lower in earnings.

This is where we are right now. The bearish force from higher rates has been neutered at least in the short-term. In fact, falling longer-term rates could provide support to some parts of the stock market (SPY).

But now we have to watch earnings as this could be the next “shoe to drop’ and trigger the next leg lower.

Potential Bullish Catalyst

There is one bullish scenario that I don’t see being discussed. It’s basically that once inflation peaks and turns (very possible this already happened), it keeps falling faster and lower than people expect.

It could be a combination of the Fed choking off economic growth, pandemic issues normalizing, and momentum-driven trades in food and energy reversing.

In essence, inflation dropping fast and hard would take the pressure off the Fed in terms of rate hikes. It would also reduce inflation risk. In essence, it would bring us closer to a Goldilocks environment of mild inflation and strong earnings growth.

Summary

So that about sums it up. Stocks could plunge to new lows if the weakness starts to have a meaningful impact on earnings. But, we could also see these lows hold if inflation falls by a substantial amount which would lead to lower long-term rates.

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All the Best!

Jaimini Desai
Chief Growth Strategist, StockNews
Editor, POWR Stocks Under $10 Newsletter


SPY shares . Year-to-date, SPY has declined -17.49%, versus a % rise in the benchmark S&P 500 index during the same period.


About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles.

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