Coming to Terms with Reality

The swift reversal for US benchmark indices midweek saw the S&P 500 index drop like a stone from within 4-points of setting a fresh record peak. Three weeks ago investors appeared to cross the Rubicon by discounting tepid data as a temporary phenomenon with activity and hiring afflicted by the cruel winter weather. For sure, first quarter growth will suffer but investors appear to be expecting positive payback for the remainder of the year. Indeed JPMorgan’s David Kelly on the back of Thursday’s Financial Times suggests that, barring any fresh financial setback around the world, the Fed’s latest projection for growth and employment may be a good call from the typically over-optimistic central bank.

As much as the weather did impact output and crimp activity, the reality is that the economy is slowly normalizing and that monthly payroll creation above 200,000 is likely to happen this year. That reality of course helps explain the arrival on the scene of discussion, if not contemplation, of a rise in short-term interest rates. Talk of a fed funds rate shift as early as the summer in the January minutes dominated much of the financial media’s headlines Thursday, with some onlookers reminding investors to favor stocks over bonds.

However, getting to the crux of the matter is the simple fact, as illustrated by dovish views in the FOMC minutes, that inflation is very likely to remain contained as far as the eye can see. And while the Fed now has its work cut out for it in safely explaining what conditions would cause it to consider a shift in rates, the framework was written by Yellen in a 2012 speech highlighting various metrics of the labor market that help explain whether its plight is structural or cyclical. Mr. Bernanke went on to use that same framework just months later to highlight Ms. Yellen’s analysis. In addition the Fed must be sensitive in positioning for any change in its fed funds rate on account of fresh financial crises around the world.

WalMart’s lackluster earnings report further dulled investor appetite for stocks, yet once again the reality remains that the US consumer is not shrinking as stock selling might suggest. The very low price model built by WalMart is leading its base to seek out braver pricing at other discounters and the retailer needs to adapt in its own wake.

Likewise, homebuilding companies who recently suffered at the hands of winter disruptions have seen their share prices mark time as investors’ patience wears thin.

Unlikely to go away is investors’ concern over the external environment and what that might mean when central banks are at diverse stages of policy stimulus. Some investors expect the ECB to embark upon further easing next week and just as the Fed has started to reduce its pace. The Bank of Japan extended its asset purchases programs at a larger size starting next month. But it is the Fed’s withdrawal that upsets investors most, particularly in respect to emerging markets.

China’s manufacturing sector saw its pace of expansion slow to its lowest in seven months according to the private HSBC survey released overnight. Meanwhile investors were relieved that the Peoples Bank failed to further drain liquidity as it mulls how to deal with Trust bank failures resulting from over lending.

Coming to terms with reality is a quest for investors at a time when not much has really changed. The domestic economy continues to heal nicely and this year will undoubtedly be better than last. Panic if you must over discussion of a shift in interest rates or use WalMart’s earnings as a barometer for consumer health if you choose. For now US equity investors must do battle with the prospect of changing probabilities of financial tempest in other parts of the globe. In the absence of such problems, the bull is likely to charge unchecked.

About Andrew Wilkinson 1023 Articles

Affiliation: Interactive Brokers

Andrew Wilkinson is the senior market analyst at Interactive Brokers Group, where he provides daily commentary and analysis on U.S. equity options trading throughout the trading day. Andrew provides webinars designed to explain option-related trading scenarios covering futures, fixed income, forex and equities.

Interactive Brokers: Interactive Brokers offers direct market access to around 80 electronic global markets from a single account. Successful traders and investors understand that superior technology and lower trading costs can result in greater returns. For 32 years we have been building direct access trading technology that delivers real advantages to professionals worldwide. With consolidated equity capital of US $4.4 billion, IB and its affiliates exceed 1,000,000 trades per day. In addition, our prudent and conservative risk policies make Interactive Brokers a safe haven for your money. Discover some of the reasons why IB, the largest independent US broker/dealer, is the professional traders' and investors' choice.

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