Comstock Partners, Inc.May 23, 2013
A Shot Across The Bow
Wednesday’s market action revealed more about the overbought and overvalued status of the market itself than it did of the perceived reasons for the downturn, as the underlying monetary and economic fundamentals did not change anywhere near enough to justify such a reaction.
Briefly, the Dow jumped 155 points on release of Bernanke’s statement that eased market fears by stating that premature tightening of monetary policy would be undesirable. So far, so good. Shortly thereafter, however, in answer to a question by Committee Chairman Brady asking when QE could be expected to taper off, Bernanke stated “We could, in the next few meetings….take a step down in our pace of purchases.” The market immediately turned around and started downward. Within a short time the Dow was down 122 points from the previous day’s close, a total swing of 277 points.
A few hours later the Fed’s minutes of the last board meeting was released and re-emphasized the fear by stating that “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting.” The result was that the market ended up recording a so-called “key reversal day”, meaning a day in which the market makes a high that is significantly higher than the previous day’s high, only to close at point substantially below the previous day’s low. This is usually a sign of an important trend reversal, a signal further emphasized by the fact that Wednesday’s highs and lows exceeded the highs and lows of each of the prior three days.
The 7.3% decline of the Japanese market the following night was a separate event. Despite knowing about the monetary events in the U.S., the Japanese market opened higher, only to be shocked by the release of China’s Purchasing Managers Index, which came in at a recessionary 49.6, abruptly ending a powerful run that began with the Japanese central bank’s announcement of a massive easing program. The Chinese data also helped extend the downtrend in industrial commodities that are so important to many of the world’s economies.
We regard the action of the U.S. market as a “shot across the bow” that indicates a significant change in the trend of the market rather than a change in Fed policy The Fed did not change policy, but was basically restating its prior stance. Strategists and economists get paid to parse all the Fed’s words to pick up any minor change and put it under a magnifying glass where it seems much larger than it actually is. In the name of transparency, they also expect the Fed to tell exactly what it is going to do and when. But the fact is that the Fed doesn’t know what it’s going to do at any future point. No matter what words the Fed uses, they always follow and react to the data.
In our view it is best to go back to Bernanke’s written statement indicating the undesirability of a premature tightening of monetary policy. That is what he and his allies on the committee believe, and it is they who are the majority. They may well consider a reversal of the current policy at future meetings, as Bernanke stated, but that is dependent on their confidence that the economy has indeed turned around and can sustain growth on its own without further monetary help.
In our view, however, the economy is showing distinct signs of softening as we discussed in our most recent comments, and the Fed may have to continue its QE program at current levels for a longer time than many think. The irony is that the pending market downturn may be a result of a weakening economy and declining earnings estimates rather than the cessation of QE. All in all, the market rally will end badly, and sooner rather than later.