Stocktake: Cautious US Fed to hold off on interest rate hike

One of the main catalysts of the last fortnight's market swings has been fevered speculation as to whether the United States Federal Reserve will hike interest rates tomorrow.

Influential Allianz economist Mohamad El-Erian thinks the Fed should get an increase "over and done with", a stance backed by JPMorgan chief executive Jamie Dimon, bond guru Bill Gross and other high-profile names concerned that ultra-low rates are distorting financial markets.

A rate hike is almost certain not to happen, however. Although two Fed members recently suggested a hike was possible, 87 per cent of economists polled by the Financial Times believe the Fed will hold off. Similarly, futures data shows expectations for a September rate hike have been in or around 20 per cent for most of the last few weeks, down from 42 per cent in late August.

Even Goldman Sachs, which has consistently warned markets were underestimating the odds of a rate hike, last week slashed its odds on a September increase, noting the Fed would have made more of an effort to "nudge the market toward anticipating a hike" if it was intending to do so.

A hike tomorrow would shock markets. Expect the Fed to hold off, and the markets’ obsessions regarding timing the next hike to continue unabated in coming months.

Valuation concerns dampen sentiment

Merrill Lynch’s latest monthly fund manager survey appears to make for grim reading, with the percentage of money managers who believe both stocks and bonds to be overvalued at an all-time high.

Clearly, investors are nervous. Cash balances have hit 5.5 per cent, almost as high as that seen during February’s market panic. Equity allocations are lower than February’s and 1.1 standard deviations below their long-term average.

Valuation concerns are understandable. Goldman Sachs cautioned last week that the S&P 500 is trading at its 84th percentile relative to history, with the median stock more expensive than 98 per cent of historical episodes.

That doesn’t mean stocks will fall, however; valuation is a key determinant of long-term returns, but of little use in calculating one-year returns. Anguished headlines regarding the Merrill figures missed the fact that the survey is a sentiment indicator best viewed in a contrarian light. Equity versus cash positioning is “effectively the lowest in four years”, Merrill notes, with allocations at levels which typically mark good entry points to stocks.

One doesn’t see such defensive positioning at market tops. Stocks may be pricey, but poor sentiment suggests the current pullback will be temporary.

Time to panic – or to chill?

After a two-month lull, volatility has returned and stocks have dipped. Are we all doomed?

Certain headline writers appear to think so. “Is this the start of a stock market crash?” asked the Motley Fool. “Market suffers worst crash since Brexit,” headlined Sky News, when the S&P 500 was 2.5 per cent off all-time highs. “World stock market MELTDOWN: FTSE 100 loses £1 BILLION a minute amid US rates rise fears,” screamed the Express, following a 1.6 per cent FTSE decline. “Prepare for ‘PERFECT STORM’ that will obliterate stocks: Economist’s terrifying warning,” said the Express the following day, referring to Gluskin Sheff strategist David Rosenberg’s not-so-terrifying warning that stocks might be entering a periodic corrective phase (“My advice is to chill,” said Rosenberg, but the Express forgot to quote that bit).

The merest hint of volatility is enough to have delighted hacks bathing in sadomasochistic delight, but naive investors ought to heed the advice of Reformed Broker blogger Josh Brown. "You're welcome to interpret the return of normal volatility as the start of a crushing bear market/economic apocalypse", wrote Brown, "but the probabilistic data from history would not be on your side."

Momentum still with the bulls

Recent volatility could represent the start of a larger selloff, but history suggests any damage is likely to be contained.

There continues to be chatter about this being a seasonally challenging period for stocks. September has historically been the weakest month for stocks while average drawdowns in October are “far and away the worst of any month”, notes money manager Dana Lyons.

However, September weakness tends to be confined to down-trending markets. LPL Research notes that since 1950 there have been 47 occasions where the S&P 500 traded above its 200-day average at the start of September; through year-end, stocks suffered double-digit declines on only three occasions, gaining in 83 per cent of instances.

The power of up-trending markets is also highlighted by Nautilus Research. Prior to the recent dip, global market breadth (as measured by the percentage of national indices trading at 52-week highs) was extremely strong, prompting Nautilus to examine past instances of similarly strong market breadth. For both the S&P 500 and the MSCI World Index, returns were well above average over the following one-, three-, six-, and 12-month periods.

The moral: sit tight.