What's actually changed for stock investors following the Fed's shift

Published Sat, Jun 19 20218:04 AM EDT

The markets last week surely behaved as if a consequential shift was afoot, with some of the trendiest trades falling quickly out of style, months' worth of bond-market bets unwound in days and the trusty rotational dance among styles of stocks not enough to rescue the tape from a 2% drop. There were some stark changes — in perceptions about Federal Reserve intentions, pricing of inflation risk and positioning across asset classes. But how much is truly different now about the Fed policy path, the fundamental backdrop and the tactical set-up, in a market caught offside and prone, as ever, to short-term overshoots? The Fed The week started with hedge-fund luminary Paul Tudor Jones saying investors should "go all in on the inflation trades" if the Fed showed nonchalance about recent stout inflation data. The rest of the week saw the markets act as if too many were already loaded up with those inflation trades, and after Fed officials showed slightly more concern about inflation than expected, those trades blew up spectacularly. The yield curve underwent a savage flattening, 10- and 30-year yields shuttling lower as short-term rates surged, textbook rhythms of a market raising probabilities for eventual rate hikes while dropping inflation expectations. Commodities cratered, value and cyclical stocks disgorged heavy helpings of their eight-month rallies and the dollar surged. All of this triggered by a handful of Fed members pulling forward their outlook for a first rate hike, the majority still seeing none until 2023. Chair Jerome Powell evidenced little change in his stance, and it appears most of those getting itchier to raise rates to fight inflation are likely regional Fed bank presidents , not all of whom vote every year. In other words, it has the look of an exaggerated positioning shock. It's not always clear how crowded a party is until a smoke detector sounds and revelers start rushing from the basement and the upstairs bedrooms, and so it is with markets smoking out over-concentrated investment bets. As Bespoke Investment Group summed it up, while the direction of the market response is in line with the incremental tilt in the Fed's outlook, "the size is excessive, driven by extremely unbalanced positioning on the Treasury curve and in breakevens, large speculator longs in commodities especially grains, and a technical flush higher in the dollar." Also worth noting: Inflation "breakevens" – the market-implied pricing of forward inflation, came crashing down with copper and the ramp in the dollar, all of which will serve to mute the inflation that some Fed folks are newly nervous about. In other words, the market has done much of the Fed's work without policy changing at all. And be alert for Fed policy makers to begin hitting the speaking and media circuits to offer more soothing context for its statement and forecasts last week, emphasizing how far the economy remains from the Fed's aggressive employment goals and the orderly process of reduced bond buying that will unfold long before overnight rates change. New York Fed president John Williams has a public appearance Monday, in fact. The Fundamentals The U.S. economy in the quarter set to end in less than two weeks could exceed 10% real annualized growth, according to the Atlanta Fed's GDP Now model . S & P 500 anticipated earnings growth continues to climb, the forecast rise for all of 2021 above 34%, says FactSet. The S & P's forward price/earnings multiple is now just above 21; it was about 23 five months ago, when the index was 9% lower. Right before the market launched higher in the huge cyclicals-led rally on Oct. 30, the forward P/E bottomed at 20.7. Not cheap by any definition, but less expensive than it's been most of the past 15 months, And the index's dividend yield again now slightly exceeds the 10-year Treasury yield at 1.45%. For good measure, companies have announced new share buybacks the past three months at close to a $1 trillion annual clip, near the upper end of the pre-2020 range (excluding the immediate aftermath of the 2017 corporate tax cut). For sure, peak profit acceleration is past and margin pressure can certainly start to pinch in some industries. Yet whatever rethink went on among traders last week, the main concrete inputs to corporate values remain pretty much unchanged. On a more macro level, financial conditions remain lavishly loose, meaning liquidity and credit conditions are about as accommodating as they've been over the past two decades. This also means they can't get much better, of course. But it's a long way from here to any threatening financial stress. The tactical setup Even before last week's vicious thumping of cyclical "reflation" stocks, not nearly offset by a firming in stable growth names, the tape had lost momentum and a growing number of stocks were falling by the wayside – a subtle change in character from the broadly inclusive rally that carried into mid-April. Last week made things a lot less subtle, eventually leading to a more comprehensive sell-off Friday, after which about half of all S & P 500 stocks were down at least 10% from their 52-week high, even with the index itself less than 3% from its peak. While that's a modest dip in the S & P 500, the index nonetheless closed under its 50-day moving average Friday, which was nearby due to the market having gone flat for the prior two months. A drop under a rising 50-day average (which briefly happened in the February pullback) is often a decent time to buy in a bull market, even if such purchases don't pay off immediately. Crucially, many cyclical and value areas have become quickly oversold, even as these groups remain in longer-term uptrends and still represent market leadership. Even though the Russell 1000 Value Index fell 4% last week and is 5.4% off its high, and the counterpart growth index is less than 1% from its peak, the value benchmark is still outperforming growth by more than three percentage points this year. Keith Lerner, market strategist at Truist Advisory Services, points out only 28% of stocks in the S & P Pure Value Index (tracked by an ETF under ticker RPV) are above their 50-day average, an oversold reading roughly similar to the one last fall before the value run got moving. Oversold doesn't mean ready to rebound, of course. This test of the bulls' conviction could surely persist, as seasonal factors and some signs of erratic vibrations have emerged. Friday was the June "quadruple witching" expiration, a big one that wiped away huge slugs of options bets and has in the past tended to lead to further choppiness. The week after June options expiration since 1990, the S & P has been down 80% of the time, averaging a loss of 0.9%, according to McMillan Analysis More broadly, Ned Davis Research's cycle composite, combining the annual, presidential-election and decennial patterns, shows a tendency for rougher air come mid-July. This year through Tuesday the S & P roughly tracked the historical path. The CBOE Volatility Index finished above 20 Friday, not leaking lower on a Friday as it usually does in a steady market. The typical Monday lift in the VIX could put it above the price of the July VIX futures contract, often an arrangement that coincides with slippery market footing in the short term. All these characteristics fit with a market undergoing a benign and brief "stealth correction" on its way higher, but also are consistent with a failing uptrend that is trapping complacent investors and needs a deeper correction to sort itself out. Yet with investor positioning now cleaner and clusters of overconfidence dissipated, much of what has changed over the past week could ultimately be for the better.

There were some stark changes — in perceptions about Federal Reserve intentions, pricing of inflation risk and positioning across asset classes. But how much is truly different now about the Fed policy path, the fundamental backdrop and the tactical set-up, in a market caught offside and prone, as ever, to short-term overshoots?

The Fed

The week started with hedge-fund luminary Paul Tudor Jones saying investors should "go all in on the inflation trades" if the Fed showed nonchalance about recent stout inflation data. The rest of the week saw the markets act as if too many were already loaded up with those inflation trades, and after Fed officials showed slightly more concern about inflation than expected, those trades blew up spectacularly.