Is The Fed Worrying Too Much About The Stock Market?

I saw a great piece of stock market analysis this week.

It’s a nice, high-level analysis that I sometimes see in reports from major Wall Street firms. But this analysis didn’t come from Wall Street. It came from the minutes of the Federal Reserve’s most recent meeting:

Broad stock market prices rose moderately over the [past six weeks], supported in part by some strong second-quarter earnings reports that bolstered investor risk sentiment.

However, some prices declined for stocks that historically have moved more closely with economic conditions—such as stocks for smaller companies and for firms in cyclical industries—as did stock prices for firms in sectors such as airlines and hotels that were negatively affected by the pandemic. Bank stock prices also fell.

One-month option-implied volatility on the S&P 500—the VIX—spiked to reach a two-month high. For the [past six week] as a whole, however, the VIX was little changed, on net, and remained somewhat above its average pre-pandemic levels. Spreads of yields on corporate bonds over those on comparable-maturity Treasury securities were little changed, and spreads of benchmark municipal bond indexes increased moderately, although both remained below their pre-pandemic levels.

You can find all of the Fed’s commentary from the meeting here. They also talked about coronavirus, wage growth, inflation, interest rates, and unemployment. But my concern is with the detailed discussion of the stock market.

Is The Fed Too Focused On The Market?

In the past, the Fed has focused on price stability and maximum sustainable employment, objectives known as the “dual mandate.” Price stability was defined as inflation of about 2% in the long run. Maximum sustainable employment was defined by the Fed’s estimate of the natural rate of unemployment. This measure has been falling for years and is now estimated at about 4.5%.

Source: Federal Reserve

With inflation over 5% and unemployment at 5.4%, the Fed is far from its policy goals. That’s why I was concerned with a detailed analysis of the stock market.

If the Fed is going to make policy decisions to please traders, they will add money to the system until inflation reaches double digits. A rising stock market isn’t really compatible with the Fed’s dual mandate.

In the past, the Fed’s job was colorfully described by William McChesney Martin, the Fed chairman from 1951-70. The Fed’s role, Martin said, was to act as a “chaperone who has ordered the punchbowl removed just when the party was really warming up.” So when the Fed spotted excesses, it would raise rates, even if Wall Street reacted negatively.

Now, we are in a new era where the Fed wants low inflation, low unemployment, and rising stock prices. That could be a recipe for disaster if the focus remains on the stock market.

How I’m Trading Right Now

In the short run, we focus on our indicators… and mine are warning of potential weakness.

My Income Trader Volatility (ITV) indicator turned bearish, as shown in the chart of the SPDR S&P 500 ETF (NYSE: SPY) below.

ITV is similar to VIX in that it rises as prices fall. Its current position, with the indicator below the MA (the blue line), points to continued strength in stocks. The initial target indicated by the consolidation that developed between April and June was achieved as ITV turned bearish.

Our last chart this week shows my Profit Amplifier Momentum (PAM) indicator is also bearish.

PAM is designed as a short-term indicator. Its recent crossover is a potential indicator of weakness.

Based on my indicators, I am looking for a continuation of the selloff that began last week in the S&P 500. The good news is, by using a form of “market insurance”, we can not only protect ourselves from potential downside – but get paid to do it.

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