Markets Don’t Like Surprises

My plan for this fine Thursday morning was to continue our discussion of how my team goes about building portfolios for financial advisors and their clients that incorporate a modern approach to diversification and risk management. I.E. How to design strategies that will keep performance “around” the benchmark most of the time and then attempt to “lose less” during those nasty bear market cycles.

However, that was before the venerable Dow Jones Industrial Average put in the largest one-day reversal since the current cyclical bull market began back in February 2016. And since the Dow had been up nearly 200 points in the morning and then finished with a loss of 41, I figured there was “esplainin” that needed to be done. So, we will take a break from the philosophical discussion on portfolio design this morning and dig into the market’s price action.

On the surface, a decline of 41 points on Dow and/or a drop of 7.2 points (-0.31%) on the S&P 500 is hardly noteworthy. But, the steady decline seen from about the time the lunch hour began until the closing bell rang certainly is worth exploring.

With the NASDAQ sitting at new all-time highs and the Dow up 198 yesterday afternoon, things were looking up. But then the bombshells started.

First, there were the minutes from the latest FOMC meeting. If you will recall, the markets seemed to like the result of the March Fed meeting as the message was that Ms. Yellen’s gang was going to stay the course of slow and steady interest rate increases. However, the minutes from the meeting released yesterday afternoon revealed a couple surprises that traders hadn’t counted on.

The first surprise was the mention of stock market valuations. Traditionally, FOMC members refrain from talking openly about the finanicial markets, for obvious reasons. But yesterday we learned that some members are concerned about the elevated level of stock market valuations. And while the comparisons to Alan Greenspan’s “irrational exuberance” comments in 1996 were immediate, the bottom line is traders know that the Fed has the ability to “talk down” markets if they want to. As such, the mention of stock market valuations put the spotlight on the market’s overvalued condition.

The question of course, is if traders will ignore such warnings like they did in 1997-1999 or take the FOMC’s concerns to heart in the near-term. We shall see.

As if that weren’t enough, the minutes from the March Fed meeting contained another surprise. Cutting to the chase, the FOMC discussed the idea of “shrinking” the Fed’s $4.5 trillion bond holdings this year. In English, this means that the Fed will, at some point, stop rolling over the bonds it owns and reinvesting the interest it earns on its holdings. But to be clear, it wasn’t the issue of “shrinking the balance sheet” itself that took the markets by surprise, but rather the discussion on the timing.

Given that, to date, Janet Yellen’s Fed has always erred on the side of caution, this discussion put some uncertainty – or perhaps even some fear – back in the markets. The worry is that if the Fed moves too hastily, the economy could be damaged in the process. And since the market is currently “pricing in” stronger economic growth, the fast money types apparently decided to sell first and ask questions later yesterday afternoon.

The second surprise came from Capitol Hill as Paul Ryan’s comments on tax reform caught traders off guard.

There were two comments from Ryan that proved problematic. First, the House Speaker told reporters, “We will need more time for tax reform.” And second, Ryan said that the White House, Senate, and the House of Representatives were “not on the same page” as far as what tax reform will look like.

In short, this is NOT what the stock market wanted to hear. Again, the market is looking for economic and earnings growth to exceed expectations in the coming quarters. And at least part of this expectation is based on the benefits expected to be provided by a reduction of corporate taxes.

So, the bottom line is if the children in D.C. don’t play well together and wind up mucking up the process, the tax benefits could be delayed for some time. (After all, this IS Washington we’re talking about here.) And if this happens, well, the valuations that Fed officials are jawing about could become a problem for investors.

The question in my mind is if yesterday’s big reversal was a one-day wonder or the start of a more meaningful corrective phase. Given the status of the current bull trend and my favorite indicators, neither is going to surprise me. But the near-term lines in the sand at 2322 on the downside and 2400 on the upside will likely hold the key to the next move. So stay tuned.