Volatility Playbook, Fed Runoff History

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Volatility Playbook, Fed Runoff History

An eventful day yesterday (and not in a good way) in US equity markets, so for “Data” we have both some thoughts on how to trade the current environment and, well, data…

Three points:

#1: When we run into a choppy spell for stock prices, we’re always mindful of the old saying that “Markets crash when they are already oversold, not overbought”. While we are not predicting a large market dislocation, we do have a mental rulebook for times like this:

  • Never buy a stock or ETF trading at a new 52 week low. Wait for it to stabilize. We’ve seen investment careers ended by breaking this rule.
  • That also goes for stocks you already own, aka “doubling down”. Again, wait for them to stabilize. The old saw “how many days can a stock go down 10 percent?” comes to mind. The answer is not 10 days …
  • If there is a down +3 percent day for the S&P 500, start buying on the next +3 percent down day. That was our playbook during the 2020 meltdown, and it drew heavily from the 2008 – early 2009 crash. You may not be in the black after a week or even a month, but it is a reasonable way to dollar cost average into a portfolio that will be profitable over time. And certainly more profitable than selling at the bottom …

Takeaway: much as we still like US equities because we think the market is underestimating corporate earnings power, we respect the tape. We’ve been writing about our worries related to Fed interest rate policy recently (more on that in a minute), so we’re not entirely surprised by today’s selloff. Still, market psychology can be brittle and it’s better to have a plan for further volatility than just wish it away with hackneyed platitudes.

#2: A reminder of the work Jessica recently showed you regarding the market aphorism “So goes January, so goes the year”, which we put together precisely because we thought more volatility was coming:

  • The S&P 500 is down 1.4 percent after the first 3 trading sessions of 2022.
  • Since 1980, when the S&P is DOWN over the first 5 days of the year, its average whole-year return is +5.6 percent. Conversely, when it is UP over the first 5 days, its average whole-year return is +13.0 percent (i.e., much better than when down over the first 5 days).
  • Over the same timeframe, when the S&P 500 is down for the entire month of January its average annual return is +2.2 percent. When it is up for the month, its average return is +15.5 percent.
  • In 2000, at the very tail end of the dot com bubble, the S&P 500 was down 1.9 percent over the first 5 days and finished the year down 9.0 percent.
  • In 2008, going into the Financial Crisis, the S&P 500 was down 5.3 percent over the first 5 days and fell 36.6 pct for the year.

Takeaway: the “January indicator” is sufficiently well known that, even if it is far from statistically bulletproof, it will inform the near-term narrative for US large cap stocks. We have two more days to go and 1.4 percent points to claw back in order to avoid a down first week of 2022. The magic number is 4,766.18 on the S&P 500, in case you want to put a yellow sticky note on your monitor.

#3: There was little in today’s Fed minutes that Chair Powell did not already discuss during his December press conference with respect to how the Federal Reserve is considering shrinking its balance sheet. He noted that the FOMC’s discussion centered on the differences between now and 2018, the last time the Fed reduced the size of the balance sheet. A faster “runoff” is likely appropriate now, due to both the strength of the US economy and higher levels of inflation. The minutes echoed those sentiments.

A few points of market history with respect to the 2018 Fed balance sheet runoff:

  • It started in earnest in early 2018, some 2 years after the Fed had started to raise interest rates. Fed Funds were already 1 percent, and the US economy has continued to grow over the prior 3 years of gradual rate hikes. Reducing the size of its balance sheet was the next logical step, so the Fed took it.
  • The S&P 500 rallied by 9.6 percent from year end 2017 to September 20th, 2018, what would be its high for the year. Balance sheet runoff did not seem to bother equity markets at all.
  • What did bother markets was the Fed’s insistence on continuing to increase interest rates. Fed Funds went from 1.95 percent in September 2018 to 2.40 pct at the end of the year. The S&P fell by 14 percent from its September highs through year end 2018. The index only started to recover in early 2019, once Chair Powell made it clear the Fed would keep rates where they were.
  • Importantly, balance sheet runoff continued all the way to September 2019.

Takeaway: there is no historical basis for saying that a declining Federal Reserve balance sheet unduly hurts stock prices – rate policy clearly matters far more. Now, markets may be objecting to a simultaneous rate liftoff and balance sheet runoff, and that is an entirely valid concern because it’s never happened before. The results could well be unpredictable. The only counter to that bearish argument is that the Chair Powell’s Federal Reserve has tended to listen to markets when they signal a policy mistake. This year should be no different, but it will take more than today’s decline to convince the Fed it is on the wrong track. Hence our points #1 and #2 above.