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S&P 500 On Knife’s Edge Ahead of Federal Reserve Meeting

June 14, 2016

With the Federal Reserve voting members set to meet later in the week, risk assets and equities in particular are pulling back ahead of the critical decision which could give hints about the future of interest rates.  While the S&P 500 reached the highest levels since last July earlier in the month, the benchmark has since retreated as traders take profits ahead of what is expected to be a volatile decision.  Following Wednesday’s rate statement, the press conference that follows the FOMC decision could have grave implication for stocks which have benefited so greatly from the low interest rate environment that has prevailed in the post-crisis years.  The prospect of higher interest rates could dent momentum higher in equities and even catalyze a reversal lower, a critical development at a time when the outlook for corporate America is increasingly bearish.

Sensitive to Policy

Stocks in particular have been very sensitive to developments in monetary policy in the post-crisis years due to record low interest rates and expansive stimulus measures.  In the aftermath, stocks rose rapidly due to two factors.  For one, with interest rates so low, individuals looking for higher returns were forced to turn to riskier assets like stocks instead of bonds which saw highly compressed returns at near-zero interest rates.  This development channeled substantial funds into equities as investors looking for higher returns with left with few other areas to turn to.  In many ways, the meteoric rise in stock benchmarks like the S&P 500 mirrored the expanding Federal Reserve balance sheet.  The more asset purchases conducted by the Fed, the more funds were channeled towards stocks, pushing valuations higher over time.

Besides balance sheet expansion, low interest rates meant low borrowing costs for corporations, a development they used to finance purchases of their own stock in a process known as share buybacks.  One of the benefits of reducing the total number of outstanding shares is that earnings per share rose even if profits stayed flat.  In simpler terms, if profits stayed constant over two years, earnings per share would actually be higher if there were fewer shares outstanding, a development corporations exploited to go ahead and make themselves appear more attractive from a results perspective.  However, now that interest rates are beginning to rise, these gimmicks are no longer as accessible to corporations, hurting the potential upside in shares over the medium-term.  Moreover, earnings growth is expected to slip, with many prominent banks revising forecasts to reflect a more bearish outlook.

Although a rate hike is seemingly off the table for now, there is rising speculation that the Federal Reserve will opt to raise rates at least once during the second half of the year if not twice.  This could cause a massive reallocation of investment capital in a move that is widely expected to take some air of the S&P 500 valuation balloon.  As bond yields become more attractive, investors that were chasing after the higher yields in stocks will likely move back into bonds and other fixed-income assets.  Additionally, higher interest rates will likely lead to a stronger US dollar, a phenomenon that will make publicly traded US companies more expensive relative to their international peers, thereby causing a decline in value.  With all these factors taken in tandem, the S&P 500 downside risks considerably outweigh the upside reward potential.

Technically Speaking

Upon further review of the price action, the first major upcoming test for the S&P 500 is the 50-day moving average which is currently below the price action, acting as support against any prolonged downturn in the index.  Further below is the 200-day moving average and despite a bullish crossover that occurred back in April, a retreat below the 50-day moving average may negate that signal.  If the S&P 500 merely undergoes a technical correction, the Fibonacci retracement levels indicate that index would conceivably fall to 1925.00-2000.00 marking a 38.20-62.80% pullback before resuming the uptrend.  However, other indicators suggest a more bearish bias, with the Stochastic Oscillator signaling for retreat.  The crossover of %D line (red) over the %K line (blue) suggests S&P 500 momentum quickly reversing lower towards support at 2020.00.

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Going Forward

A jam packed week of events is likely to see financial markets and risk assets in particular come under renewed pressure, especially as the FOMC interest rate decision approaches.  Should the Federal Reserve signal its preparedness to raise interest rates, any upside in the US dollar is likely to see the S&P 500 retreat.  With the corporate outlook deteriorating and earnings growth expected to be more subdued going forward, the bullish case for stocks has been overwhelmed by numerous negative factors.  When taken in the context of risk and reward, the upside potential remains heavily outweighed by the risks.