S&P 500 Vulnerable Ahead of Yellen Speech

August 28, 2016

With not a peep uttered from the US Federal Reserve Chair since she last spoke in June, financial markets are acting slightly spooked ahead of her remarks set to be delivered on Friday to the Jackson Hole Symposium of central bankers.  Key figures within the US Central Bank have struck a more hawkish tone in recent commentary, underscoring the increasing embrace of the idea of higher interest rates.  Nevertheless, with the Open Market Committee split during its last interest rate decision in July as evidenced by the meeting results, Yellen’s comments will carry serious weight, especially when it comes to market momentum.  Although the S&P 500 remains not far from record highs, the wait-and-see energy prevailing in financial markets might just be the calm before the storm.  Should she echo other members’ hawkish sentiment, it could well be the beginning of a steep correction in stocks.



Policy as a Valuation Driver

Monetary policy has been the single most influential driver of stock valuations in the post-crisis years.  The significant amount of support that was breathed into the system through a mix of record low interest rates and asset purchases designed to drive borrowing costs lower was most effective at spur greater risk-taking.  Evidence of this point comes from the significant correlation between the Federal Reserve’s balance sheet and record breaking performance from stock indices such as the S&P 500.  Although the index has managed to reach new highs despite the removal of the training wheels following the rate hike last December, further normalization efforts may see a widespread reallocation of investor assets.  Once of the main reasons the S&P 500 so greatly benefited from low rates was few other places for investors to chase after higher returns compared to the near-zero returns available from safer, more risk-averse assets like bonds.

While corporations were readily able to benefit from record low interest rates, utilizing low borrowing costs to fund repurchases of their own shares to boost profitability and shareholder returns, another rate hike would shut the door on these activities.  This would force companies to spend more investing in R&D and capital expenditures to fund growth instead of cutting costs and slashing the workforce to impress investors.  At present, the S&P 500 is exhibiting one of its highest historical valuations relative to company earnings on record aside from the dot com bubble of the early 2000s and the last financial crisis.  However, as those crises before showed so eloquently, what goes up, can also come down.  A current price-to-earnings multiple of 25.17 versus a historical average of 15.61 implies that a 38.00% retreat from current levels is entirely possible, adding to the downside risks.

With the countdown to Yellen’s speech already well underway, financial markets will be looking for any hints towards the future of policy.  Should she take a more cautious approach, highlighting the risks to the outlook and painting a more downbeat picture of the economy, market’s may interpret her comments as dovish, or indicative of more accommodative policies.  Nevertheless, a more upbeat assessment could be interpreted as hawkish, or suggestive of further rate hikes.  While she is unlikely to define an exact path for interest rates over the coming months, the language of her speech will be carefully monitored for any tipoffs about the time frame for adjustments to monetary policy.  Furthermore, her outlooks for inflation and growth in the US economy could sway the S&P 500, with more hawkish leanings likely to translate to losses in the index where as more dovish remarks may spur buying activity.

The Price Action Interpreted

Although the S&P 500 is rebounding modestly after a losing session, momentum and volatility remain very subdued relatively to more normal activity.  After trending higher in an equidistant channel pattern for the last few weeks, the S&P 500 is trading near the lower channel line.  Although traditionally more bullish in nature, because volatility is ebbing near multi-month lows along with trading volumes, a move below the lower channel line would be considered a breakout, especially if accompanied by higher momentum and volume.  Should this occur, the first downside target would be near 2150 which coincides with the 50-day moving average followed by support at 2070 which is near the 200-day moving average.  Any break below these levels paves the way for a move towards the 2000 psychological level in the S&P 500.


Looking Ahead

The topic of stocks being overvalued has long been held both by analysts and economists alike, even meriting periodic remarks from the Federal Reserve.  With Fed Chair Janet Yellen on deck to speak on Friday, her words will carry significant weight when it comes to determining the outlook for stocks.  Just one word could change the course for one of the most followed global benchmarks.