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Outside the Box: Even if stocks rise in the months ahead, the market has limited upside potential

There’s a reason the late investor Marty Zweig came up with the phrase “Don’t fight the Fed.”

The Federal Reserve isn’t the only thing that controls the stock market, but it’s very influential.

The market moves for many reasons. Two main factors are earnings and interest rates. Monitoring the Fed’s actions, therefore, is important because the central bank affects interest rates, especially short-term rates and liquidity.

The Fed started pumping tons of liquidity into the system in April 2020. Policy makers not only kept interest rates near zero, but they also made more Treasury purchases in the six weeks following the pandemic than they did in the nine years from 2009. They continued with $120 billion in monthly bond purchases, keeping rates low.

The Fed’s about-face

In mid-December 2021, I turned cautious on the market, mainly because the Fed started talking about taking accommodation away. In a series of announcements between early December 2021 and mid-January 2022, the Fed discussed ending bond purchases, raising interest rates and decreasing its balance sheet. Since then, central bankers’ hawkish actions have provided a serious headwind for the market.

Chart by MarketSmith

My conclusion is that the market is unlikely to see sustained upside as long as the Fed is raising rates and removing liquidity from the system.

What will it take for the Fed to turn dovish or at least pause its rate hikes? No one knows, of course, but I think policy makers will keep going until something breaks.

By “breaks,” I mean the benchmark S&P 500 Index
SPX,
+0.63%

falling 20%, valuations correcting to a reasonable level, a problem in the bond market or credit spreads widening too much.

In the fall of 2018, the Fed was already raising rates and Fed Chair Jerome Powell said he would continue to raise rates three or four more times in the upcoming year. The market proceeded to drop 10%. At its Dec. 19 meeting, the Fed forecasted more hikes, and discussed reducing its balance sheet — sound familiar? The market dropped another 10% until Powell eventually pivoted on Jan. 4, saying the central bank would be “patient” on interest rate increases.

So what changed in those intervening weeks? The S&P 500 completed a 20% correction.

You might think this is a little conspiracy theory, but on April 6, former New York Fed President William Dudley said the Fed “will have to inflict more losses on stock and bond investors than it has so far.”

My interpretation is that the Fed will continue to raise rates and reduce its balance sheet as long as the stock and bond markets allow it to. Considering the S&P 500 is about 6% off its high, it seems there’s plenty of room left.

Keep in mind that just because the Fed is creating a difficult headwind for the market, it doesn’t mean that stocks will go straight down. In other words, when sentiment gets too negative, there will be countertrend rallies to keep the bears in check.

The rally in the second half of March, for instance, had nothing to do with the Fed. It was mainly because sentiment was getting too negative and also quarter-end portfolio adjustments. Remember that there are still many stocks acting well, especially in commodity-related sectors. In a stronger market, there would be a broader range of stocks acting consistently well, but there are still decent opportunities out there.

What you can do now

From here, your strategy should depend on your overall investment objectives. For traders, here are a few suggestions: 1. Don’t overthink the macro picture. Keep things simple and follow price. 2. Since there is likely to be higher volatility over the next few months, use lighter-than-normal positions. 3. Get strong entry points. Use the 21-day EMA as your guide and do not chase extended stocks. 4. Gain exposure to the strongest stocks. 5. Manage risk and cut losses based on your timeframe. 6. Use index ETFs in addition to stocks. 7. If you are on margin or stuck in many of the old leaders that are down 50%-70% or more, consider cutting losses. It would make sense to have some cash on hand for when better opportunities present themselves later this year.

If I can offer any words of encouragement: Things can change quickly. Stay defensive but don’t get overly bearish. The market is a discounting mechanism and tends to trade on what will happen six to nine months from now. In other words, although the Fed will remain hawkish and inflation is likely to be high for a while, the market will eventually factor this in and turn around. There will be tremendous opportunities in growth stocks later this year, but you just have to be patient until conditions improve.

Joe Fahmy is a portfolio manager at Zor Capital LLC, a New York-based investment-management firm. He can be reached at jfahmy@zorcapital.com and on Twitter.

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