Navigating markets as a trader is very challenging, because none of us can know for certain what will happen in the future. However, if we pay attention to the signals, we’ll have a good understanding of where things are headed. Right now, it looks like they’re headed in a bearish direction.
The stock market is an efficient discounting machine. While not perfect, it can tell us where the economy is headed – most of the time.
Market sages were predicting strong economic growth for 2020, and the stock market reflected that positive sentiment. When it became apparent that the economy faced dire consequences from the COVID-19 pandemic, the stock market tumbled hard and set a record for the sharpest crash.
Economic conditions changed quickly as the Fed added liquidity to the markets and Congress passed a stimulus bill that put cash into the hands of the public. Consequently, the stock market ran up to all-time highs for months on end. That may now be coming to a close.
Why markets are looking bearish
Last week, Fed Chair Jerome Powell issued a very hawkish statement about inflation. The last time he was hawkish – in December 2018 – markets bombed. The late Santa Claus rally (barely) saved the day, and on January 4, 2019, Powell changed his tune. Markets rallied after that speech all year and continually made new highs.
But now we are in the early part of 2021 and at a crossroads. The message of the markets is now one of caution and care. With most of the gains for 2021 wiped out now (save for the Russell 2K), it’s time to re-evaluate.
The rise in interest rates is not that unexpected, but the speed at which it has occurred is a bit disturbing to everyone, including central bankers. Chair Powell and other Fed officials have acknowledged this. With rising prices and a much stronger economy, it stands to reason that inflation is starting to rise. Is this a problem for the Fed? Probably not right now, but they will need to be vigilant.
When interest rates go up due to rising inflation expectations, equities do not fare well. The Nasdaq is in the middle of a major correction, and other indices are close behind.
The Fed stimulus policy includes two elements: zero interest rates and outright bond purchases. The latter that will eventually slow down before the former sees a rise in rates. The bond market is pushing the Fed to see what they see. Are they right? We’ll soon find out, but the bond market is hardly ever wrong.