Charting Time
Charles H. Dow described the stock market as a series of ocean tides that go in and out. One of the basic tenets of the prominent news columnist’s work near the end of the nineteenth century was to approach markets based on various trends, with the most important one being the primary trend. The theory states the primary trend remains in force until the weight of the evidence says otherwise. Dow theorists would classify this year’s primary trend as facing down because market prices have failed to rally above their previous highs. With that said, Dow theory is one of many belief systems used to paint a picture of the overall stock markets. In this current bear market, monetary policy, fiscal spending, and asset fundamentals have been driving forces and these factors may quickly evolve, which will surely impact the financial markets.
The broad stock market averages experienced a short rally in early September that ended abruptly when the monthly inflation announcement came out. The inflation announcement exceeded expectations forcing markets to believe the Federal Reserve (Fed) would continue to act forcefully and send the economy closer to the brink of recession. Unfortunately, September’s mini-rally failed to break the tops posted in August when the inflation report came due, leading some technical analysts to believe the price pattern is still aimed down.
The Fed did as expected in September by raising short-term interest rates by 0.75%. This lifted short-term rates to 3.25%. Their decision to hike rates again caused the inverted yield curve, the spread between long- and short-term rates, to deepen further. For example, today the government pays a higher interest rate on two-year debt than on ten-year debt. As a result, more-and-more savers will probably flock to markets with higher short-term rates, increasing the volume of loanable funds available at shorter maturities. Today’s dislocation, higher short-term and lower long-term rates, will likely slow the economy as credit supplies in long-term markets shore up and will likely be allocated to shorter-term maturities. If the yield curve stays inverted, business investment could stall and lessen expenditures and job growth.
The Fed likely has significant control over the shape of the yield curve. It has the power to raise short-term interest rates and can influence long-term rates as they tighten the balance sheet. Since last June, the Fed has allowed over $100 billion to roll off its 9 trillion dollar balance sheet. The balance sheet remains massive compared to historical standards. As more government debt matures and rolls off, it will put upward pressure on long-term rates since private capital channels are likely to charge higher rates on future government debts. However, the Fed could normalize the yield curve if it wanted to. All it has to do is a pivot and slash short-term interest rates. But the economic consequences of doing so would likely increase the severity of inflation.
Forty-year high inflation has forced interest rates off zero rate policies. As a result, the stock market has experienced indigestion along the way. Earnings and dividends that stocks produce continue to appear resilient; however, there’s always a chance the fundamental picture weakens as the economy progresses over time. Yet, today’s higher interest rates are likely the driving force behind the stock market’s losses. As a result, investors now demand stocks to yield a higher earnings rate to take on the nature of business risk. This shift in demand caused by higher interest rates is heavily responsible for this year’s losses since earnings and dividends have grown this year. The markets may have entered the late phase of the market cycle. Interest rates reached a new 4% high in September, and those were also some of the worst days in the stock market. However, interest rates have since retreated rather significantly. Dow theorists can now use the current interest rate top and stock market bottom as critical thresholds to evaluate the primary trend as investors look for a change in direction.
