Wednesday, April 30, 2008

Three Key Questions Going Into the Fed Announcement

* Have we put in a durable bottom in stocks? - I've been writing for a while about the drying up of stocks making new lows as we tested the January lows in March. Since that time, we've bounced nicely and are hugging that major resistance area around 1400 in the S&P 500 Index. I've also noted of late that the recent market strength has been accompanied by waning participation to the upside and uneven sector performance. We need to see the broad range of stocks in gear to the upside to confirm that this is more than just a catch-up move of beaten down stocks, sectors, and asset classes at the expense of first-quarter winners. I'll be looking to see if the Fed announcement can generate the rising tide that lifts all boats. Conventional wisdom has stocks selling off at the prospect that the Fed may be finished with its easing; less conventional wisdom (which I prefer) suggests that such a shift in Fed policy might be seen as a vote of confidence in credit markets and the economy.

* Will deflation or inflation concerns rule the markets? - Watch the fixed income markets in the wake of the Fed announcement. Will we see the risk-averse flight to quality, with rising Treasury prices and falling yields? Or will we see money continue to move from safety toward riskier assets, as has occurred this past week, with Treasury rates rising and yield spreads narrowing vs. mortgage-backed and high yield debt? The Fed may well offer a balanced perspective in their statement to preserve flexibility at future meetings, but the bond markets will tip us off to the market's interpretation of Fed priorities. Conventional wisdom is still focused on weak housing, and even the taxi cab driver seems to know about LIBOR. Less conventional wisdom is focused on the breakout moves we've already seen in yield spreads.

* Will sector themes mirror confidence or lack of confidence in the economy? - I've mentioned at numerous points over the past few months the importance of the financial sector and especially the bank stocks. With Citi's recent move for further cash infusion, those stocks have seen a recent resumption of weakness. Keep an eye on them in the wake of the Fed announcement. It is very difficult for me to believe that we'll sustain a bull move without confidence in the banks. But I'm aware that conventional wisdom is also focused on financials; less conventional wisdom also sees the influx of funds into consumer discretionary stocks vs. staples at the same time that commodities have been falling and the U.S. dollar has shown a bit of strength. I'll be watching the latter trends carefully as a barometer of nascent economic confidence.

Themes and transitions among themes reflect the flows of funds within and across asset classes. Even short-term traders can benefit from standing back and seeing where capital is flowing and why. The upcoming Fed meeting should prove instructive in this regard.