Market Review And UpdateWe hope that you and your families had a wonderful and blessed Thanksgiving with your families. We are also taking a much-needed break but wanted to provide you with an update on this week’s market action.Last week, we noted that:“Market rallies are common heading into year-end, and this rally is no different. However, we are now reaching more extreme levels of typical reflexive rallies, and a consolidation or correction to support should be expected.That rally continued this past week, and we are approaching the 100% retracement of the July highs. Such changes the dynamics of a pullback to the previous resistance levels of 78.6%, 61.8%, and 50% retracements. With the 50-DMA coinciding with the last 50% retracement level, we expect the maximum drawdown of any correction to hold that level going into year-end. As we will discuss in more detail on Tuesday, the typical seasonal trends of the market suggest that a pullback in early December should be expected. (Notice the early December dip in the chart below.) “Before “Santa Claus” makes his anticipated visit to “Broad and Wall,” mutual funds must distribute their capital gain, dividends, and interest income for the year. These distributions start in late November, but a large number of distributions occur in the first two weeks of December. Again, notice that dip in the seasonality chart above.”While the setup for a year-end rally remains intact, such does not preclude a short-term “dip” to reduce the market’s more extreme overbought and deviated conditions currently. Such will provide a much better entry point to increase equity risk accordingly.However, heading into next year, the stock and bond rally creates a problem for the Fed as looser financial conditions will potentially help sustain inflationary pressures in the economy.That is a problem the Federal Reserve doesn’t want at the moment. Need Help With Your Investing Strategy?Are you looking for complete financial, insurance, and estate planning? Need a risk-managed portfolio management strategy to grow and protect your savings? Whatever your needs are, we are here to help. Looser Financial Conditions Are A ProblemIn Last week,, we discussed how the rally was problematic for the Fed. To wit:
“The problem with market rallies and yields dropping is that it undoes the financial constriction they provided on the economy. Higher asset prices boost consumer confidence, and lower yields provide buying power. Both actions create the possibility of a resurgence in inflation, putting the Fed back into “hawkish” mode to ensure inflation falls.“
Given tight bank lending standards, that discussion sparked many emails about why a rally in stocks and bonds mattered.It is a good question and worth discussing in more detail.First, we must go back to a statement by Fed Chairman Ben Bernanke in 2010 when he launched a second round of “quantitative easing.”
“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” – Ben Bernanke, 2010
There it is in black and white.A zero Federal funds rate and a bond-buying program resulted in higher asset prices and lower long-term interest rates. In other words, the rally in stocks and bonds eased financial conditions by creating a “wealth effect.” That “wealth effect” boosted spending, which led to “higher incomes and profits that, in a virtuous circle, will further support economic expansion.”At the time, this was the result the Federal Reserve wanted as economic growth and inflation were running at very low annualized rates and were at risk of slipping into recessionary territory. However, currently, that is not the case. Both economic growth and inflation are still well above the Federal Reserve’s “comfort zone.” If the current economic data continues to strengthen, as Wall Street expects next year to support increased earnings growth, then inflation will potentially rise from the pickup in demand. Given that the inflation spike was due to the artificial surge in demand created by government stimulus, the Fed countered that demand by tightening financial conditions. However, looser financial conditions from rising asset prices and falling yields, thereby increasing consumer sentiment, undermine the Fed’s goal.The biggest fear of the Federal Reserve is a repeat of the 1970s.That 70s ShowIn “That 70s Show,” we discussed the problem facing the Fed, where monetary policy actions only temporarily quelled inflationary pressures.
“When the US Federal Reserve embarked on an aggressive campaign to quash inflation last year, it did so with the goal of avoiding a painful repeat of the 1970s, when inflation spun out of control and economic malaise set in.” – CNN  That concern of “spiraling inflation” remains the key concern of the Federal Reserve in its current monetary policy decisions.You will also notice in the chart above that each period of rising inflation coincided with increased stock prices. As discussed in that article, Authur Burns and Paul Volker, then Chairmen of the Federal Reserve, would engage in an aggressive rate-hiking campaign. Such eventually resulted in a bear market, a recession, or both.“The chair of the Federal Reserve at the time, Arthur Burns, hiked interest rates dramatically between 1972 and 1974. Then, as the economy contracted, he changed course and started cutting rates.However, there are many reasons why today differs from the 1970s and why such an environment can not exist today. The most notable reason is the current level of debt.“While the Fed is currently engaged “in the fight of its life,” trying to quell inflation, The economic differences are vastly different today. Due to the heavy debt burden, the economy requires lower interest rates to sustain even meager economic growth rates of 2%. Such levels were historically seen as “pre-recessionary,” but today, they are something economists hope to maintain.” However, such does not mean inflation can’t pick up modestly if consumer confidence increases economic demand. That was the problem with the 70s, as stock and bond market rallies created looser financial conditions. 2-Measures Of Financial ConditionsAs noted, the recent drop in bond rates and surge in the stock market works against the Fed’s goal of tightening monetary conditions. The Fed’s goal remains “tighter” conditions to reduce consumer spending and increase unemployment to reduce economic demand. The only way to quell inflation, which is solely a function of supply and demand, is to cripple the demand side of the equation. As discussed last week, two measures of financial conditions suggest the market is working against the Fed.The first is our monetary policy conditions index.
“The ‘monetary policy conditions index’ measures the 2-year Treasury rate, which impacts short-term loans; the 10-year rate, which affects longer-term loans; inflation, which impacts the consumer; and the dollar, which impacts foreign consumption. Historically, when the index has reached higher levels, it has preceded economic downturns, recessions, and bear markets. Unsurprisingly, when monetary policy conditions have become tight, and the event occurs, the Fed generally cuts rates or keeps them at zero, providing liquidity to the markets.”

“Secondly, as we noted in ‘Bond Bear Market,’ there are implications for the Federal Reserve as bond rates are repriced lower, particularly when it remains focused on inflation. Lower yields and potentially higher asset prices reverse the financial conditions the Fed hoped to tighten. As shown below, our economic conditions index has loosened over the past week.”
  Looser financial conditions are problematic for the Fed, which needs tighter conditions to bring down inflation towards their target rate. As Michael Lebowitz noted this week, the market may not like what the Fed says next month. A December Fed Shocker?
“The Fed’s tone markedly changed in the weeks preceding the November 1 FOMC meeting. Many Fed speakers offered that higher interest rates will tighten financial conditions, thus allowing them to take a break from rate increases. The messaging was solidified at the November 1 FOMC meeting. To wit, the following statement from Jerome Powell.
What Powell stated was overlooked by the market last week. Powell clarifies that recent interest rate increases, a stronger dollar, and weaker stock prices could keep them from hiking rates. However, he qualifies the statement by emphasizing they want to see the persistence of said market conditions. What they do not desire, as shown above, is a reversal to looser financial conditions. In other words, the Fed does NOT want to see stock prices and bond yields “fluctuating back and forth.“Of course, since the Fed meeting, stocks have risen about 10%, ten-year note yields are nearly 0.50% lower, and the dollar index has fallen 3%. Looser financial conditions are precisely the opposite of the Fed’s stated goals. With the next FOMC meeting coming in mid-December, looser financial conditions will likely force the Fed to revert to its more hawkish tone to once again tighten financial conditions.The question is how the stock and bond markets will react to the disappointment of “coming rate cuts” when “higher for longer” remains the Fed’s mantra.We suspect that if the Fed fails to change its message, the stock and bond markets are set up for short-term disappointment. How We Are Trading ItAs we noted in Thursday’s Daily Market Commentary:“With both the stock and bond markets reaching more extreme overbought conditions, this is a good opportunity to temporarily take profits and wait for a correction to add back into these positions. Whatever triggers a correction in stocks will also trigger a correction in bonds, given their high correlation this year. Most likely, comments from the Federal Reserve about needing to remain vigilant on inflation will likely do the trick as they try to push out current expectations of near-term rate cuts.”That remains good advice heading into December, and as stated above, before any potential disappointment from the Federal Reserve. Let me repeat the following from last week’s newsletter:“I know many got caught flat-footed by the magnitude of the recent rally. Therefore, if you are underweight equities and feel pressured to add positions, do so carefully. As an individual investor, there is no need to chase markets. Use pullbacks opportunistically to add exposure as needed to match your risk profile. The following rules are helpful in adding exposure in a tenuous environment.” 

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