Category: Blog

With the S&P down nearly 20 percent and the Nasdaq index down nearly 4,000 points since the beginning of 2022, one could say the indices are in a bear market. While we can’t predict the future, economic indicators can offer some insight into the likelihood of the market’s future performance.

There are many ways to determine how the market might act the next day, week or longer into the future. Looking at sectors and how they’ve performed against the entire market is a good way to see if it’s bottomed out or if it’s time to look at other sectors. Volatility and the near-term expectations are other ways to see how professional investors gauge the market’s future moves. Reviewing the current and expected path of monetary policy and evolving economic indicators are still other ways to determine how markets will likely perform going forward.

The VIX and Market Capitulation

The Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX) or “fear gauge” is one indicator of a market bottom. When investors attempt to hedge their investments, especially when volatility is expected, long options on the VIX can provide an “insurance policy” against falling equity prices. While there have been many levels on the VIX in the mid-30s, it often reaches levels in the 40s, 50s or even potentially higher to see a true bottom or market capitulation. Looking back to the 2008/2009 financial crisis, the VIX spiked to 79.13 on Oct. 20, 2008. Similarly, the VIX spiked to 82.69 on March 16, 2020, during the lows of the COVID-19 crash.

Measuring the Put/Call Ratio

Another indicator to gauge if the market has bottomed is when there’s a large consensus of bearishness. Using the put/call ratio, investors can see the current and past ratios of puts to calls presently held in the market. As the number of puts increase relative to call options, or the number of contracts betting stocks will increase in price over time, it indicates the market movers are expecting a down-turn in the markets. As the put/call ratio rises, it implies investors are feeling more and more bearish about the markets. When the ratio hits an extreme, higher implying a market bottom and lower implying a market top, investors are signaling they are nearing a turn in the markets.

Analyzing Moving Averages

When it comes to moving averages (a 50-, 100- or 200-day, for example), it can help establish trends for stock price action. Depending on the moving average used, the lower the number of stocks above or below a particular moving day average, the sector’s or index’s strength and direction can be measured. When it comes to measuring an index or a sector with a moving average, if a trend is showing more stocks are declining and staying below a moving average, it gives investors a sign of bearishness. If a big percentage, such as 70 percent or 80 percent of an index or sector, is below a particular moving average, this can indicate it may be forming a bottom or oversold conditions.

The Federal Reserve and Managing Inflation

According to the Federal Reserve Bank of San Francisco, the historic range for the federal funds rate grew from 11 1/3 percent to 11 3/4 percent based on decisions from the September 1979 Federal Open Market Committee (FOMC) meeting. The Oct. 6, 1979, FOMC meeting created a four percent range for the federal funds rate (11.5 percent to 15.5 percent). By the end of 1979, the federal funds rate was nearly 14 percent, reaching 17.60 percent during 1980. Then January 1989 saw a recession due to the Fed changing reserve requirements, adding on additional fees for loans directly from the Fed, and promoting the economy to be more judicious in obtaining new loans. These changes led to interest rates rising toward the end of 1980, creating another recession in July 1980. While unemployment increased, inflation fell to four percent as 1982 closed out, compared to inflation running 14.6 percent annually between May 1979 and April 1980.

Immediately before the Oct. 6, 1979, FOMC meeting, the S&P 500 index hit a peak of 111.27 at closing the day before. Following a trend that began the Monday after the FOMC meeting, it eventually hit a “double-bottom”: 100 on Oct. 25, 1979, and then 99.87 on Nov. 7, 1979. It eventually reached a high of 118.44 on Feb. 13, 1980, before falling back to its last lows on March 27, 1980, to 98.22, and then eventually seeing an upturn.

While there are many economic, technical and fundamental indicators to gauge the direction of the stock market, taking a comprehensive approach to analyze the markets is not foolproof and risk can be mitigated only to a certain degree.

The Bureau of Labor Statistic’s Consumer Price Index rose by 8.5 percent year-over-year ending March 2022, leading most economists to agree that inflation is going to be with us for a while. With inflation seeming not to abate, at least in the near term, how will different types of investments react to inflation that is sustained and unknown when it will peak and begin to drop. Looking at a 2004 study from the Federal Reserve, an unexpected 25-basis point rate cut can be expected to see equities appreciate by one percent.

Defining Different Rates

The Federal Open Market Committee (FOMC) sets the federal funds rate – the overnight rate at which banks borrow from each other. This undoubtedly will impact the economy and the domestic and global stock markets. While it can take months, if not more than a year, for a change in interest rates to have a universal impact, the stock markets see the impact sooner. This is opposed to the discount rate, which is the interest rate banks are charged when loans come from regional Federal Reserve Banks – the so called discount window.

One main reason the Fed adjusts the federal funds rate is to shape inflation. When the federal funds rate is raised, it is trying to reduce the money supply available for consumers and businesses. With less money available to circulate throughout the economy, it costs more to borrow money as interest rates rise.

Another important reason to keep an eye on the federal funds rate is due to the fact that the prime interest rate is based largely on the federal funds rate. Whether a mortgage, credit card or other personal or commercial loan, the prime interest rate is an influential factor in these lending vehicles’ interest rates. As the Fed Board of Governors explains, the prime rate is how each individual bank determines its own interest rates. Their unique prime rate is based on the target level of the federal funds rate, which is how much other banks charge them for short-term loans. Once the prime rate is established, it is used as a reference base rate for a multitude of lending products, including personal and commercial loans and credit card lines.

FOMC and Federal Funds Rate Adjustments

As the Federal Reserve increases its discount rate, short-term borrowing costs for financial institutions increase. Financial institutions in-turn are pushed to increase borrowing costs for companies and consumers. Whether it is a credit card or a mortgage, rates increase. The higher the interest rate, the less spending ability the account holder has. The account holder also sees higher bills via the higher interest rates. The higher the bills, the less money they can spend elsewhere, often impacting the economy.

Rising Rates and the Markets

Publicly traded companies can suffer in different ways. A company may bring in less revenue or have higher borrowing costs, cutting into its growth forecast or reducing its profits. Companies also may see lower growth expectations and a decline in future cash flow projections. Assuming no other changes, the stock price will likely fall. Depending on how severe the increase in interest rates, this can impact entire sectors – and depending on how much weight a particular company comprises within an index, an entire index.

Bond Market Dynamics and Interest Rate Fluctuations

Compared to corporate bonds, where bondholders are first in line to be paid if a company goes bankrupt, government securities, such as Treasury bills and bonds, are viewed as more likely to pay their investors back even in more challenging financial circumstances. This is because, according to the U.S. Securities and Exchange Commission, they are backed by the full faith and credit of the U.S. government.

As the Financial Industry Regulatory Authority (FINRA) gives an example, interest rates have a noticeable impact on bonds. Say a bond is sold for X and matures in Y years down the road with a Z percent coupon at par value. Twelve months later, interest rates have risen and another of the same type and amount of bond is issued at the same par value but is issued with a one or two percent higher coupon rate. Based on these two different bonds’ characteristics, the original bond is less attractive on the open market. If the original bondholder wants to sell a bond issued a year ago, he will have to sell for less than face value due to the more attractive interest rate of the newly issued bond.

While there is much uncertainty in the financial markets, including the FOMC and the bond and equity markets, understanding how past market moves have occurred can offer guidance to how increasing interest rate environments may evolve in this rate-tightening environment.