Why the Fed Had to Fold

With the Fed’s final meeting of the year now behind us, the markets can finally move on (for now, at least) from the constant speculation about a rise in interest rates…

As I’ve been writing here for some time (here and here), the markets had already priced in at least two (and probably three) rate hikes for 2022.

And that’s what the Fed delivered…

It has now laid out a clockwork plan to raise rates higher – three quarter percent rate hikes in 2022, the same again in 2023… followed by another two hikes in 2024. By the time the Fed finishes its tightening cycle, that will put the cash rate around 2.1%.

That’s the schedule (and tightening policy) the Fed believes will achieve its goal to rein in inflation without punching a hole in the economy.

It would be nice to have the economy like that on a string…

But that’s the thing… with the consumer price index (CPI) recording its highest reading in 39 years at 6.8% – and its seventh consecutive month at 5% or higher – the obvious question must be if the Fed waited too long to act. After all, it’s not like inflation just jumped up out of nowhere…

After initially selling down on the rate hike news, the major indices turned around and closed near their daily highs. That puts both the Nasdaq (up 1.6%) and S&P 500 (up 1.2%) on the day and back within a whisker of their all-time highs.

For now, the market is buying the story that the Fed will get the balance right between hiking rates and controlling inflation.

However, while the major indices might be looking strong – with market leader Apple (AAPL) closing back in on a $3 trillion market cap – the next layer of stocks are already starting to struggle. This week, Bloomberg noted that almost two-thirds of Nasdaq stocks are trading below their 200-day (long-term) average.

That means it’s the familiar mega-cap tech growth stocks that continue to dominate and determine the market’s direction. And that makes the market even more vulnerable to any correction in these handful of stocks.

The way I see it, the risk in these stocks (and thereby the market) lies with any contraction in the sky-high multiples (price to earnings ratios or P/E) these stocks currently trade on. The higher the P/E ratio, the more investors are betting on earnings growth… and the more vulnerable they are if those earnings don’t materialize.

While Microsoft (MSFT) and Apple trade on P/E ratio multiples of 37 and 31 respectively, others in this group are significantly higher. Amazon (AMZN) trades on a P/E of 66 and Tesla (TSLA) is almost off the charts at over 300.

Any pullback in consumer confidence – including a hiccup in the economy – and these higher P/E ratios will come under pressure.

And that brings us back to where we began with the Fed and how it hopes to walk the tightrope in increasing rates without pulling the rug on the economy.

Unless the Fed gets ahead of the inflation curve (it’s starting well behind it already), then rising inflation could force it to raise rates more quickly (and by a larger amount) than it foreshadowed at its meeting this week.

And as the largest consumer-facing stocks on the planet, that means stocks like Facebook, Amazon, Apple, Netflix, and Google (FAANG) (and by extension, the market) are particularly vulnerable to any decrease in consumption.

As I wrote last week, investors will need to be increasingly nimble in how they approach the markets. That means hunting out one-off situational events… not just sitting back and blindly holding the same stocks as they did last year, and the year before that.

One thing is for sure… with interest rate rises now locked in and inflation nowhere yet under control, when it comes to trading opportunities, 2022 is shaping up as one for the ages.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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