Has The Focus For Stock Market Success Changed? – Seeking Alpha

Over the past eight years or so, the success mantra for the US stock market has been “to follow the Fed” or “Don’t Fight the Fed.”

As the Federal Reserve has gone through three rounds of quantitative easing, followed by a period where Fed officials have modestly increased the Fed’s policy rate of interest, but only if the increase was justified by the economic data, with the caveat that the Fed would always err on the side of ease so as not to disrupt the recovery of the economy.

This policy stance was aimed at creating a stock market “wealth effect” that would provide the support for increasing consumer spending and the rising consumer spending be the foundation for sustained economic growth.

The Fed’s monetary policy has resulted in a massive climb in the stock market, the S&P 500 index has risen by 170 percent since June 29, 2009, the last business day of the “Great Recession,” and the economy has risen consistently since the second quarter of 2009 at a 2.1 percent compound rate of growth.

Note that from the stock market trough in the “Great Recession”, which occurred on March 9, 2009, the S&P 500 index has risen by 270 percent.

Along the way, the stock market has continuously reached new historic highs, the latest being achieved on Tuesday, September 12, 2017.

The “Don’t Fight the Fed” mantra developed during this time period as the stock market rose in general, with little discrimination between various sectors of the economy. The Federal Reserve policy impacted the economy “generally”, and it also impacted the economy “generally.”

The crucial fact supporting this “general” rise in the market was the correlation between sectors and companies and the stock market indexes. Morgan Stanley reports that a year ago, the correlation of companies that make up the S&P 500 stock index was about 60 percent one year ago.

This market has been a real winner for passive investment funds during the eight-year economic recovery from the Great Recession and large amounts of funds have moved into passive vehicles as the evidence of their higher performance accumulated.

Whether or not the stock market, in general, continues to grow and continues to reach newer historical highs and whether or not the passive investment funds will continue to outperform all others seems to depend upon one thing…whether or not the Federal Reserve continues its policy of accommodating further increases in the stock market.

And, this concern, I believe, is one of the major factors weighing on investors’ minds these days. Doubts are growing.

Akane Otani writes in the Wall Street Journal that there seems to be growing skepticism about the ability of the stock market to go higher. He presents evidence that the “percentage of investors who say they are bullish on stocks’ direction over the next six months is trending downwards.

Mr. Otani presents evidence that investors are moving into “assets considered safer stores of value” like gold futures.

And, short interest on the S&P 500 index has dramatically increased during 2017.

Mr. Otani writes “many investors and analysts are finding reasons for the eight-year bull market to draw to an end. Some are concerned that stocks have risen with few prolonged interruptions, especially given the uneven pace of US economic growth. And, others are nervous that the Federal Reserve, which is looking to raise rates and wind down an unprecedented asset-purchase program, could send stocks tumbling.”

Still, stock prices continue to rise to new highs.

Could one change in the environment be an indication that the “times are a changin'”?

In an earlier post, I recommended that we should “Watch the Hedge Funds.” Well, maybe we should start paying a little more attention to what is happening in the hedge fund space.

Lindsay Fortado writes in the Financial Times that this year, the funds that are relying more on stockpickers are outperforming funds that have a different focus.

“Nearly three-quarters of the way through the year, hedge funds focused on equities are outperforming nearly every other strategy.”

“The better showing comes as the US stock market has broken free of the tight correlations of recent years in which sectors have generally moved up and down together, a pattern that has favored passive investors over stockpickers.”

The Morgan Stanley report alluded to above now shows that the current correlation number is just under 20 percent, down from the 60 percent number of one year ago.

Could this be a sign that the value of the investor focus of the past eight years is now coming to an end as the Federal Reserve is faced with a situation that is not so conducive to underwriting continued stock market gains?

The stock market is still increasing to new highs because many investors continue to bet that the Fed will continue as it has over the past eight years.

But the confidence in the Fed continuing to underwrite the stock market may be weakening as investors wait to see how the Fed will handle its balance sheet reduction exercise and see whether or not the Fed continues to raise its policy rate of interest.

And, if market correlations are changing because of what is happening in the economy, what is happening to the government’s economic policy, and what is happening in the world, then we may be entering a new phase of stock market performance.

Katie Martin writes in the Financial Times: “Banks continue to report being inundated with questions about when the wheels will finally come off major markets.”

She goes on that “Investors are spooked by the notion that high valuations, poisonous politics, and a potentially synchronous rush to the exits by quant funds could reach the boil at the same time.”

Still, as we are well aware…stock markets can remain at high market levels for indefinite periods of time, regardless of what the underlying stories are. As the economist Robert Shiller argues when he discusses the fact that his measure of stock market value, the Cyclically Adjusted Price Earnings ratio, CAPE, has indicated that the stock market has been overvalued for years, there is no correlation between an overvalued stock market and the time that a market correction takes place.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.