S&P 500 and the Goldilocks Taper narrative

by George Hatjoullis

S&P500The performance of the S&P 500 in the last few months has impressed even a bull like myself. September is normally a seasonally weak month for the S&P but it powered through largely unscathed. Indeed it has done so despite various scares; tapering, intervention in Syria, government shutdown and risk of default. Despite all this the S&P has made new highs. A very powerful bull market. The pattern has been consistent. The narrative has changed to favour the market and this is a good clue that the market still wishes to go higher.

The prevailing narrative has a Goldilocks feel about it. The economy is not growing particularly fast but it is growing. Indeed it is growing just at the right pace to keep the Fed erring on the side of caution (“just right!” said Goldilocks). The consensus is that the Fed will not introduce a taper this week and indeed probably not until next year. This is a somewhat naive view as it implies a rather simplistic Fed reaction function. One can only hope this is an incorrect view.

The Fed is not unaware of the state of the economy and of the influence or rather lack of influence of the current stance in monetary policy. It is concerned not to upset a delicate balance by beginning tightening policy too soon. It is also aware of the impact of its policy stance on asset prices. The longer the rally goes on based on an easy money narrative, the greater the risk of a severe adverse response to the onset of less easy money. If the market response is sufficiently severe even a small tightening will have severe real economy effects. The Fed would thus not be in control and find itself a hostage to the market. Is this really desirable?

My previous blogs have already suggested that the sooner the Fed gets the event ‘taper’ out of the way the more control it will have over monetary policy. The taper does not need to be large or even preset. It merely needs to begin. It can then vary the amount or even halt if circumstances are deemed to warrant. The current policy stance is starting to distort risk perceptions and this will then distort positions. When reality dawns again the markets may fail. If the Fed has learned anything from the 2003 to 2008 experience it should taper this week, albeit gently, and introduce some uncertainty into the market context. This would allow a healthy correction and set up conditions for a sustained rally in stocks.

The S&P 500 chart (see above and courtesy of IG Index) shows new highs but falling momentum. The market is set up for a correction and may do so after the FOMC meeting irrespective of what the Fed does. The ‘natural’ correction is only likely to be down to circa 1680, from which another grind higher would be likely. This is the most one could expect from a no change stance. Introducing the taper might give a deeper correction but get the taper event out-of-the-way and change the narrative from ‘when’ to ‘how quickly’. The latter is a healthier state of affairs and returns control to the Fed. There is little risk in the greater scheme of things as this is a strong bull market and the run-up to Christmas a seasonally good period for equities. The greatest risk would be if the S&P 500 was encouraged to keep climbing without any pause.