{"id":54265,"date":"2020-08-30T18:05:35","date_gmt":"2020-08-31T01:05:35","guid":{"rendered":"https:\/\/drduru.com\/onetwentytwo\/?p=54265"},"modified":"2020-08-31T07:32:51","modified_gmt":"2020-08-31T14:32:51","slug":"t2108-update-overbought-stock-market-celebrates-new-fed-inflation-policy","status":"publish","type":"post","link":"https:\/\/drduru.com\/onetwentytwo\/2020\/08\/30\/t2108-update-overbought-stock-market-celebrates-new-fed-inflation-policy\/","title":{"rendered":"An Overbought Stock Market Celebrates New Fed Inflation Policy – Above the 40 (August 28, 2020)"},"content":{"rendered":"\n

Stock Market Statistics<\/strong><\/h2>\n\n\n\n

AT40<\/strong> = 71.2% of stocks are trading above their respective 40-day moving averages (DMAs) (ended 7 overbought trading days)
AT200<\/strong> = 46.5% of stocks are trading above their respective 200DMAs
VIX<\/strong> = 23.0
Short-term Trading Call<\/strong>: cautiously bearish<\/p>\n\n\n\n

Stock Market Commentary<\/strong><\/h2>\n\n\n\n

Last week was not a good time to be sitting on the sidelines of the stock market cloaked in bearishness.<\/p>\n\n\n\n

When I saw the convincing signs of a bearish divergence<\/a> in the stock market the previous week, I decided against an “easy” downgrade from cautiously bullish to neutral. While bullish trades still abound in the market, the remaining runway looks shorter and shorter for this moment of sky high valuations, soaring prices, and relentless momentum and speculation. Therefore, I prefer to get mentally and positionally ready for a pullback rather than attempt to time an exact top.<\/p>\n\n\n\n

The week ended with AT40 (T2108)<\/a>, the percentage of stocks trading above their respective 40-day moving averages (DMAs), closing above the 70% threshold for overbought conditions. Along the way to overbought conditions, another bearish divergence flashed on Wednesday, the day before the start of the Jackson Hole confab with the globe’s major central bankers<\/a>. The trading conditions were very similar to the previous Friday’s bearish divergence: the S&P 500 and the NASDAQ printed healthy gains, 0.6% and 0.6% respectively, yet small caps and financials closed in the red, AT40 closed down on the day (and fell short of the overbought threshold), and decliners well outpaced advancers<\/a>. As a result, this latest ride into overbought conditions appears to have weak foundations.<\/p>\n\n\n\n

Yet, the Federal Reserve looms large as ever over the trading action. I had a good chuckle at the latest claims from the Fed<\/a> that it is not creating an asset bubble with its extremely accommodative monetary policies. The Fed has consistently shown itself reluctant to call out asset bubbles. Indeed, the Fed by rule is paralyzed against acting against bubbles, so by extension it cannot label a bubble in real time. For example, Federal Governor Frederic S. Mishkin gave an important speech on this topic<\/a> on May 15, 2008…ironically enough, just ahead of the near collapse of global financial markets after a massive housing bubble:<\/p>\n\n\n\n

“Central banks or government officials are unlikely to have an informational advantage over market participants. If a central bank were able to identify bubbles in the stock market, wouldn’t market participants be able to do so as well? If so, then a bubble would be unlikely to develop, because market participants would know that prices were getting out of line with fundamentals.”<\/p><\/blockquote>\n\n\n\n

This reminds me of the classic joke about the economist’s view of market efficiency. Two economists stroll down the street and one of them sees a $20 bill sitting on the sidewalk. The other economist insists that the $20 bill cannot be real because someone would have picked up the money already.<\/p>\n\n\n\n

Mishkin goes on to caution the Federal Reserve away from trying to directly address bubbles (emphasis mine):<\/p>\n\n\n\n

“To be clear, I think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements.<\/strong> This point of view implies that actions, such as attempting to ‘prick’ an asset price bubble, should be avoided.”<\/p><\/blockquote>\n\n\n\n

Since soaring stock prices can easily disconnect from the real economy and produce little, a stock market bubble can and will bypass the mechanisms that generate the inflation the Fed watches. The Fed can remain blithely on the sidelines as stocks go to whatever price market participants choose.<\/p>\n\n\n\n

Here is how Mishkin explains his caution:<\/p>\n\n\n\n

“I take this view for (at least) three important reasons.10<\/sup><\/a> First, asset price bubbles can be hard to identify. As a result, tightening monetary policy to restrain a bubble that has been misidentified can lead to weaker economic growth than is warranted. In addition, central bank actions to influence asset prices when the central bank is uncertain about the presence or extent of a bubble can interfere with the role of asset prices in allocating resources.11<\/sup><\/a><\/p>

Second, even if asset price bubbles could be identified, the effect of interest rates on asset price bubbles is highly uncertain. Although some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, raising interest rates may be very ineffective in restraining the bubble, because market participants expect such high rates of return from buying bubble-driven assets.12<\/sup><\/a> Other research and historical examples (which I will discuss later) have suggested that raising interest rates may cause a bubble to burst more severely, thereby increasing the damage to the economy.13<\/sup><\/a> Another way of saying this is that bubbles are departures from normal behavior, and it is unrealistic to expect that the usual tools of monetary policy will be effective in abnormal conditions. The bottom line is that we do not know the effects of monetary policy actions on asset price bubbles.<\/p>

Third, there are many asset prices, and at any one time a bubble may be present in only a fraction of assets. Monetary policy actions are a very blunt instrument in such a case, as such actions would be likely to affect asset prices in general, rather than solely those in a bubble.”<\/p><\/blockquote>\n\n\n\n

Ironically, the Fed sure appears quick to respond to a plunge<\/strong> in asset prices. Thus, the Fed gets the nickname the “Plunge Protection Team” (PPT).<\/p>\n\n\n\n

\n

"I don't feel right now that we are engendering an asset bubble. I do feel we are supporting the economy and we're doing what we can to make sure financial markets continue to function," says @ClevelandFed<\/a> President Loretta Mester on if equities are too highly priced. pic.twitter.com\/4C8AjhOWcV<\/a><\/p>— Squawk Box (@SquawkCNBC) August 28, 2020<\/a><\/blockquote>