​As Sam Sees It: How Much Room Does the Fed Have to Work With?

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: As expected, the Fed announced it will raise interest rates to 2-2.25% for September and maintained its pace for December and 2019. It also provided a more upbeat projection for economic growth while removing the “accommodative” language from its statement. The market responded favorably to the news. What were your thoughts?

Stovall: Overall, the Fed really didn’t do anything that most investors and Fed watchers hadn’t anticipated. Yes, they raised rates and they indicated that there would be a fourth rate increase this year as well as three more in 2019. They did remove the accommodative language, and I believe that since investors are not looking for a spike in the inflation rate, they don’t really think that the Fed will have to take on a more aggressive stance.

Also, with the trade rhetoric heating up, that could end up reducing economic growth and also inflationary tendencies. That would likely allow the Fed to stay ahead of the curve, and not slip behind it as it has done in the past.

EQ: Because of the Fed’s seemingly business-as-usual approach and upbeat economic forecasts, do you think that helped to calm investors’ nerves regarding trade tensions?

Stovall: Yes. The market does not like surprises, and there were no surprises in my opinion in what was done or said by the Fed. So, in this case, with the financial media letting us know what to expect and then actually having that come true, I think it helped to calm investors’ nerves and cause the whole Fed meeting to be essentially a non-event.

EQ: In this week’s Sector Watch, you pointed out that historically, bear markets don’t occur when the differential between the Fed funds rate and year-over-year change in CPI is as narrow as it currently is. Based on this metric, how much wider would it need to get before it becomes a potential concern?

Stovall: Historically, the Fed funds rate has been above the year-on-year change in core CPI by an average of 2.5 percentage points before a bear market. There is one observation, in 1955, where it was only 0.8 points above.

Right now, with the Fed funds rate being in a range of 2-2.25%, and the most recent year-on-year CPI reading being in the upper-end of that range, we probably would have to see the Fed raise one more time before we end up in the net neutral real rate policy. What that means is when inflation is to equal interest rates.

Yet, we would still need to see the three rate increases in 2019 before we come close to that minimum threshold that we’ve seen over the past 60 some-odd years before slipping into a bear market. Of course, there’s no guarantee that it’s the only indicator that the market is looking at, but it’s certainly one to gauge how restrictive monetary policy is relative to inflation.

EQ: This week marked the sector recategorization of many of Wall Street’s favorite stocks, most notably with the creation of the Communication Services sector and elimination of the Telecom group. How does this shakeup better reflect the landscape of the current market and economy?

Stovall: What happens, first off, is the Telecommunication Services group simply becomes the Communication Services group. Instead of having only three companies in it, we now end up with a multiple of companies because it took companies out of the Consumer Discretionary sector as well as the Information Technology sector.

The weighting in the S&P 500 came down for Consumer Discretionary by a couple of percentage points and is now around 10%. Information Technology’s weighting went from about 26% down to a shade below 21%. Telecom used to be 2% but Communication Services is now closer to 10%.

It’s still the same number of stocks in the S&P 500, but they are simply being grouped into different categories. So, it really would have no effect on the market itself. It would simply alter how investors might categorize those stocks. There are still 11 sectors in the S&P 500, but the characteristics definitely do change for the Communication Services group. Instead of being a high yielder at 5.4% as it is today, it will come in closer to 1.4%.

In terms of volatility (beta), instead of having an average beta of 0.6, it will end with a beta higher than 1.0. So, this traditionally defensive, high-yielding, low-volatility group will change its stripes to become a more low-yielding, cyclical category.

EQ: What are the implications for investors, particularly for those that have adopted more passive strategies through sector ETFs and index funds?

Stovall: If you are a holder of the S&P 500 index fund, the answer is nothing and nothing. Meaning, it really will not affect what you do and your portfolio because there will be no effect on the S&P 500. It’s simply moving deck chairs on a steamship. The actual count and the percentage that each company represents on the index has not changed. It’s just how they are categorized below the surface.

Only if you are a sector rotator do you need to pay closer attention because, as I mentioned, now the characteristics of the sectors is very different from its foundation. Somebody who just uses the broad benchmarks, yes, it’s good to be aware of what happens to the overall benchmarks but it’s not something you need to worry about.

EQ: What about for those investors that do rely on sector-based rotation strategies?

Stovall: Sector SPDRs has already come out with the Communication Services ETF (XLC) for the new group, and there are other companies that do offer sector level ETFs and funds that have or will come out with new offerings.

If, however, you are one who looks more at sub-industries, I have a sub-industry Momentum Portfolio on our MarketScope Advisor platform. Here is another example in which things do not change because it looks for those sub-industries with the strongest trailing 12-month price performance, so it has more to do with the sub-industry than it does the overall sector.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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