Important Market Lessons

There is a lot to be learned from the two stock market corrections that occurred during the past 13 months.

Last year the S&P 500 index fell 11% between August 17th and August 25th. By November, it had recovered and set a new high. It then fell again, by 12.4%, between December 29th and February 11th. Since then it has climbed 19%. I believe that analyzing the causes of those corrections – and the reasons behind the recoveries – will give us a great deal of insight about what is likely to happen during the months ahead.

There was a clear pattern in those corrections and recoveries. The corrections were caused by concerns that Fed interest rate hikes would cause the Dollar to strengthen. The recoveries came when the Fed backed away from planned rate hikes, alleviating fears that the Dollar would strengthen further. Understanding this pattern is important because the Fed is once again considering hiking rates, either in September or December – or both. If it does increase interest rates, stocks are likely to tumble again; and, then, to rebound again after the Fed backtracks once more.

Let’s review what happened, beginning with the August 2015 correction. The Dollar began strengthening in July 2014. Over the next nine months the Dollar index moved up 25%. This occurred because the Fed was hinting that it planned to hike US interest rates at a time when the European Central Bank and the Bank Of Japan were loosening monetary policy with Quantitative Easing. The stronger dollar caused a sharp fall in commodity prices, which dealt a serious blow to the commodity producing emerging market economies and to their currencies.

At that same time, China’s economy was weakening rapidly, in part, because the appreciating Dollar was pushing up the Yuan and damaging China’s exports. (The Yuan was closely tied to the Dollar.) World trade had begun to contract sharply in dollar terms. Global sentiment was weak and there were concerns that the planned rate hikes by the Fed would make matters much worse.

Against this background, China devalued its currency by more than 3%, sending shock waves around the world. Suddenly, China’s exports were 3% cheaper (and more competitive), while China’s purchasing power was 3% less. Consequently, commodity prices tumbled further and the Emerging Markets were hit. The following week, global stocks sold off.

The Fed had signaled its intention to hike US interest rates at its September 2015 meeting for the first time in nearly a decade. The market correction forced it to change its plans. When the Fed announced that it would not hike rates that month, the markets began to rebound. The S&P 500 set a new high in early November.

In mid-December, however, the Fed did hike by 25 basis points. Furthermore, it suggested that it would hike rates four more times during 2016. The second correction began at the end of that month. By January, market sentiment was terrible. There were widely held concerns that the bottom was about to drop out from under global markets. Commodity prices continued to drop. Oil fell to $27 per barrel. The outlook for the global economy looked quite alarming.

Then things changed. In late February, the Finance Ministers and the Central Bank Governors of the G20 countries met in Shanghai. Although no deal concerning the Dollar was announced, there has been a considerable amount of speculation that a deal was struck to weaken the Dollar. In any case, two weeks later, in a remarkably dovish turnaround, the Fed abandoned its plans to hike US interest rates four times during 2016. Two hikes were reported to be more likely. So far, there have been none.

Afterwards, the Dollar weakened and stocks, commodities and emerging market currencies recovered. Oil nearly doubled from its January low. Gold also moved significantly higher.

There is good reason to believe this pattern is likely to continue recurring. If the Fed does hike interest rates, then stocks, commodities and emerging market currencies are likely to fall. In addition, China is likely to allow the Yuan to depreciate further, adding to global deflationary pressures. However, if that scenario does play out, don’t despair. The Fed is quite likely to backtrack once again by pushing back expectations concerning the timing of future rate hikes or by actually cutting rates if the selloff is too severe.

As I have written many times before, the Fed is driving the economy by pushing up asset prices. It will not sit idly by if asset prices plunge. It will push them back up again – one way or another.

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