The Fed is Not this Market's Friend

The Fed is Pulling the Interest Rate Carrot Away from the Market

Stocks are trading lower this morning as treasury yields move higher.  We really haven’t heard that much talk about treasuries, so I’ll dive in for a minute.

Two weeks ago, we saw inflation readings from the CPI and PPI reports that suggested maybe, just maybe, inflation was slowing.  That would be a good thing, right?  But the “Fed Heads” have been very vocal over the last week about their intention to continue a “wait and see” outlook on when they’re prepared to lower interest rates.

That’s a problem, because the one thing that is getting on consumers’ nerves more than inflation right now is high interest rates.

Yesterday, Federal Reserve Bank of Minneapolis President Neel Kashkari suggested that the Fed could raise rates before they start easing.  Kashkari’s comments are part of a growing chorus from the Fed.

The bond market was listening and reacting.

The yield on the Ten-Year Treasuries is often seen as an indication of where interest rates are heading.  This morning, that yield moved aggressively towards its recent highs at 4.7%.  This is a signal that bond market traders, “the smartest money in the room” are preparing for more “longer and higher” talk from the Fed.

At its core, that’s not great for stocks and it suggests that we may see a tough June.

TNX Price Chart

Let’s Talk About Market Breadth for a minute.

Market breadth has turned negative, and that’s something you need to watch.

Last night, in my latest “Three Stocks” YouTube video, I touched on the lack of breadth in the market.  This may turn into a larger problem as we approach June.

The market feels great.  Stocks are moving higher, and we keep hearing about how the S&P 500 and Nasdaq 100 are closing at new all-time highs.  But there’s a problem with the math behind those new highs.

The chart below displays the percentage of stocks in the S&P 500 that are trading above their respective 50-day moving average.  This is one of the best ways to measure the breadth of a market trend.

When the percentage of companies above their 50-day is trending higher it tells us that the market’s breadth is strong as more stocks are participating in the rally.

Note that the last two weeks have seen the percentage of companies above their 50-day rollover and begin to trend lower.  This means that the market has been moving higher while the number of stocks above their 50-day is getting smaller.  That’s a sign of weakening breadth.

S&P 500 Percent above their 50-day Indicator

The bottom line here is that the market’s advances have been on the backs of fewer stocks.  You know the names, Alphabet, NVIDIA, and the other investors “favorites”.  At some point, these companies will get “tired” and that’s when the market will start moving aggressively lower.

For now, this is a warning.

One More Chart to Guide You Through this Market

Interest rates are turning back into the market’s Achilles Heel, and there’s no index that displays the effect of that interest rate risk like the Russell 2000 Index.

The Russell 2000 is comprised of stocks from the small cap universe.  These are the stock that are more interest rate sensitive than large cap stocks because they don’t have the same bargaining power to negotiate lower rates to fund their business.

For that reason, you’ll see more of a relationship between the Ten Year Yield that I discussed above and the small cap Russell 2000 Index.  But there’s more.

The Russell 2000 also does a better job of reflecting investor’s appetite for risk and speculation.  I always say that the market is driven by speculation, not necessarily fundamentals.  For that reason, I always maintain a vigil eye on the activity of the Russell 2000 ETF (IWM).

Today’s drop in the market is taking the Russell 2000 ETF below its 50-day moving average.  That same 50-day is trending in a neutral trend, which means that a few days of additional selling will put the trend for small cap stocks in a short-term bearish pattern.

IWM Price Chart

The last break below its 50-day moving average resulted in a quick 5% drop in the IWM just a little over a month ago.

Here’s the catch.

We’re heading into June, which is one of the seasonally weaker months of the year.

Combining the weak seasonality with a technical breakdown in small cap stocks is likely to see a little more extended selling as investors will begin to take profits in a market that feels like it has been dodging a healthy correction for more than six months.

Here’s How I Position for this Short-Term Bearish Outlook.

Using the IWM as my gauge, I start to reduce my exposure to some of the high-flying stocks that have made this rally work.  Leaders in the Nasdaq 100, semiconductor companies and the financials.

Personally, I choose to hedge some of the risk of the market away using a combination of inverse ETFs like the ProShares Short QQQ (PSQ) or the ProShares UltraShort QQQ (QID).  Keep it simple and easy by targeting a price where you will close those hedges out when you buy the hedge.

More aggressive traders may choose to use put options to hedge.  I favor put options that are at-the-money with roughly 60 days until expiration.

At the time of this writing I am considering the IWM July 19, 2024, $200 puts as a short-term hedge.  As with the inverse ETFs, make sure that you set a target to close an option position.  You’re not trying to hit the ball out of the park with hedged positions, just protect some of your portfolio against short-term drops in the market.