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Market Forecasting Fed Disappointment

As shown in the chart below, the Dow was having a rough day on August 9 as it waited for the Fed's statement to be released. After digesting the pledge to keep interest rates low "at least through mid-2013", stocks spent the rest of the day rallying.

Since top performing ETFs that experience gains on above average volume can turn out to be attractive investments during the subsequent rally, we screened ETFs after the close on August 9 looking for:

  1. The day's top performers in terms of percentage gain.
  2. ETFs that trade at least 500,000 shares per day.
  3. ETFs that had daily volume on August 9 above their 3-month average volume (conviction).

The screen above helps us keep track of where institutions, pension funds, hedge funds, etc. are seeing potential for gains. You would think that if the market was anticipating a similar bullish reaction to this Wednesday's Fed announcement, the top ETFs from August 9 would have (a) made money on Tuesday (9/20), and (b) seen a lot of buying interest as measured by trading volume. There were fifty-three ETFs that met the criteria above after the close on August 9. On Tuesday of this week, only 25% of the fifty-three ETFs made money, posting an average gain of 0.49%. The lack of interest in Fed-friendly assets was highlighted by the 75% of the fifty-three ETFs that lost ground on Tuesday, posting an average loss of 0.79% (see table below).

Using the figures above, a back of the envelope "Fed Risk-Reward Announcement Forecast" yields a weak ratio of 0.20. A ratio of 1.00 would "forecast" 50-50 odds of a favorable reaction to the Fed. Tuesday's ETF activity leans toward a disappointing reaction to Wednesday's Fed announcement. Obviously, the most important thing to watch is price and volume action (conviction of buyers) from 2:15 to 4:00 p.m. on Wednesday. However, given the Fed has telegraphed its menu of possible policy options, the market does not seem to be anticipating a strong rally to follow the Fed announcement; if it did, it stands to reason the buying interest in Fed-friendly ETFs would have been more convincing on Tuesday.

Is the market anticipating a somewhat surprising announcement of QE3? Based on the performance of QE2-winning ETFs on Tuesday, the answer appears to be a definitive "no". We have been tracking QE2 winners for a few weeks looking for signs of life. More details on recent performance of QE2 ETFs can be found here.

Concerns we have mentioned in recent weeks, including tepid interest in Emerging Markets and Greece / weak technicals, also align well with the possibility of a disappointing reaction to the Fed's statement. Another scenario calls for a sharp rally to roughly 1,260 on the S&P 500, followed by a sharp reversal. The bullish scenario where debt problems in Europe are resolved and stocks sprint higher into year-end remains a possibility, but not a highly probable outcome. Our large cash position allows for a flexible stance heading into the Fed meeting. If the S&P 500 (SPY) breaks below last Monday's low of 1,136, we would consider adding to our deflationary/bearish stance, which includes bonds (TLT), the dollar (UUP), gold mining stocks (GDX), and a short (SH).

 

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