Fed: Sooner Than Expected?

We noted on July 26 and again on July 29 that recent data may force the Fed to raise rates sooner than the market expects. Note the first item in the The Wall Street Journal's list of what may have sparked Thursday's selloff:

Investors said an upbeat reading from the labor market sowed concerns about the Federal Reserve possibly raising rates quicker than many investors anticipate. Some pointed to disappointing earnings reports from U.S. companies Thursday, which disrupted what has been a strong season for corporate profits. Others pointed to Argentina's default on some bonds and fresh worries that the euro zone's central bank will need to provide more stimulus.

Evidence Showed Mounting Concerns

Regular readers know we use hard data and evidence in hand to assist with risk management. Three examples were helpful in recent days; last Friday's video outlined evidence of waning bullish conviction, a July 26 article showed a lower high that was forming on the weekly NYSE Composite chart, and a July 30 piece showed evidence of concern on the ratio of stocks (SPY) relative to bonds (AGG).

Evidence Continues To Say Be Careful

Is there anything else that can help illustrate the observable shift in investor confidence that has been taking place? Yes, we could cite numerous examples, including the charts below showing the performance of the S&P 500 relative to the VIX Fear Index. The first chart shows a bullish breakout that occurred in early May (see green arrow). Notice how the risk-on vs. risk-off ratio stayed above previous resistance (red arrows) for several weeks and carried into July 4th weekend. The second chart shows the same ratio as of July 31. The breakout has been "given back", which indicates investor concerns have increased sharply.

Inflation Creeping Into Wages?

Wednesday's FOMC statement noted the Fed "will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments". A big part of what spooked the markets Thursday was new data showing inflation potentially creeping into wages. From Reuters:

U.S. labor costs recorded their biggest gain in more than 5-1/2 years in the second quarter and a gauge of trends in the jobs market fell to an eight-year low last week, bolstering the economy's outlook. Though economists cautioned against reading too much into the rise in the employment cost index, they said a tightening jobs market suggested wage growth would soon accelerate significantly.

Investment Implications - The Weight Of The Evidence

Our market model uses a wide array of inputs to monitor the stock market's risk-reward profile. Enough deterioration was present on July 25 to trigger two rules-based defensive chess moves, cutting equity exposure (VTI) and adding some bond exposure (TLT), along with some cash.

Thursday's broad selloff called for another reduction to the equity side of the equation. We will enter Friday's session with more cash and an open and flexible mind. The market now needs to "prove it to us" before we will consider redeploying assets into growth-oriented assets. The key is not to anticipate or forecast - we need to see it.