The Fed’s decision to unveil its buying policy – to cut its bond purchases every month until it falls to zero by the end of next year- sent prices to new highs. The surge surely is contrary to fundamentals –because the Fed’s stepping back means higher interest rates, and those in turn will lead to reduce the price of all assets.
Nevertheless, this policy shift played well with investors for two reasons. First, it eliminated uncertainty. The question of when and how much the Fed will cut back on its purchases had dominated financial commentaries for too long. Now with that ambiguity removed, the uncertainty resolved, buy, sell and hold decisions will depend only on personal and business fundamentals.
The second, even more telling result is its dampening of inflationary expectations. Whether correct or not, there are many who believe the Fed’s buying activity results in higher commodity prices. Now with the Fed’s turn around, the resulting boost in confidence supports expectations of higher security prices.
Yet today’s surge signals caution, for gains this large accompany market declines more often than occur in bull markets. The diagram shows these large gain days clustering at market bottoms. Indeed, they account for 6.7 percent and 10.7 percent of all closes during the last two bear markets. In contrast, this proportion falls to 3.9 percent in the current expansion. Further, today’s combination is only the third this year, though there were 20 in 2009. That number has declined in each of the following years. There were 12 in 2010, 7 in 2011, and just 2 last year. All told, these early happenings account for nearly a third of the 38 large gain days in the current bull markets.
DJIA 1.84 percent
NASDAQ 1.15 percent
S&P500 1.66 percent
