Snapshot Notes - August 5, 2008


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TUESDAY, AUGUST 5, 2008

No Surprise From Fed Or Market Reaction

08/05/08 3:15 PM EST

As of:

SPX 1251

HELP ARCHIVE

This morning I mentioned some tendencies regarding these Federal Reserve interest rate decision days, in terms of when the market was negative the day before the decision, and also in terms of the gap up opening. So far, equities have responded in line with their historical precedents.

It is unusual, however, just how much stocks were up just prior to the release, with the S&P 500 gaining nearly 2% from yesterday's close. Over the past decade, I could find only one other day with such a large gain before the statement was even released – 3/18/08, which rallied into the close then gave it all back the next day. There was one other one with a +1.5% gain prior to the announcement (10/15/98), after which we again rallied into the close then went basically nowhere for a week.

In total, there were 7 days that showed +1% gains prior to the FOMC release. They added on further gains into the close 4 times. But by the next day’s close, only 2 were higher than where the market was prior to the release, and the average return was -0.9%. Taken from the equivalent of today's close to the close three days from now, again 2 of 7 were positive and the average return was -0.6%. Both winners were under 1%, and the risk/reward was titled 2-to-1 to the downside, helping to confirm the post-Fed tendencies we went over this morning.

We're also seeing a negative reaction in Treasury Bonds as stocks rally, with the yield on 10-year Notes up about +0.9% from yesterday (bond yields rise as the price falls). I looked for any time the S&P was up 1% or more on an FOMC decision day, while yields on the 10-year Note also rose at least +0.75%. Basically, we want to see what's happened when stock traders liked the Fed's approach and bond traders didn't.

The following day, the S&P 500 was negative all five times it has occurred, averaging a loss of -1.1%. Even a week later, only one was positive (just barely) though the average return didn't change much at -1.0%. Most of the decline was immediate, then stocks went into a period of choppiness.

We have pretty small sample sizes here because of the "extremeness" of the reaction we're seeing, but it helps confirm what I mentioned this morning as the most likely scenario - a positive reaction into the close, perhaps a bit of upside follow-through early tomorrow, then some give-back of these gains and choppy behavior after that. If we continue to rally into the close, then we could get some overbought extremes among our more sensitive guides, so if we get that and an early push higher tomorrow towards the recent highs (1285-1290 on the S&P), I'll look for that rally to fade over the coming day(s).

The Fed Had Better Not Surprise Us

08/05/08 9:15 AM EST

As of:

SPX 1251

HELP ARCHIVE

Good Tuesday morning...We begin the day with a fairly large gap up open indicated in the equity futures as commodities are getting hit hard across the board, and foreign markets are very strong (ex-Asia). Traders will be watching the ISM Non-Manufacturing Survey after the market open, but the most attention is focused on the FOMC interest rate decision (and particularly any changes in their accompanying statement) at 2:15pm EST.

As always, I have no time for the guessing game of what the Fed is going to do or should do, rather I just follow the futures market, which has a record better than any "expert" economist in the days leading up to scheduled FOMC meetings.

Currently, the Federal Funds futures market is implying a 93% chance of no change in the target rate, and a 7% chance of a 25 basis point increase. That is unchanged from a week ago, and a slight increase in the chance of no change from a month ago.

For September's meeting, there is a 66% chance of no change and 32% chance of a 25bp increase, and by October the chance of no change drops to 49% while the chance of a small bump up increases to 41%. So traders are looking for an increase in the Fed Funds target rate in the coming months, but they will be surprised if it comes today.

And as we know, traders do not like surprises. Surprises create uncertainty, and uncertainty equals volatility. Almost always, volatility equals negative price returns.

Yesterday we discussed the idea that there tends to be an upward drift heading into a scheduled FOMC rate decision, so if we had another down day that helped to generate some short-term oversold readings, then we should have the ingredients for at least a blip higher.

Yesterday's selling pressure wasn't intense enough to push many of our sentiment-based guides into oversold territory. Still, there is something of a positive bias here...if the day before a scheduled FOMC meeting was down 0.75% or more, then buying that day's close and holding through the day of the meeting was successful only 4 out of 8 times - but holding through the next day's close was a winner 7 of the 8 times by an average of an impressive +1.6%. Regardless of the market's reaction to the Fed's decision, the market tended to rally the next day if it got hit fairly hard leading into the decision.

Looking at those instances, there were 4 times when the S&P 500 gapped up 0.5% or more the day of the meeting. It closed higher than the open 3 times by an average of +0.5%. If we just look at any time the S&P gapped up 0.5% or more the morning of an FOMC decision (regardless of what it did the prior day), then it closed higher than the open 8 out of 9 times, and tacked on an extra +0.5% on average during the day.

The next day, however, it was up only 3 of the 9 times and sported a -0.6% average return - while negative, on average it wasn't enough to completely take away the gains by buying the day prior to the meeting. By three days later, though, it was up only 2 times and the average dropped to -2.1%, with an average maximum risk (-3.1%) that was three times larger than the average maximum reward (+1.0%) during those three days.

That helps to confirm something I noted yesterday (and every time we have a major economic release) - extreme reactions to these events tend to be better contrary indicators than anything in the short-term, so generally it tends to work better to "fade", or trade against, a big directional move after the news is out.

If I was going to trade purely based off historical reactions, then I would be looking for stocks to continue higher into the FOMC decision this afternoon, with volume dropping off precipitously around the noon hour. After the decision, I would expect two or three violent whipsaws, then a more directional move into the close, probably to the upside. After some additional upside follow-through tomorrow, I would then expect some of the gains to be given back over the subsequent sessions.

The market never follows these patterns exactly, but it at least provides a solid base of what we can expect if there are no surprises in the Fed's release. We'll have to wait until after the news is out and traders have an opportunity to digest the implications going into the close to get a better handle on what we might most reasonably expect in the coming day(s).

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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