Posted by: Aaron Pressman on February 3, 2006
Withy today’s jobs report, it appears that the economy is stronger than most investors thought. Happy coincidence with Business Week’s cover story out today: Why the economy is a lot stronger than you think. And it’s not just today’s report, which showed the unemployment rate down to 4.7% which has people reassessing. A recent report on the amount of factory capacity in use showed the highest reading since 2000. And consumer confidence surveys are at recent highs showing no signs of real estate induced worries. So if the economy is better than we thought, why are stocks going down? It’s not the economy stupid, it’s the Fed stupid.
As a result of the stronger economic signals, the bond market's happy consensus that the Fed was about to stop raising short-term interest rates has collapsed. If you look at the futures market, where traders can buy or sell a contract directly linked to the Fed's fed funds rate, you see a dramatic shift. Where just a few weeks ago, traders gave less than even odds to a rate hike in March and zero chance of a May hike, they're now showing a 90% chance for a March hike and 35% chance for another in May. You can also see it in the currency markets. The dollar rallied most of last year as the Fed's continuous series of rate hikes made parking cash in the states more and more attractive. At the end of 2005, as investors began to expect the end of the rate rise, the dollar fell off and dropped further in January. Now the dollar is on the rise again. A final piece of evidence comes from the Philadelphia Stock Exchange's index of bank stocks, one of the sectors that is most affected by the Fed. It's down from about 106 in January (an all-time high) to 101 and change today.
But why does the stock market care about the Fed? It's never as simple a question as it seems and some argue that there is little or no correlation between what the fed actually does and how the market performs. But interest rates do matter - they are the cost of capital for many companies and the cost of borrowing for hedge funds, securities firms and investors playing stocks on margin. And whether or not the stats back it up, clearly many investors cling to the old saw "don't fight the fed" - or sell stocks when the fed hikes rates and buy when the fed cuts rates.
But the more important question for any individual investor is should you care? If you are investing for the long term or if you are value investor looking to buy solid companies at depressed prices, such sell-offs are an opportunity. If you've got three months to live and your life savings parked in stocks -- or you like to jump in and out of JP Morgan Chase (symbol JPM) shares as a day trader -- than you should be more worried.