These Are the Odds of a Post-Fed Rally

We did the math on previous post-FOMC SPY rallies

Senior Vice President of Research
Jul 30, 2018 at 8:38 AM
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"FOMC policy decisions have had a clear and obvious impact on the short-term direction of the stock market since December 2015, which marked the first of multiple rate hikes in the current cycle... the market's best days during the current policy-tightening cycle have occurred after decisions by the Fed to hold rates steady... stocks have struggled in the month after a rate hike during the current tightening cycle -- with a notable exception being December 2017, when tax cuts 'Trumped' Fed policy."
-- Monday Morning Outlook, June 11, 2018

The arrival of a new trading month on Wednesday, Aug. 1, also brings a big event for investors from a macro perspective -- the Federal Open Market Committee (FOMC) policy decision. Per the excerpt above, equities, as measured by the SPDR S&P 500 ETF Trust (SPY - 281.42), have performed better in the immediate aftermath of a decision by the FOMC to hold rates steady versus a rate hike.

If past is prologue, the next month could be a good one for equities, as fed funds futures are placing only a 2.5% probability on a rate hike on Wednesday, according to the CME Group web site. The tables below break down SPY price action in the calendar month following a decision by the FOMC to either hike the fed funds rate or hold it steady since the tightening cycle began in December 2015. Clearly, investors have been in more of a buying mode after a Fed decision to hold rates steady.

spy returns after fed meetings 0727

Despite the quantified results above, retail investor sentiment, as measured in the weekly American Association of Individual Investors (AAII), is not overly bullish. The bullish percentage is 31%, which is only 5 percentage points higher than the 26% bears.

The table below breaks down retail sentiment heading into previous FOMC meetings in which the Fed held rates steady. The middle row would describe the situation at present if, indeed, the Fed holds rates steady on Wednesday. Based on how the SPY has behaved during this tightening cycle, there is an 83% probability that the SPY will be higher over the next month if the Fed holds, with an expected return of 2.2%.

spy returns post-fed with aaii sentiment data

For what it's worth, ahead of the Fed's early May decision to hold the fed funds rate steady, bears outnumbered bulls by 13 percentage points, and the SPY went on to rally 4% in the calendar month after this decision.

The extreme negative sentiment ahead of the May meeting was confirmed by the heightened equity-only buy-to-open put/call ratio, which you can see on the graph below. Right now, this ratio suggests that equity option buyer sentiment is situated between the extreme pessimism that preceded the rate hold in early May and the extreme optimism that preceded the rate hike in mid-June.

The point is that while there is ample buying power to fuel a rally if the Fed holds rates steady, it isn't quite the buying power that existed prior to the early May meeting.

equity put-call ratio ahead of fed meetings

Of course, seasoned market veterans know that the only certainty in the market is that nothing is a slam dunk. If the Fed surprises market participants and raises rates, risk in the short term would very likely outweigh potential reward. Moreover, if the Fed holds rates steady as expected, it is not a 100% guarantee that stocks will rally in the next month. A SPY close below its pre-FOMC June 12 closing high of $278.92 would certainly endanger a post-Fed rally into early September.

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