Before we get into our summary of the week that was for the S&P 500, in our previous edition, we featured a quiz where we challenged our readers to interpret our chart showing the actual trajectory of stock prices against the backdrop of the alternative trajectories of the future path it could take.
As part of that quiz, we asked one question that we had to phrase very specifically, which we'll highlight in the following quote (we'll also add the answer to the "previous question" in parentheses):
If investors were to maintain their forward-looking focus on the period of time you identified as your answer to the previous question (2016-Q4), and assuming that the projected future doesn't change and that there is no sudden onset of a noise event, would you expect the S&P 500 to rise or to fall with respect to its value on 19 February 2016 at the end of the first quarter of 2016?
Why did we have to phrase that question so specifically? As you'll see in the following chart, which we've animated to help visualize the changes that have taken place over the last week, the future itself has changed. The easiest way to see it is to simply look at the alternative trajectories on the right hand side of the chart (corresponding to the future date of 1 April 2016):
The answer to the question is still the same (lower). However, we couldn't pass up a good opportunity to demonstrate the extent to which the recent evolution of stock prices can influence the likely future trajectories of stock prices.
But as you can see in the animated chart, there was one rather spectacular change in the previous week that had absolutely no impact on the actual trajectory stock prices when it happened, because investors were focusing on a much more distant future (2016-Q4) when it did.
That change is seen in the likely trajectory of stock prices associated with investors focusing on the current quarter of 2016-Q1, the end of which is still in the future. What happened is that on Tuesday, 23 February 2016, the dividend futures for the S&P 500 2016-Q1 (WCB: DVMR) suddenly increased from $11.62 to $11.95 per share. Meanwhile, there was no similar change in any of the other dividend futures for 2016-Q2 (WCB: DVJN), 2016-Q3 (WCB: DVST) and 2016-Q4 (WCB: DVDE).
That's an important thing to note, because as you can also see in the animated chart above, the actual trajectory of stock prices tracked closely along with the future defined by the expectations for dividends in 2016-Q4 from the previous week through Thursday, 25 February 2016, before breaking toward the nearer term future of 2016-Q3 on Friday, 26 February 2016.
Even though it didn't affect the actual trajectory of stock prices in the fourth week of February 2016, the change in expectations for dividends in the current quarter of 2016-Q1 has produced two positive benefits. The first benefit is that the risk of a large downward move in the S&P has been greatly reduced. The second benefit is that the market should be considerably less volatile than it was in the first half of 2016-Q1 - investors shifting their forward-looking focus from one point of time in the future to another won't have the same impact that it did earlier in the quarter.
That doesn't mean that stock prices will continue to be as apparently steady as they've been. As for what to reasonably expect in the week ahead, we'll let the chart do the talking, although we'll caution that the week ahead has the potential to be noisier than normal.
Speaking of which, here are the main market driving news events of the fourth week of February 2016.
- 22 February 2016: Although a number of analysts worried that the that the U.S. inflation rate was firming up, increasing the potential for the Fed to hike rates again sooner than 2016-Q4, stock prices discounted the news and instead rallied on the day as investors remained focused on 2016-Q4, although closing above the middle point of the range we would expect them to fall.
- 23 February 2016: Although the S&P 500 was initially "lifted by muscular oil rally" in the morning, oil prices fell later in the day and stock prices followed. If you look at the chart above however, you'll see that in actuality, they simply dropped down to the mid-point of the range that our model had projected they would fall for when investors are focused on 2016-Q4.
- 24 February 2016: Following along with the 2016-Q4 trajectory, stock prices initially slipped in the day, but rebounded when Dallas Fed president Robert Kaplan indicated that he expected to downgrade his expected path of rate hikes at the FOMC's March meeting, which served to closely focus investors on 2016-Q4, and the market closed up accordingly.
- 25 February 2016: Investors remained focused on 2016-Q4 as Richmond Fed president Jeffrey Lacker proclaimed that it was "still logical to expect rate hikes this year", but the bigger news keeping investors looking at 2016-Q4 came as St. Louis Fed president James Bullard acknowledged that the Fed's January rate hike "may have spurred market turmoil". The S&P 500 closed up on the day.
- 26 February 2016: Although Wall Street initially responded to better-than-expected GDP data by going higher, as investors absorbed additional news indicated that inflation really did kick up toward the Fed's 2% target level in the fourth quarter of 2015, stock prices would ultimately close down as investors began shifting their attention to the nearer term future, as that higher inflation would likely drive the Fed to hike interest rates sooner. We see that change in our chart above, where investors would appear to have shifted their focus to 2016-Q3.
On a comical note, Friday, 26 February 2016 was also the day when San Francisco Fed president John Williams intentionally made the following statements:
"Although it’s understandable to want to communicate a comprehensive view of monetary policy with all of its incumbent uncertainties, the public has only so much bandwidth dedicated to central bank messaging," Williams said in remarks prepared for delivery Friday. "So, like a sledgehammer, strongly worded forward guidance can be a powerful tool when it’s needed."
Williams stopped short of advocating forward guidance in all instances, adding that "like a sledgehammer, care needs to be taken when and where it is used."
Combine those thoughts with James Bullard's comments earlier in the week acknowledging the Fed's role in sparking market turmoil and also with the knowledge that we actually use the Fed's forward guidance to check the calibration of our futures-based model for projecting the alternative future trajectories of stock prices, and hopefully you'll understand why we found the "sledgehammer" comment to be so funny, coming as it did from one of the Fed's own minions.
For more insight into the nature of forward guidance, we can recommend James Hamilton's well-versed and timely discussion of recent research on the topic at Econbrowser.