Unexpectedly Intriguing!
February 1, 2016

What if you had advance knowledge of how the U.S. stock market would behave in the upcoming week? Or at the very least, you were told by someone who works in the future exact how the market would respond to a given set of circumstances that would be likely to play out in the week ahead, but not exactly when the market when the market would react to those circumstances.

Would you be able to craft an investment strategy that would be able to take advantage of such foreknowledge?

We ask, because last week, we wrote the following:

In this next week, the Federal Reserve's Open Market Committee will command an outsized portion of the attention of investors on Wednesday, 27 January 2016. In addition, earnings season continues as a number of very large companies, especially in the distressed oil industry, will be announcing their earnings and addressing investors regarding their business outlook during the week.

With investors currently focused on 2016-Q2, should the Fed hold tight to its plans to hike short term interest rates again before the end of 2016-Q1 at the same time that U.S. firms announce that their outlooks are less bright than currently expected, it is highly likely that investors will once again shift their attention back to 2016-Q1, sending stock prices considerably lower.

On the other hand, should the Fed indicate it will adopt a more dovish stance combine with news that troubled U.S. firms see the potential for real improvement in their outlook by the end of the year, then we could see a fairly strong rally as investors shift their focus to more distant future quarters.

And if the combination of market driving news mixes elements of these two scenarios, then it's likely that the market will stabilize somewhat and largely move sideways within a relatively narrower range than the previous week during the week to come.

Back then, that was the future, as expressed in what might as well have been a sequence of "If-Then" statements from high school geometry. Now, here is how Week 4 of January 2016 actually played out. First, for 2016-Q1 to date:

Alternative Futures - SP 500 - 2016Q1 - Standard Model - Snapshot on 29 January 2016

And in the larger scale of 2016 to date:

Alternative Futures - SP 500 - 2016 - Standard Model - Snapshot on 29 January 2016

Here were the week's main events:

  • 25 January 2016: Stock prices fell as investors shifted their forward-looking focus toward 2016-Q1, as oil prices continued sliding as the future outlook for energy firms dimmed.
  • 26 January 2016: Even though the news that China's stock markets plunged more than 6% opened the day, the combination of a rebound in oil prices and positive earnings reports brightened the outlook of investors, who shifted their focus back toward 2016-Q2, in a day whose trading was described as "schizophrenic".
  • 27 January 2016: Investors remained tightly focused on 2016-Q2, all the way up until the Federal Open Market Committee of the Federal Reserve announced that it would leave interest rates unchanged in January. The initial reaction of the statement was negative, sending stock prices lower as investors shifted their attention back toward 2016-Q1 in setting today's stock prices, as they initially interpreted the statement to indicate that the Fed would hold to its previously announced plans. However, a deeper analysis of the FOMC's statement revealed the Fed was backing off those plans somewhat, citing its concerns for "global tumult". The S&P 500 rebounded on that latter assessment, closing the day with investors returning their focus to 2016-Q2 as they give just over a 50% probability that the Fed might hike short term interest rates before the end of June 2016.
  • 28 January 2016: The S&P 500 was little changed on Thursday, as the Fed's communicated change in stance becomes more widely understood.
  • 29 January 2016: Global tumult arrives well before the market opens, as the Bank of Japan announces that it will adopt a negative interest rate policy, in direct opposition to its public statements of its policy plans from a week earlier. With the Fed having cited its global concerns, investors shift their forward-looking focus to the more distant future quarter of 2016-Q3, reinforced by a weaker than expected initial report for GDP in the fourth quarter of 2015, hopes that a deal to limit the supply of oil in a glutted market would be reached, and also the confirmation by two Fed officials that the Fed was indeed backing off its previously planned pace for interest rate hikes.

Before concluding with what we really want to get to in this post, let's take a closer look at the reported comments of San Francisco Federal Reserve Bank president John Williams from Friday, 29 January 2016 to understand why investors only shifted their focus to 2016-Q3 and not, as yet, to a more distant future quarter as they consider the likely timing of the Fed's next change in the level of U.S. short term interest rates:

At the time, officials at the Fed, the U.S. central bank, had as a group expected about four further rate hikes this year, and Williams had said that was in line with his own expectation.

That view appears to have changed, after investor worries about a global slowdown and weakness in China sent equities and oil prices plunging through most of January. Meanwhile the dollar has strengthened, pushing down on U.S. inflation, which is running well below the Fed's 2-percent target.

"Standard monetary policy strategy says a little less inflation, maybe a little less growth ... argue for just a smidgen slower process of normalizing rates," Williams said.

"We got a little stronger dollar, some mixed data on the economy, some weakness in (fourth-quarter U.S. GDP growth), all of those coming together kind of tell me that we probably need a little bit more monetary accommodation this year than I was thinking in the middle of December."

Getting back to what we really want to get at, do you see how all these changes in the value of the S&P 500 were specifically covered in our If-Then conditions representing how stock prices would be most likely to behave during the fourth week of 2016?

And since they were, the question of how you as an investor could have taken advantage of the foreknowledge of how stock prices would behave under the circumstances we described, but not the knowledge of the exact timing of when the changes in stock prices we described would take place, is a very open question. One where the strategies you might have used in the fourth week of January 2016 would be very similar to what you might do in future weeks when similar circumstances come back into play.

So what would you have done with your investments to maximize your returns given these circumstances (and the benefit of 20-20 hindsight)? If you're reading this article on Seeking Alpha, we'll monitor the responses addressing that question in the comments over the next week, and will share the more interesting strategies that are put forward through that venue in our next discussion of our alternative futures model for the S&P 500.

Previously on Political Calculations

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