The equity markets rocketed higher last week recording the best five day advance in two years. Stocks were supported by a deeply oversold condition, better than expected quarterly earnings reports and anticipation that the Fed will keep interest rates low beyond 2015. The financial markets are especially alert to any change in interest rate policy given that it is widely anticipated that the Fed will announce an end to quantitative easing (QE) on Wednesday.

In previous cases (QE1 & QE2) when the Fed ended asset purchases the stock market reacted negatively. This prompted a change in strategy, gradually reducing QE3 over an extended period of time. Therefore, it might not be a coincidence that the equity markets have struggled in 2014 with the average stock unable to keep pace with the S&P 500. The good news is that the Fed’s prolonged exit from QE could mean that this is already built into current prices.

The economic fundamentals are gradually improving. This has led to stronger than expected third quarter earnings results. There have also been some disappointments from a few large-cap multi-national companies. The strong dollar is likely playing a role in the conflicting bottom line performances. Should dollar strength continue in the fourth quarter it would likely have an even greater influence over top and bottom line results of U.S. corporations.  

The flip side is that a strong dollar is deflationary which could hold the Fed hostage to maintaining a zero percent interest rate policy. Inflation is running below Fed targets of 2.0%. This is due to the weak global economy and the sharp drop in commodity prices including the plunge in oil prices since the peak in June. As a result we anticipate that the Fed will keep interest rates low for much longer than is generally believed. This should continue to help attract investors into the equity markets.

Technically, improving short-term trends and the excessive pessimism found at the October lows is expected to lead to further stock market gains in the fourth quarter. The fact that the markets did not experience a breadth thrust where upside volume exceeds downside volume by a ratio of 10-to-1 or more is problematic. This suggests that further upside progress will be more difficult over the very near-term and also leaves open the possibility of a retest of the lows before the longer-term bullish trend continues. In terms of the S&P 500, resistance is in the 1980 to 2010 area with support in the vicinity of 1880 to 1900.

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Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC. The opinions expressed are subject to change, are not a complete analysis of every material fact and the information is not guaranteed to be accurate. 

Evan R. Guido

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