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Fed Just Made a Huge Change -- What This Means For Stocks

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The Federal Reserve announced Thursday that it is rethinking the way it approaches monetary policy and inflation, a decision that certainly has market implications for the future, although this will provide relatively less upside for stocks in the near-term. 

The Fed said on its website before the market opened for trading Thursday that, after having had an inflation target of 2% for the past year-plus, it is now adopting a strategy to try to push inflation above 2%.

Pre-pandemic, the economy had begun to run smoothly, with inflation nearing 2%, but stubbornly, routinely below it. The Fed had to keep rates low in order to maintain economic demand and growth. Then, the pandemic hit and unemployment is still at around 10%, a negative for consumer spending and inflation. Many experts and market participants now wonder whether the U.S. will see a spike -- or even a modest rise -- in inflation soon or at least when a vaccine enters the fray. Beyond the next few months, the Fed realizes that maintaining economic stability and growth will depend very much on keeping rates low and liquidity flowing through the system. It has various bond-buying programs, from safe assets to risker debt, that are designed to do just that. So at least until the pandemic is finished, the Fed’s programs will be as large as they need to be to produce the desired result. 

One reason for the run-up in the stock market in 2020 has been the trillions of dollars of both monetary and fiscal stimulus, enabling consumers to spend some cash and companies -- large and small -- to maintain some of their employees. Low interest rates help with that. Importantly, it has been growth tech stocks powering the S&P 500 to a more than 5% gain year-to-date. While cyclical value stocks -- large cap economically-sensitive ones -- have rebounded sharply from their March 23 lows, partly because of the stimulus, they remain at far lower levels than their pre-virus highs. 

And it isn’t just better-than-previously-expected near-term earnings upholding these stocks -- even the cyclical ones. Lower interest rates are a positive for valuations, or the multiple placed on near-term results. That’s because cash flows to companies are now generally discounted at lower rates -- they’re more valuable to the risk-investor. The average forward one-year earnings multiple on the S&P 500 is around 25 times currently, compared to the 10-year average of below 17 times. That’s because interest rates are lower. 

But the Fed isn’t necessarily lowering rates from here. It’s benchmark lending rate has a bottom at its range of 0%. Lower rates could mean negative rates, which many fear would be a huge drain on the banking system. And investors already knew -- as the Fed had already made it explicitly clear -- that rates will remain where they are for the foreseeable future. It’s an approach of unlimited stimulus -- a 'throwing the ‘kitchen sink’ approach -- that gets priced into stocks fairly quickly. 

So with low interest rates priced into valuations and near-term economic expectations, one question to consider is whether the Fed’s adjusted long-term policy can boost the economy from here if rates can’t fall much. 

First off, cyclical stocks responded well to the announcement Thursday -- and those stocks may have some valuation upside. They trade at very cheap earnings multiples relative to where they usually trade against growth stocks. The S&P 500, with growth tech stocks faltering, still rose 0.4% by 2:45 EDT. And the 10-Year Treasury yield, with plenty of long-term upside, rose to 0.74% because the Fed’s new policy is totally inflationary and the yield is already reflecting the ultra-low benchmark lending rate. 

There may be strong reasoning behind Thursday’s apparent stock-buying trading action. 

“Loosening up on target inflation ushers in a new age of low rates for the foreseeable future -- which could have a heavy impact on everything from the banking sector, to the housing sector, to retail in the form of low credit card interest rate,” wrote Mike Loewengart, head of investment strategy at E*Trade in emailed remarks to reporters. "It could be a win for investors and the market.” That’s especially true if the Fed’s stance means there is upside to economic and corporate earnings forecasts past 2021. That remains to be seen, though, given that -- again -- we all knew the Fed is doing all that it can. 

Either way, “against this backdrop, many more will pile further into equities, which appear to be on a winning streak,” said Nigel Green Founder of deVere Group, in reference to the idea of “TINA,” or “there is no alternative.” This means that, with interest rates offering no real return over inflation, investors have no choice but to favor equities over safe bonds. 

With all of this said, the market would have a hissy fit if the Fed were to indicate it is considering anything less than the current approach. That would be equivalent to pulling the floor out from under the stock market. 

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