What Will It Take for Markets to Grind Higher with Headwinds on the Horizon?

U.S. equities rallied sharply on Wednesday last week, after the midterm election, surging 2.1 percent. But that budding rally was quickly short circuited by the Federal Reserve on Thursday. Although the Fed, as expected, chose to leave the overnight rate unchanged, it also gave no hint of any intention to pause on the current path of steady, gradual rate increases. The odds of another quarter point rate hike in December edged higher to 76 percent, according to the CME FedWatch tool. The odds for a March rate hike edged back above 50 percent.

What do the Midterm Results Mean for Markets?

The midterm election has produced a divided government, as the Democratic party won back control of the House of Representatives, while Republicans retained control of the Senate. The next two years in Washington promise to be quite different from the past two.


U.S. Equities Rebound Ahead of Midterm Elections

After establishing a new closing low for the recent downturn last Monday, U.S. equities staged a strong three-day rebound, pushing the S&P 500 to a 2.4 percent gain for the week and back into positive territory for the year, up 1.9 percent. It was the best weekly gain for the index since March and could have been even better if not for a modestly disappointing earnings report from Apple that triggered a tech-led selloff on Friday.

Investors in Search of a New Normal

The selloff in equities accelerated last week, as the S&P 500 closed lower by 3.9 percent, its fourth week of losses in the past five. From its closing peak on September 20, the index is now lower by 9.2 percent, just shy of an official correction. That semantic distinction hardly matters, as the damage done has been widespread nevertheless. Almost all the damage has occurred since October 3, the day Fed Chairman Powell opined about the distance between the present level of the fed funds rate and the elusive so-called neutral rate. Investors have been scrambling ever since to determine the appropriate valuation multiple to apply to stocks if the Fed does continue to raise rates according to plan, and what that might mean for earnings growth. 

In Defense of Diversification

Diversification is a time-tested, foundational principle of wealth management. Reduced portfolio volatility and downside loss mitigation are bedrock principles of its value. Yet the further removed we get from the type of market conditions in which diversification reveals its value, the more likely we are to question it. We see this pattern of belief, frustration and abandonment repeated time and again over market cycles. We appear to have, once again, arrived at one of those moments.

The Mood in the Markets Takes a More Cautious Tone

The S&P 500 managed to arrest its three-week slide last week but had to rely exclusively on a one-day gain to do it. The index barely edged higher, rising just 0.02 percent, and it took a 2.1 percent surge on Tuesday to accomplish even that. Stocks have fallen in 10 of the past twelve trading days and sit 5.6 percent below the September peak. The VIX index of implied volatility has moved higher recently. After averaging 13 throughout the third quarter, so far this month it has averaged 18, and currently resides at 19.