Dow Jones Biased Higher Despite Downside Risks

The Dow Jones Industrial Average (DIA) has had a whirlwind few weeks following some of the steepest declines and volatility witnessed since the last financial crisis.  With the fallout from China reaching American shores, uncertainty regarding the outlook and concerns about the future of Federal Reserve policy have seen optimism towards equities wane. Added caution and renewed risk aversion have increasingly seen institutional investors flattening out exposure ahead of critical decisions due in the coming session.  Profit-taking is defining the current trend as the Index consolidates ahead of the FOMC Statement.  Any shift in Federal Reserve policy is likely to have an immediate impact on the outlook at an especially pivotal moment.

The Fundamental Perspective

Along with most asset classes, stocks are also in the process of consolidating with investors paring risk in advance of the looming monetary policy decision.  Risk assets in general have been experiencing measured gains to the upside after the substantial selloff last month, but have still not fully recovered from the weakness.  Stocks in particular have been hard hit by the present earnings environment.  Hurt by a stronger dollar and contracting export market, corporations face substantial headwinds to growing both the top and bottom lines.  Even though the latest American consumption figures showed a reasonable expansion, sentiment remains depressed as evidenced by the latest University of Michigan confidence numbers.  That spells problems for corporate America as it worries about generating shareholder value in a rising rate environment when the ability to finance buybacks ebbs.

Federal Reserve Chairwoman Janet Yellen has referenced the “stretched” valuations of American equities at length.  The day of reckoning may quickly be arriving for equities, especially if the Federal Reserve opts to raise interest rates.  Renewed momentum higher in the dollar is likely to make equities more expensive by comparison and thereby less attractive from a value investor’s point of view.  Rising rates will make bonds more attractive, especially for investors left with few options in the zero interest rate environment.  Valuations are also historically much higher than average, leading to the resurgence of mean-reversion fears, or the idea that valuations could fall by 30-40% in certain circumstances.  Although corrections are part of any trend, corporate multinationals are limited in their ability to deal with the potential downside from the long-anticipated Fed decision.