Awakening to a Future Without the Fed, S&P 500 Lurches Into Correction

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Could it have ended any other way?

U.S. stocks, stuck in neutral since quantitative easing was curtailed 10 months ago, went into freefall as the prospect of higher interest rates became too real to ignore. For all the talk of a slowing China and crashing oil, signs a correction was coming have been visible ever since the Federal Reserve began withdrawing stimulus.

The losses that dragged the Standard & Poor’s 500 Index down more than 10 percent from its May peak were inevitable to Komal Sri-Kumar, the Santa Monica, California-based founder and president of Sri-Kumar Global Strategies Inc.

“The Fed is out of ammunition,” with “less and less potency in terms of preventing stocks from going down,” said Sri-Kumar. While it’s possible that policy makers will delay the first interest rates increase in eight years, “if that doesn’t help the equity market, what do they do next, start QE4?”

Since the Fed ended its bond buying program in October, the S&P 500 is now down 2.2 percent, its longest period of motionlessness since the third leg of QE began in September 2012. The stretch interrupted what is still one of the biggest bull markets in U.S. history. The S&P 500 rebounded 2.2 percent to 1,934.42 at 9:54 a.m. in New York.

Removal of stimulus has corresponded with bouts of volatility in the past. When the Fed concluded its first round of QE in March 2010, the The Chicago Board Options Exchange Volatility Index more than doubled over the next two months, reaching a peak of 46. When the second round ended in June 2011, the volatility gauge was near 16 and then jumped, averaging about 30 through the third quarter.

QE History

After climbing to an 18-month high in April 2010, the S&P 500 fell 16 percent just as the first program ended. When QE2 ran out in June 2011, stocks were in a midst of a decline that sent the S&P 500 down 19 percent.

“It’s been 10 months since the Fed initiated that last tapering move and went to no QE, so I’d like to think that this market weakness maybe is just a reflection of that lagged impact,” said Doug Ramsey, the chief investment officer of Leuthold Weeden Capital Management LLC. “That could be responsible for the carnage that we’re seeing.”

A rate hike still is likely this year, though Fed Bank of Atlanta President Dennis Lockhart cautioned Monday that a stronger dollar, a weaker Chinese yuan and falling oil prices are “complicating factors in predicting the pace of growth.”

Tightening Outlook

“I expect the normalization of monetary policy —- that is, interest rates —- to begin sometime this year,” Lockhart said in a speech in Berkeley, California, without citing a particular month. “I’m going to stick with later this year. We have three more meetings.”

Fed funds futures now show a probability of a December rate increase at 44 percent versus 61 percent on Friday. Bets on the first increase in rates in almost a decade in September fell to 22 percent, down from 34 percent. The calculation is based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase.

It was a day of wild swings Monday as U.S. equities plunged at the open before staging a rebound, with the Nasdaq 100 Index by midday nearly erasing a 9.8 percent drop. The Dow Jones Industrial Average dropped 1,000 points in the opening minutes, while the S&P 500 tumbled 5.3 percent and then pared declines before an afternoon wave of renewed selling.

Market Recap

The S&P 500 dropped 3.9 percent to 1,893.21, and closed 11 percent below its May record. The Dow lost 588.40 points, or 3.6 percent, to 15,871.35, after sliding as much as 6.6 percent. The Nasdaq Composite Index retreated 3.8 percent to its lowest level since Oct. 27.

The whirlwind action sent the VIX to its biggest two-day increase on record. The fear gauge closed at 40.74, almost three times its average level for the three years through July.

“There’s a question of what more the Fed could do if anything else happened to the economy,” said Richard Sichel, chief investment officer at Philadelphia Trust Co., which oversees $2 billion. “If they’re going to raise rates, the economy should be strong enough to withstand any of that and grow organically without stimulus.”

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