The Federal Reserve kept interest rates unchanged Thursday. Though a slight majority of pundits were predicting that the Fed would do just that, I don’t think many had anticipated the reason why the Federal Open Market Committee (FOMC) kept rates at near-zero.
Here’s the money quote, direct from yesterday’s FOMC statement:
“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
So, the Fed is admitting that it now takes into account economic and market tumult in China and the emerging markets in its decision on how much interest savers at home will get on their money market accounts.
The Fed also now is basically admitting that the price of stocks here at home is a big factor when it comes to whether there will be a rate hike.
While I’m not too surprised to find this out, it’s interesting that the Fed has now basically admitted as much.
Given this rather overt admission, I think it makes sense to look at the prices of equity markets around the world to see why the Fed is questioning whether the world can handle a 25-basis-point increase in the cost of capital.
Take a look at the following three charts — the SPDR S&P 500 (SPY), iShares MSCI EAFE (EFA) and iShares MSCI Emerging Markets (EEM).
Although stocks in the S&P 500 (SPY) have seen some recent stabilization, they remain firmly below their 200-day moving average.
As for Europe, the Far East and Australia (EFA), there has been an even bigger downturn, which is something Fed officials apparently think is reason enough not to upset the monetary apple cart.
Finally, the emerging markets (EEM) are now in a confirmed bear market that just looks downright ugly on the chart.
The downturn in stocks both at home and abroad is something we identified and reacted to in my Successful ETF Investing advisory service — and we did so before the damage got really bad.
If you are an ETF investor who is looking for strategies to help get you out of a market when even Fed officials think things are going to hell in a handbasket, then check out my Successful ETF Investing advisory service today!
New Rule for ETF Investors: Stop Using Stops
I am a huge fan of exchange-traded funds (ETFs). In fact, there may be no bigger advocate of these products than me. I love ETFs for multiple reasons, including their transparency, ease of use, low cost and diversity.
It is my view that ETFs are perhaps the best innovation to ever come out of the financial services industry.
However, the recent price action in many ETFs during a period of extreme market stress has prompted very real concerns for investors.
It’s also prompted a PR firestorm for the ETF industry, a topic I discuss in detail in this week’s ETF Success with Doug Fabian podcast.
The stress test in question came on Monday, Aug. 24, when the Dow plunged nearly 1,100 points in the first five minutes of trading. The massive imbalance of sell orders vs. buy orders in the market caused the broad-based S&P 500 Index to crater more than 5% in those tumultuous first five minutes.
A scary plunge in the S&P 500 is bad enough, but if that was the only damage ETFs suffered during that brief period, I wouldn’t be too concerned. The real cause for concern was that some ETFs that track the S&P 500 were down nearly 50% in the first five minutes of Aug. 24.
The massive imbalance between sell orders and buy orders was in part due to many individual investors who reacted to the early market action by logging onto their online brokerage accounts to put in sell orders “at the market.”
Another key factor that caused these massive price discrepancies was a little-known and rarely used SEC regulation called “Rule 48.” Rule 48 permits designated market makers to not tell anyone where things are going to open until they start trading. This lack of transparency takes critical information away from markets. The “blindness” that ensued caused many investors to sell into the landslide.
Additionally, because ETFs are made up of individual securities, they are subject to circuit-breaker rules in individual stocks. So, if a stock falls 10%, it is halted from trading for a short period, usually five to 10 minutes. Once this period passes, the stock is reopened; however, on Aug. 24 the backlog of orders continued to press ETF share prices lower. This situation, in turn, caused another 10% circuit breaker to be triggered, and hence another security stop.
In some ETFs, this happened three or more times, causing those ETFs to trade down as much as 50% below the actual price of the securities within them.
This is a major problem for the ETF industry, and it is especially a problem for investors who had “market order” stop losses in place. While I think the actual cause of the big declines wasn’t due to a flaw in the ETFs themselves, but rather a case of poor management, bad rules and scared investors running for the exits, the damage was still done.
In light of these events, I have been forced to rethink a principle that I had previously held on to for many years, and that is the principle of always putting in a stop-loss order on any ETF position you enter.
So, from here on, I am implementing a new rule for ETF investing, and that is to cease using stop losses.
I will not be using stop-loss orders on ETFs, either personally, or in my newsletter advisory services.
Instead, I am going to use mental stops, or something I call “exit points.”
The way I see it, if we want to navigate the current volatile market landscape, we need to adjust course. We simply cannot do what we have been doing and hope for good results.
By setting your own personal “exit point” on a position, you can determine how much you are willing to lose and when you should cut and run.
The Real ‘Deflategate’: A Limerick
The Fed has intensely debated
When interest-rate hikes should be slated.
Like a team I won’t name,
They’re playing the game
With balls that are underinflated.
You don’t normally associate limericks with the Fed, or anything in the realm of markets and the economy. But if you want to read some witty poetry about just that, I recommend a blog site called Limericks Économiques, Humorous Poems on the Dismal Science of Economics by Dr. Goose. It’s guaranteed to generate a smile.
Wisdom about money, investing and life can be found anywhere. If you have a good quote you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my audio podcast, newsletters, seminars or anything else. Ask Doug.
In case you missed it, I encourage you to read my e-letter column from last week on Eagle Daily Investor about why investors shouldn’t use stop losses on ETFs. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.