SPY: Stocks May See A Massive Rally After The Fed Meeting

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The FOMC announcement and press conference will be on Wednesday, May 4. Unless the Fed announces something entirely unexpected, it is likely to serve as a de-risking event for the stock market and the S&P 500 and S&P 500 ETFs (NYSEARCH:spy). The VIX index, which is a measure of implied volatility, is currently trading around 33, an indication the options market is pricing in a nearly 2.1% daily move in the S&P 500.

A falling VIX indicates that implied volatility levels are declining, which will cause put options to lose value very quickly. The decaying value of put options is very likely to result in traders and investors selling the puts they may have acquired ahead of the FOMC meeting. The selling of these put options will result in market makers being over hedged and will cause market makers to start buying S&P 500 futures, providing a tailwind for the index to move up.

The FOMC Cycle

Since the end of 2021, the FOMC meetings have been followed by huge rallies in the S&P 500 ETF, while sharp market drops have followed the FOMC Minutes. Unless the Fed does something completely unexpected, I think there is a good chance this cycle continues with the S&P 500 rising following the meeting, for the reasons stated above.

FOMC cycle

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The VIX index has typically traded at lower levels when the FOMC minutes come out and trading at higher levels before the FOMC meeting. The VIX again finds itself trading at elevated levels heading into the FOMC meeting.

VIX Index and FOMC meetings

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It could help to produce a rally following the meeting. Still, any rally is likely to be short-lived because the underlying fundamentals of the S&P 500 ETF and the broader stock market are deteriorating; as higher interest rates compress, the PE ratio and earnings may turn lower.

Real Yields

Rising real yields is the biggest problem the stock market faces, and while the damage in the S&P 500 ETF has not been as severe as the NASDAQ, the S&P 500 ETF also trades broadly in line with the TIP ETF. A rising TIP ETF indicates real yields falling, and a falling TIP ETF indicates increasing real yields.

SPY and TIP ETF prices

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PE Compression

The compression in the PE multiple has been witnessed over the past few weeks, with the ratio dropping to 17.5. That compares to an average of 16.1 since 2002. But let’s face facts, the S&P 500 PE ratio between the spring of 2020 and the end of 2021 was historically very high. The average drops to just 15.4 when examining the period between 2002 and February 2020.

SPX index P/E ratio

Bloomberg

Earnings Estimates

The other problem is that earnings estimates for the S&P 500 may now start to come under pressure. The NASDAQ 100 and the NASDAQ composite have already begun to see their earnings estimates for 2022 decline. It seems hard to imagine that the S&P 500 earnings estimates will hold up as the NASDAQ 100 starts to see lower estimates, considering the overall overlap, especially between the NASDAQ 100 and the S&P 500.

NASDAQ SPX and CCMP Indexes earnings estimates

Bloomberg

If S&P 500 earnings start to fall, it will mean that the Index can drop, but that doesn’t have to equate to a decline in the PE ratio, especially if earnings begin to drop at a pace faster than the index.

Financial Conditions

On top of this, the Fed has made it clear that they want financial conditions to tighten, and stocks have never done well when financial conditions tighten. Stocks have seen very sharp drawdowns when financial conditions have tightened, and this time is not likely to be different. The Chicago Fed National Financial Conditions Index is already tightening, but it still needs to rise much more if the Fed desires it to reach a neutral level.

Chicago Fed National Financial Conditions Index and SPX Index

Bloomberg

How Much Of A Rebound?

The S&P 500 will probably see a sizeable rebound after the FOMC meeting, but it isn’t likely to be long-lived, and the upside will likely be very limited. The chart would suggest that resistance around the $428 to $430 area should be reasonably firm but there is the potential for it to climb to as high as $438 and $440, filling the gap created on April 21. But the size of the rebound is dependent upon where the S&P 500 and the VIX are on the day of the meeting.

S&P 500 rebound after FOMC meeting

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Still, as already noted, the fundamental forces will be too powerful and should once again take over towards the end of May, as the market receives the release of the FOMC minutes and the usual summer weakness.

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