Using “First Principles” to Determine Market Direction

On Wall Street, investors can argue about what impacts equity prices the most until they’re blue in the face. Is it earnings, geopolitical events, or the general economy? While the above factors all play a role in the stock market’s direction, it can be helpful to break down the answer to the question by using the “first principle” technique.

In science and mathematics, first principles refer to the fundamental axioms or laws that cannot be deduced from other principles, but must be taken as self-evident. Using this method as a guide rail, the most fundamental driver of stocks is supply and demand. Because liquidity greatly impacts supply and demand it must be at the forefront of consideration for investors. Ten years of a “dovish” Fed is evident on the S&P 500 Index ETF (SPY Quick QuoteSPY - Free Report) chart below:

Image Source: Zacks Investment Research

Liquidity is Controlled by the Fed

When it comes to investing track records, Stanley Druckenmiller of Duquesne Capital Management is in a league of his own. Across four decades, through several boom and bust periods, Druckenmiller has never recorded a down year. According to Druckenmiller, the single most critical factor is liquidity. He says, “focus on the central banks and the movement of liquidity – it’s liquidity that moves markets.” If you size up Druckenmiller’s robust performance, it’s hard to argue.

Look Deeper Than the Headlines

Though the importance of tracking the Fed’s latest moves cannot be understated, investors must be aware that not every item you hear about in the financial news should be taken at face value. Below are 3 examples:

1. “Jobs numbers are near record highs!”: While this statement remains true for the government-tracked numbers, these numbers tend to lag. Job listing websites such as Indeed are more of a leading indicator and show a significant drop off in the number of openings available. A slowing employment market should lead to a slowing of rate hikes.
2. “The ultimate level of interest rates is likely to be higher than anticipated.”: The previous statement came from Powell’s Monday testimony to the senate. Just one day later, Powell stressed that “no decision has been made on the pace of rate hikes.” In other words, the Fed makes decisions based on the latest information, which is subject to change. Watch what the Fed does, not what they say.  
3. “The Fed flipped to extremely hawkish!”: While the Fed has taken a more aggressive stance toward taming inflation in recent months, one must also consider recent history. After ten years of the most dovish fed in history, it is unlikely that the Fed will do a complete U-turn and flip to the most hawkish in history.

Bottom Line

Liquidity, not conventional measures, drive the stock market’s direction. Keep a close eye on what the Fed is doing, but don’t hang on every word out of Fed Chair Powell’s mouth as he can be flexible and change the trajectory of monetary policy with new data. With job sites like Indeed showing slowing employment growth, a more dovish Fed stance may be on the horizon sooner than you think.