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.

While the current probability of liftoff is below 50% according to prevailing expectations, there still is room for a surprise and change in language in the actual statement.  The base case scenario of no change would give the Dow Jones Industrial Average the temporary lift needed to drive higher towards levels recorded before the August drop.  A rate hike or hints towards rising rates before the end of 2015 would be enough to see recent momentum higher reverse to the downside.  The mostly likely outcome is the Federal Reserve choosing to punt until the October meeting in the hopes that recent turmoil in emerging markets will calm.  Firmer anchoring of the inflation outlook is also essential considering recent CPI figures which show deflation proving an ever present risk factor.  The costs currently outweigh the benefits when it comes to higher rates, but the door for policy normalization is rapidly closing, meaning a correction for equities is closer with each passing session.

The Technical Take

A closer examination of the charts show that the short-term bias in the Dow Jones Industrial Average is to the upside despite the looming fundamental risks emanating from the Federal Reserve.  The Index is currently consolidating, having retraced approximately 50% of the move lower in August as the rebound begins to run out of momentum.  On a medium-term basis, the consolidation has led to the formation of an ascending triangle setup on the one-day candlestick chart and breakout.  The pattern is typically indicative of further momentum higher considering prices managed to breach and close above key resistance sitting firmly at 16660.   The subsequent move is likely to be accompanied by renewed upward momentum towards the next important resistance level at 17348.  The more medium-term nature of this setup suggests that another leg higher is possible despite the strong possibility of a longer-term correction in the Index’s strength. 

On a longer-term basis, the Dow Jones Industrial Average looks to have a formed a top, oscillating in the early phases of a reversal in the prevailing trend.  The emergence of the “death cross” technical pattern should be viewed as a worrying sign by investors.  Typically it is indicative of the beginning of a protracted slump in an instrument, adding to the preexisting downside case over the long-term as faltering earnings and contracting revenues force companies to guide lower.  With both the 50-day and 200-day moving averages signaling further losses, longer-term investors would be keen to use near-term rallies as opportunities to initiate Put positions targeting recent lows at 15365.  If that is broken, a deeper correction may be in order for stocks in a reflection of the new realities for monetary policy.  However, for intraday traders, Call positions should be targeting secondary resistance at 17348.

Conclusion

While equity benchmarks such as the Dow Jones Industrial Average have benefited from the looseness of monetary policies over past years and balance sheet expansion, the shifting tides are signaling the potential for a sharp correction in stock indices.  Even though near-term technicals could spell a further upside rebound and renewed momentum should the Federal Reserve avoid acting, longer-term decelerating top and bottom line growth provide the fuel for a deeper pullback from a fundamental perspective.  The pivotal announcement from the Federal Reserve will be setting the pace as market participants tune in to glean crucial details about the outlook for stocks.  The Dow Jones Industrial Average is key juncture, with a hike catalyzing a drop while no change in policy will see prices trend horizontally until corporate shares experience a painful retrenchment from stretched valuations.