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What will the Fed bring: buy the dip or sell the rally?

markets fall

US stocks are getting choppier one day ahead of the US Federal Reserve’s monetary policy decision tomorrow. Uncertainty and fears are the biggest factors that have been driving the market's turbulence. Will there be a 'buy the dip' opportunity when uncertainty and fears settle?

There might be a bounce opportunity if you are a trader

Since the Fed signalled a U-turn of its inflation theory from “transitionary” to “no longer transitionary” in early December, the US stock markets started to head to peaks. Investors enjoyed a short period of “Christmas Rally” before the broader markets started crashing after they came back from holiday.

Tech shares have been dumped like hot potatoes amid fears of a more aggressive tightening policy to come. The biggest YTD losses are seen in the growth stocks or the tech shares, which caused the Nasdaq to fall 14% in January. Coinciding with the big tech company’s fourth-quarter earnings reports, investors are more cautious about future guidance rather than past performance.

Netflix started with a horrible drop of 25% in the big techs, as the company indicated its slowest growth in new subscribers in the first quarter. Microsoft fell 5% despite beating expectations, for the same reason. We might not see the other leading tech companies give very positive guidance against the backdrop of a rapidly spreading omicron variant, ongoing supply-chain disruptions, and the recent Russia-Ukraine crisis.

However, there might still be a bounce opportunity for traders when the Fed confirms its policy and provides a clearer picture of its tightening path. The markets will be more sensitive to any words that could indicate a less hawkish stance and find an opportunity to buy the dips.  

There are three questions the Fed needs to answer: how soon to completely end tapering, when will the first rate-hike be, and when to start unwinding the balance sheet? Any less hawkish signal in answering these three questions could lead to a relief bounce for stock markets.

More bargains for investors

However, being an investor, some questions need to be answered before establishing a “buy the dip” trade. Have the markets done the correction? Will the Fed give up its tightening policy? Can the tech giants keep the same pace to grow the business in the first quarter?

18% of correction in Nasdaq could not be enough, the tech heavily weighted index rose as much as 240% since March 2020 when Fed started its massive stimulus measures. Nasdaq almost wiped out the whole year's gain n 2021 in the first month, which shows how quickly investors are cashing out for the long gain profit. Now that the Fed starts scaling back the liquidity when the high growth companies cannot satisfy investors with its near-term performance, valuation downgrade will keep driving funds out of the risky assets.

And we might see an even dipper correction in the benchmark index, typically the tech stocks. In the last tightening cycle, the Fed took a whole year to end tapering from December 2013 to October 2014 and started the first rate hike in December 2015, a 2-years’ time to finish tapering. This time, the Fed started tapering from November 2021, and projects to end in March 2022, only a 4-month time. It is also expected to start raising interest straight after finishing tapering.

On top of all these moves, it may also start unwinding the near $9 trillion balance sheet. The Fed turned from a massive stimulus to an ultra-aggressive tightening policy, the turbulent in the stocks markets might not have digested enough and it will need to take time for investors and companies to settle and react. It is still hard to say how much a correction the market could approach, but an investor needs to wait for certainty to be re-established and confidence to recover. 

US Major Indices vs Historical Volatility Index

The Historical Volatility Index shows an ongoing upward momentum, which indicates that price fluctuation could remain high. Usually, a reversal signal starts establishing when volatility falls to a lower level. 

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