Vicious stock reversal is symptom of the Fed's feedback problem

Question for market experts: When U.S. stocks staged their biggest rally in two years Wednesday after the Federal Reserve enacted its first half-point rate hike in 22 years, was Jerome Powell happy or sad?

And what about Thursday, when the entirety of that advance went poof in 90 minutes?

Only he knows, but the question goes to the heart of a puzzle that is likely to be dogging markets for weeks and months to come.

How does the motion of markets affect the state of financial conditions, the cross-asset measure of stress that in Powell's words is the channel via which monetary policy "reaches the real economy?"

The tension is playing out vividly right now. Wednesday, stocks soared in the biggest Fed-day advance since 2011, ignited when Powell appeared to take the prospect of a 75-basis point hike off the table.

But since stocks are a key component of the financial-conditions mosaic, the rally caused constraints on the economy to loosen, something Powell is presumed to disdain.

Which brings us to Thursday, when investors rethought the whole thing, pushing the S&P 500 Index down as much as 4%.

That dynamic is being taken to absurd lengths right now, when it's possible to frame the sight of rising stock prices as themselves sending a bearish signal, given their influence on financial conditions.

"We've seen this picture before. The Fed has their meeting, Powell talks, and the markets react. Positive or negative, the markets react," Paul Nolte, portfolio manager at Kingsview Investment Management, said by phone from Chicago. "The next day, the markets tend to undo whatever was done prior. It's almost as if investors slept on it and decided, 'Oh, that's not so bad,' or 'Oh my gosh, that's terrible."'

The S&P 500's plunge on Thursday completely erased Wednesday's surge. Still-expensive technology shares bore the brunt of the selling as Treasury yields took flight, with the Nasdaq 100 sinking as much as 5.4%.

The Fed's commitment to compressing financial conditions will probably mark the end of the buy-the-dip mentality that has kept a cushion under the pandemic-era equity market. Instead, any signs of strength should be seized as an opportunity to offload stocks, according to Penn Mutual Asset Management's Zhiwei Ren.

"You want to sell the rally in this kind of market," Ren, portfolio manager at the firm, said. "When the Fed tries to ease financial conditions, you want to buy the dip, because they needed to push up equity prices so people can spend more money. Now they want people to spend less money and they want to push down asset prices. So you should sell the rally."

The Fed's focus on cooling conditions is why 22V Research's Dennis DeBusschere expects stocks to stay in a tight trading range after a nearly 13% drop in the S&P 500 year-to-date.