'Investors must still buy the dip, because of the Fed's backstop'

The sharp three-day decline in stocks that began this month was “horrific”, according to Fundstrat’s Tom Lee, but a message derived from Wednesday’s rebound suggests investors should stay calm and “still buy the dip”.

That’s according to a Fundstrat note sent to clients on Thursday, which pointed to the Fed as the message investors should pay attention to.

In the note, Lee highlighted a dovish Federal Reserve and its easy monetary policies as the ultimate factor that supports a year-end rally for stocks.

The monetary policies enacted by the Fed since the COVID-19 pandemic began this year include slashing the Federal Funds rate to near zero per cent, buying corporate and municipal bonds to help shore up the credit market and directly lending to small and medium-sized businesses.

All together, the Fed’s balance sheet has expanded by nearly $US3 trillion ($4.1 trillion) to $US7 trillion since the new stimulus measures went into place six months ago, according to data from the Federal Reserve.

The dovish Fed policies enacted in response to the COVID-19 pandemic pale in comparison with the Fed’s response to the Great Recession of 2008. In 2008, Fed stimulus policies resulted in its balance sheet more than doubling to $US2 trillion from $US1 trillion.

But it wasn’t until 2013, five years after the 2008 recession, that the Fed’s monetary policies of quantitative easing expanded its balance sheet by $US3 trillion from its 2008 pre-recession level.

“Ultimately, if the Fed is dovish and monetary policy is easy, markets have a backstop,” Lee said. "In other words, we must still by the dip."

And there’s little sign the Fed won’t remain dovish for the next few years. Last month, the Fed announced an overhaul to its framework that now targets an average rate of inflation of 2 per cent. The move signals that even after an economic rebound, the Fed will probably leave interest rates low to help fuel full employment.

Lee suggested investors will find a better risk-reward set up in the “epicentre” stocks, or stocks that were hit hardest by the COVID-19 pandemic and stand to benefit from a reopening economy. He said the improving COVID-19 case trends in the US and strength in the economic recovery favour the reopening trade.

Although investors may be scared to own cyclical stocks, which have little earnings visibility and are not obvious winners from the pandemic, “they are going to be primary contributors to EPS [earnings per share] growth in 2021, thus, we see better risk/reward”, Lee said.

This story first appeared in Business Insider. Read it here or follow BusinessInsider Australia on Facebook.

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