The Dow Jones Index (DJI) and Nasdaq (NDX) have been under pressure since the Federal Reserve woke up to an inflation problem that might have been brewing for more than 20 years.
In late 1996, former Fed Chair Alan Greenspan made his infamous “irrational exuberance” observation about the frothiness in the tech sector.
Many observers seemed to have forgotten that he backed away from that perspective in 1997 and the Nasdaq boomed to new heights until 2000. In any case, many commentators believe that the modern era of the so-called “Fed put” was born then.
The asymmetric bias of central banks toward looser policy than what is otherwise necessary is a debate for another time.
At the outset of the pandemic in 2020, governments and central banks around the world rushed to put measures in place to support their respective economies and indeed, society.
The result of this tsunami of stimulus that was added to the global economy enabled capital to flood into all sorts of risk assets that would normally struggle to get funding. The mainstreaming of the Special Purpose Acquisition Company (SPAC) might best represent this episode of “exuberance”.
Since the Fed acknowledged that the inflation genie is out of the bottle, an aggressive tightening of monetary policy has unfolded in 2022. This has seen equity market indices descend from their peaks.
The Nasdaq (NDX) could remain vulnerable to the continuing tightening of financial conditions. The Dow Jones Industrial Average (DJIA) might not be as exposed as the technology-laden Nasdaq.
If this is to hold, then trading a long DJIA/short NDX relative value position might best express this view. The ratio of DJIA divided by NDX just moved back above 3 this week. During the pandemic, it visited an all-time low of 2.14 in November 2021.
LONG-TERM DJIA/NDX RATIO
While the ratio has already moved up significantly, it might go toward, and possibly above, its long-term average of 5.31 (1995-2022). The 3-year average prior to the pandemic is 3.6 (2017-2020).
While the Fed has made it clear that tight monetary conditions are needed for the foreseeable future to rein in inflation, any material change to this outlook will undermine the prospects for this position.
This article has been written before US CPI data and this number might provide an opportunity.
PANDEMIC DJIA/NDX RATIO, 2020 – 2022