Stocks recently have started to pause after having run up so strongly since last Thanksgiving. So far, through June, we've made a nice full year's performance. I think it's unrealistic to assume the market would continue up at the rate it has so far this year.
One of the main reasons we've gone into this skip-and-skid mode is as a result of what has come to be called tapering. This term represents the perception that Federal Reserve Chairman Ben Bernanke and his associates soon will begin to move back from the quantitative easing policy (QE) that's been in place since 2009.
Most people I talk with are only somewhat aware of what QE actually means. A gentleman named Cullen Roche, writing in the Pragmatic Capitalist, offered a good definition. "QE is an asset swap of privately held bonds for money (called reserves, if a bank sells them, or deposits, if a non-bank sells the bond). So, there's no change in the private sector's net financial assets. In other words, the private sector doesn't experience some form of excess financial assets from QE. If you want to call it "money printing," then fine, but it's a lot like changing a saving account (t-bonds) to a checking account (reserves/deposits). So, the moneyness of the private sector's assets change, but the net financial assets do not change. Money moving, yes. Money printing, I don't think so." I agree with his conclusion.
There are a number of people, in and out of the financial world, who seem to have decided that anything good happening is actually bad; that this more than four-year recovery is all just a QE sugar high and that any talk of tapering QE is negative. So, the latest fear is that any good data on growth or employment is actually bad, because it means the Fed will wind down QE soon.
Doug Cote, chief market strategist at ING US Investment Management seemed to represent this group when he said, "QE is a temporary phenomenon for the market and ultimately, as soon as [the Fed support] ends or tapers off, the market would lose major support."
As Cote says, every time the stock market sells off, this group says it's a clear sign that the QE is no longer effective and that stocks can't possibly keep rising if tapering is on its way. As Alec Young, global equity strategist at S&P Capital IQ, said, "Given how successful QE has been in keeping interest rates low and encouraging investors around the world over to increase portfolio risk in search of higher returns, it's logical the threat of declining stimulus would induce knee-jerk profit taking." I don't know that I agree with the logical part, but the knee-jerk response is spot on.
I'm taking the other side of this trade. I say, bad isn't good ... good is good.
I think that Liz Ann Sonders, chief investment strategist at Charles Schwab, nailed it when she said, "The Fed is still treating the patient like it's in the emergency room. Yet the Fed also wants the patient to go out and leave the hospital and act normally. We're treating the economy as if it's still in an emergency." I agree that the Fed's insistence on treating the economy as if it still needs emergency-like measures is holding back confidence and keeping trillions in cash from coming off the sidelines and going to work.
I think there are a couple reasons not to be concerned about the Fed tapering. For one, QE tapering will mean the end of a monetary policy that has been a major source of uncertainty. It's not a new source of uncertainty.
Also, understand that higher interest rates typically accompany a recovering economy, and this is reason for less concern. Higher interest rates only have become a threat to growth after at least a few years of aggressive Fed tighteningwhen the yield curve becomes inverted and short-term rates are ahead of longer-term yields. The Fed would likely tighten only if the economy and/or inflation start to really boom, i.e., overheat.
In a recent note to clients, Deutsche Bank's Chief US Equity Strategist David Bianco said, "The beginning of a Fed tightening cycle is bullish far more often than not."
Bianco added that, "It is only when tightening continues into a late-cycle environment that it becomes risky. Contrary to popular belief, the party really starts when the Fed puts through its first hike. The punch bowl is removed when the curve inverts or inflation runs hot. Stock market dips on early hikes should usually be bought."
In his note, he reviewed what the stock market did the last 15 times the Fed began tightening monetary policy. He said that, "Of the 15 tightening cycles since 1965, the S&P 500 continued to advance without correction during the 'early-cycle' portion of the hikes all but three times: 1971, 1977, and 1994. The exceptions in 1971 and 1977 were when the Fed hiked early post-recession on high inflation. In 1994, the Fed hiked in response to falling unemployment in a move that proved to be too hawkish."
It's highly likely in my view that when the Fed does begin tapering, we'll see broad knee-jerk selling in the markets. However, I also support his "dips should usually be bought" idea. More on what might be bought after a couple interest rate thoughts.
You may have seen drops in the values of your bond and bond fund holdings over the past couple months. Since May 2, long-term interest rates have moved up significantly, causing bonds in that range to lose value.
One good reason for the higher long-term rates is that the economy seems to be improving more broadly. For instance, the housing market continues to expand, the energy sector is creating a tremendous ripple effect of its own, and auto sales are strong. As the economy grows, the demand for money increases, moving rates higher.
The rise in real yields since 2009 is also telling us that inflation expectations have dropped. Expected inflation is still in line with the norms of the past.
The markets are cyclical. What I think investors need to consider is that, whether it's due to tapering or whatever, this is a normal transition period for the market. Depending upon your personal goals and asset allocation strategy, those areas that have proven to be rewarding over the last three years might be ripe for pruning. Those types to consider can include TIPs, long duration bonds, a lot of dividend-paying companies and REITs; basically, any sector that's benefited from low interest rates.
As alternative investment choices, you might want to consider looking at dividend-growing issues, as opposed to the dividend-paying types. You might give up something in current income but the potential for increasing dividend payouts over time is the trade-off. I think too that the economy will continue its recovery so those companies that benefit from economic growth are definitely worth considering. The general category for companies of this type is termed cyclical.
It's my belief that the markets have overreacted, and will continue to do so, to any hints about the Fed tapering its QE bond purchases. We're likely still some time away from any meaningful Fed tightening that might threaten the recovery. In the meantime, indicators show me no sign of any deterioration in the economy, so that suggests that risk assets, primarily stocks, will probably still see appreciation.
The Fed's last tightening cycle consisted of 17 consecutive 25 basis-point rate hikes carried out over the course of more than two years.
Remember, Mr. Bernanke is a student of the Great Depression. As such, he doesn't want to repeat the error made on FDR's watch in 1937-1938. Money was tightened then, which contributed to the Depression continuing until WW II started. Anyone who thinks Bernanke will pull the rug out from under this recovery before he feels it's solid hasn't been paying attention.
Stay confident and don't let the pundits try to scare you by saying the good times can't possibly last or be true.