We are starting to see more debate regarding when Ben Bernanke and company might begin to alter their practice of quantitative easing (QE). As I’m sure you know by now, QE is the process of the Federal Reserve buying both treasury and mortgage bonds in the open market in an attempt to keep interest rates artificially low.
In the past I’ve noted that QE is arguably the single largest force behind the strength of the markets in recent quarters and it’s logical to fear that the market’s strength will come to an abrupt end when the Fed stops these QE-related bond purchases. However, that may not be the case. The result of the QE endgame will depend largely on how the policy of QE itself is wound down.
The New Buzzword: Taper
The most likely scenario is that the Fed will begin to slow, or “taper” the rate of QE-related purchases in the future. In this era of a more transparent Fed, it would seem foolish to stop the enormous bond buying cold turkey since it would likely dislocate the markets and be a shock to the system.
This opinion was echoed Monday morning on CNBC by Dallas Fed President Richard Fisher. Fisher, who is a voting member of the Fed, stated that “stopping purchases altogether would be too disruptive.” He added “I would start by scaling back MBS (mortgage backed security) purchases.” Fisher also commented that “all members are trying to achieve the same goal” and “I’m not alone in my thinking about tapering our bond purchases.”
There’s no assurance that just because Fisher, along with a few others, has a favorable opinion about tapering QE that this will be the actual approach taken by the Fed but it seems to be both the most logical and now most likely scenario to anticipate.
We need to think about what this means as investors.
This is welcome news to me because, as an investor, I care more about the foundation of our economy and financial system than a spike in market indices. I’m more concerned about the long term consequences of poor economic policy than I am about immediate gratification.
Richard Fisher also mentioned on CNBC that “we’re (the Fed) basically underwriting Congress for not getting its job done” and that “both Republicans and Democrats are doing a bad job.” He said “we need a rational fiscal policy to spur the economy.” I take great comfort in seeing that a member of the Fed recognizes their excessive policies but it’s very troubling to see that our elected officials in Washington are so inefficient that they need the Fed to overcompensate for their incompetence.
The investment community knows that the QE programs are pushing money to financial instruments like stocks and real estate and away from 0% money market funds. It is nice to see these assets appreciate, but I would prefer to see them appreciate at a sustainable pace for the long haul and not bubble up into speculative disasters. If the Fed were to carry on with QE for too long, we could see a surge in the stock market but we then run a very high risk of seeing all of those gains wiped out even more swiftly than they were created.
Where is the benefit in this scenario to investors, companies, employees, and the financial system as a whole? I much prefer a market supported by sound policy and fueled by rising corporate profits over yet another boom/bust cycle in both the financial markets and the economy.
So I stand on the side of those who want to see a tapering off of QE and the sooner the better. I don’t know exactly how Ben Bernanke will justify it since he has publicly talked himself into a conundrum. The Fed’s dual mandate to hold prices stable (keep inflation in check) and provide for maximum employment of the nation’s workforce presents a problem at the moment. As I’ve noted in previous commentaries, we will be above Bernanke’s unemployment target for raising interest rates for a long time, and we are also well below the inflation target he has set.
Is It All About the Fed?
Many people believe 100% of this market resurgence is due to the Fed’s easy money policies. There are others who think these policies have done nothing to help spur the recovery. They think the Fed’s actions have actually slowed the natural course of recovery and that the Plow Horse economy story I’ve put forth is too conservative.
I think both are incorrect.
From all I read and hear from business owners around the country, I see a story of gradual economic recovery. We have seen business investment and consumer confidence increase in recent quarters and the theory I put forth six months ago about a real estate resurgence helping the economy recover is proving to be true.
These trends are firmly enough in place to withstand a tapering of QE but not an immediate cessation. This era of super-cheap money from the Fed has had a considerable effect and I’m sure things will cool off when the Fed begins to taper.
There’s probably no way yet to know just how much Fed policy is to credit for the recovery in the markets and the economy. If I were to guess, I’d say it has been more dominant for the past six months and perhaps less so prior. If I were to guess at the future, I’d say that if the Fed maintains their current stance without tapering, the spike they’d put into the markets would be almost entirely due to their actions. But if they do begin to taper I think the market’s reaction will likely prove the genuine strength in the economy also deserves some credit.
The Public is Slow to Get Involved
I routinely see evidence of the pessimism of the American investor. A recent Allianz Global report noted that stocks are “under-owned” by most investors. They cite a Gallup poll published on May 8th which showed only 52% of US investors own stocks versus 62% in 2000 and 65% in 2006. We are now at the lowest level of stock market participation since 1998.
Interestingly, the 52% figure is the same as where it was last year, so the strength in the markets still hasn’t attracted those buyers just yet. History clearly suggests that those folks will be future stock buyers – later and at higher prices. Those are some of the signs to watch for when you wonder if bubbles are truly being created. It is when the most reluctant buyers finally come aboard that caution is most necessary.
Some additional commentary from Allianz confirmed that consumers are benefiting not just from less overall debt but also lower interest rates for the servicing of that debt. The proof can be found in the household debt service ratio – the amount of income required to cover revolving debt costs – which is now at an all-time low of 10.4%.
Finally, here is additional evidence from Allianz that may explain why the markets aren’t likely to call it quits if we do see a tapering of QE:
• In April 2000, when the S&P 500 hit a record high, the trailing P/E ratio was 27.4; forward P/E was 25.6.
• In October 2007, when the index hit a record high, trailing P/E was 16.5; forward P/E was 15.2.
• Last week, when the index hit another record high, trailing P/E was 14.7; forward P/E was 14.3.
While the ratios of today might not look dramatically cheaper than those of 2007, other critical factors like interest rates, government bond yields, leverage, and real estate valuations point to more favorable conditions today. We are comfortably within long-term valuations. The cheap days of the market are long gone but we’re not dangerously expensive either.
Fed Turnover: Will it be Ben Bernanke’s decision to make?
As Mr. Fisher reminded people during his CNBC interview, the membership of the Federal Reserve, and very likely the Chairmanship, are set for some changes next year. Not only is Bernanke perhaps going to step aside, the composition of the FOMC voting membership will change and we may see the appointment of new members. Will this reconstituted Fed maintain current policies?
The takeaways:
• The tale of the taper is likely to be a good one. Hopefully we’ll get the chance to find out. My fear is that we see the Fed either take too long to begin to taper or that they move in too swiftly.
• Since so many investors are still sidelined, the notion of stocks being in a bubble at this stage is probably inaccurate. Those who actually are in the market are possibly too optimistic (bearish indicator), but that is offset by the multitude of others that are still not participating at all (bullish indicator.)
• The Fed’s easy money is certainly the biggest current factor in the markets but the accumulation of other positive forces is legitimate and meaningful as well. The lion’s share of money that has been moved into stocks in recent quarters hasn’t been pulled away from bonds; it’s been pulled away from the 0% money markets, CDs, and T-bills. This is good news because it means there is still plenty of ammunition for money to move into stocks when the rotation from bonds eventually gets underway.
• This normally isn’t a strong time of the year for stocks and a welcome correction could come at any moment. I have no idea where stocks will be in 2 or 3 months’ time but I do think markets will be higher a year or so from now.
• With that in mind, I would suggest being invested for growth via stocks as much as your comfort level allows. Don’t speculate and don’t invest like a 40 year old if you’re clearly relying on your portfolio for retirement income but don’t be one of the folks over- intellectualizing things from the sidelines. And don’t be overly concerned about short term market swings, either. If you are properly allocated and staying within your true tolerance for risk, now is a time to participate in the markets.
Jeff Winn – Orlando Financial Planning
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