May 1, 2014 at 9:03 AM
As investors celebrate the fifth anniversary of the bull market, they must give thanks to our Federal Reserve. Its unprecedented monetary support has been an important factor in the market recovery.
To fight the most vicious downturn since the 1930s, the Federal Reserve slashed short term interest rates to near zero and forced longer term rates to the lowest since World War II. It gobbled up longer dated Treasuries and mortgage backed bonds, to the point where its balance sheet is burdened by some $4 trillion in debt. Investors have shifted billions from bonds to stocks as yields plummeted. Corporations bought back their shares by borrowing at the low rates.
Investors cheered Fed induced improvements in the economy. Lower mortgage rates staunched the slide in home prices, as buying became cheaper than renting. Waves of mortgage refinancing put more money in Main Street pockets, boosting spending.
However, the Federal Reserve has started to take the punch bowl away, reversing its liberal monetary policy. In December, it started reducing (tapering) by $10 billion per month its bond buying program; short term rates are poised to rise in 2015.
Given the powerful impetus the Fed’s expansionary policy provided, just how should investors play the great coming contraction in liquidity, with a corresponding rise in interest rates?
In a Nutshell
There’s no way you can spin the tapering as a positive for stocks. Higher interest rates reduce their present value, including their dividends. Higher yielding bonds create greater competition for equities.
The great rationalization is that the Fed wouldn’t taper if it didn’t feel the economy had improved; better economic conditions lead to superior profits which lead to higher stock prices. Longer term we’re optimistic. The stock market will remain a cornerstone for portfolios. Even if rates rise, they’re still at very low levels. A 3.5% ten year Treasury is still not enough for retirees to live on, endowments to distribute, or pensions to rely upon.
Different companies will react differently to a tightening in monetary conditions. More cyclical companies will benefit more from the improving economic conditions giving rise to the tapering. Valuations still matter. Even non-cyclical stocks can perform well if the tapering proves less damaging than has already been priced in.
Before getting too alarmed over the taper, realize that the future is never certain. Fed Chair Janet Yellen has repeatedly stated that monetary policy is flexible; if the economy slows or stumbles there’s nothing to prevent the Fed from halting or even reversing the taper.
A portfolio’s first job is to preserve capital. Even if you’re committed to restructuring your portfolio to compensate for the taper, stay diversified enough to cope with no taper, or even an expansion in liquidity.
In a taper, financial stocks’ earnings should rise with higher rates. Their business is lending money, so when rates rise the yields on their loans and investments should improve, padding the bottom line.
If the Fed doesn’t taper, and money velocity picks up, all the Fed’s monetary creation can trigger inflation. If that velocity picks up faster than the Fed can or wants to taper, inflation may result.
Investments that hedge that risk could be a good bet now. Chair Yellen and many others see inflation as quiet. While that’s true, the good news from an investor’s point of view is that the cost of inflation insurance is cheap. Commodity producing stocks are desirable inflation hedges.
The Federal Reserve is confident the economy can withstand the taper because it is growing fast enough to tolerate higher interest rates. One strategy to offset the taper is to focus on those companies that most benefit from a growing economy. Cyclical stocks’ earnings vary with the economy, like home builders, auto makers, appliance outfits, and other makers of big ticket items.
However, shunning non-cyclical stocks, such as utilities, consumer staples, and telecoms, merely because their earnings are less sensitive to economic variability, may be an error. Why? Investing isn’t just about predicting future earnings; it’s also factoring in how other investors have handicapped those earnings, and considering whether the resulting valuations make sense.
Note: David G. Dietze, JD, CFA, CFP™ is President and Chief Investment Strategist of Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit. The full-length version of this article is available at: www.ptview.com.