Fear of Fed Tapering Results in Two-Week Decline for Stocks

After the S&P made a new all-time high on the first trading day of December, it, along with other measures of the market, declined for two weeks in a row as a series of better economic reports led investors to believe that the Federal Reserve would begin tapering some of the current $85 billion a month of stimulus as soon as today instead of early in 2014.

This negative reaction to the old “good news is bad news” syndrome resulted in a 1.7 percent decline from those all-time highs before the new week began with some upside stabilization on Monday.

In addition to the better reports that show the economy might not be in need of as much stimulus as the Fed has been providing, a bipartisan budget deal reached last week, albeit modest in its spending cuts, could bring to a conclusion three years of impasse and fiscal instability in Washington, DC that culminated in October with a partial shutdown of the federal government. The House voted to pass it, as equal numbers of legislators from both political parties approved the compromise, and it should go to the Senate this week, after which the president will sign it.

The plan would blunt the effect of automatic “sequester” spending cuts by allowing federal agencies and discretionary programs to spend $63 billion more over two years, while savings are made elsewhere. It would also provide an additional $22 billion in deficit reduction over 10 years.

What was different this time was that a politically polarized Congress that in recent years waited until the last minute to reach stop-gap agreements on the budget and on raising the debt ceiling to avert historic defaults was able to reach this agreement more than a month before the January 15 deadline, when existing funds to run many government programs expire.

Their work was made easier by the fact that they avoided the most acrimonious disagreements in recent budget debates, namely the future of big retirement and healthcare programs that Republicans want to cut and the closing of tax loopholes that benefit the wealthiest, which Democrats want to go after.

There were $6 billion in cuts to federal workers’ retirement benefits and an additional $6 billion in cuts to military pensions as these and other new savings would replace some of the second round of automatic spending cuts (i.e. sequestration) that were supposed to start in January.

Federal Reserve officials had cited the drag from fiscal policy in their October 30 statement, and since this compromise bill removes that concern to some extent, the “tapering this week crowd” hit the sell button again last week, which resulted in the largest market decline since August.

Another negative input was that investors in U.S.-based mutual funds withdrew $6.5 billion last week, the largest such outflow this year and the biggest withdrawal from funds since August 2011. These outflows stemmed from concerns that tapering might begin today, and were even more pronounced because investors have poured cash into these funds almost every week this year; these were just the third full week of withdrawals. The other two weeks of drawdowns occurred in early October during the partial government shutdown and amounted to just $435 million.

The economic reports this past week that were stronger than projected were November retail sales, which rose by 0.7 percent, the largest such increase since June, and November industrial production, which rose by the highest amount in a year.

One sign that some investors are bracing for a volatile reaction to what the Fed says today at 2 p.m. is the behavior of the volatility index, known as the VIX. There is an almost 90 percent inverse correlation between this measure and the performance of the stock market itself. In other words, when stocks rise, the VIX declines and vice versa. But lately, even on days when the market rises such as it did on Monday with the Dow up by 129 points, the VIX has gone up as well. These latest increases have gotten it up to the same level it was trading at on October 15 as the partial federal government shutdown was coming to an end. But at that time the S&P was 1698, as opposed to the 1786 level it closed at on Monday, which means that the S&P has risen by 88 points without a corresponding decline in the VIX. This means that investors believe today’s announcement will produce a violent reaction in the stock market, which might not be the case.

This is because markets often move in anticipation of an important event, and the recent two-week decline by the major averages could have “discounted” any disappointment that investors might have if the Fed pushes the tapering button. It can also be argued that tapering in the context of an improving economy should be something that investors should be glad about, which is another reason that perhaps any downside reaction might be muted. On the other hand, assuming that the Fed sticks to its stimulus program without any reduction, the market would probably react by regaining some of the ground it has lost these past two weeks, although cynics could argue that if they do not taper, they still perceive the economy to be too weak to stand on its own two feet, so to speak.

All of this drama and uncertainty takes place within the historically friendly month of December, which as pointed out two weeks ago, has produced an average monthly gain of 1.5 percent since 1928 as opposed to a 0.6 percent advance for all months since that time. So far this year’s December performance has lagged that average badly, as we head into the home stretch of 2013. There is also a statistic that says that during the last 10 trading days of the month — the period we are currently in — the market has risen by an average of 1.2 percent since 1928 as opposed to an increase of 0.3 percent for any 10-day period.

This is why what the Fed says or does not say today is going to determine whether these historical statistics have any validity for this year. And even if they do not, let it be remembered that the market has put in its best yearly performance in 10 years, which is nothing to be ashamed of.


 

Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media. 

If you have any questions, contact dselkin@nationalsecurities.com.