Equities Skyrocket to Further New Highs After the Fed Tapering Decision

In last week’s column I pointed out that the two-week stock market decline during the first half of this month could have “discounted” any disappointment that investors might have if the Fed pushed the tapering button last week. I also stressed the fact that tapering in the context of an improving economy should be something that investors might be glad about, which is another reason why any downside reaction might be muted.

And this is exactly how things played out, as the dramatic announcement on December 18 that the Fed was going to finally withdraw some of the $85 billion a month in bond buying stimulus by $10 billion starting in January produced the exact opposite reaction that the majority of market “experts” had predicted. After a knee-jerk downside decline of 67 Dow points when the statement was released, stocks made one of their most dramatic intraday turnarounds ever by closing with a 292 point gain at a new all-time record high, and for good measure it added to the upside festivities by closing higher for the next three days as well.

This meant that by Monday of this week, the Dow had closed at a new all-time record high for the 48th time this year, and the S&P also closed at its best-ever level for the 42nd time in 2013. And they were joined at record upside festivities by the Russell 2000 Index of small stocks, the various mid-cap indexes and the Dow Jones Transportation Average as well.

So what did they say that caused all the upside fireworks? The central bank announced that it will gradually end its stimulus bond buying program next year, which is a modest first step toward doing away with its broader stimulus program as they now believe that the economy is improving more steadily. The current program will be cut to nothing by the end of 2014 as outlined above. On the other hand — and this is what caused that huge upside turnaround last Wednesday which has continued from there — they suggested that the federal funds rate (at which banks lend to each other) would remain at current all-time low levels for longer than they had previously promised.

Chairman Bernanke said that if job gains continue as expected, bond purchases would likely continue to be cut at a “measured” pace throughout next year and would probably be wound down “late in the year, certainly not by the middle of the year,” as the economic recovery “clearly remains far from complete.” He also mentioned that new Chairperson Janet Yellen “fully supports what we did.”

Of course this unprecedented bond purchase program has left the central bank holding around $4 trillion of bonds and the path to unwinding this is fraught with risks such as the possibility of higher-than-assumed interest rates.

In perhaps the most dramatic statement, which is what turned the stock market around after the initial negative reaction as just mentioned, the Fed said it “likely will be appropriate” to keep overnight rates near zero “well past the time” that the unemployment rate falls below 6.5 percent as they had previously suggested, especially if inflation expectations remain below their 2.5 percent target. The jobless rate is currently 7 percent.

And sure enough, the economic releases during the past week have given credence to the Fed’s justification for beginning the tapering process as reports have shown that the economy is on an improving path. November housing starts rose by 22.7 percent to the highest level since January 1990; November personal spending rose by the most in five months, as did the final December U. of Michigan Consumer Sentiment Survey.

But the most dramatic evidence of a better economy was the final revision to the third-quarter G.D.P. numbers which showed a gain of 4.1 percent, up from the most recent estimate of 3.6 percent and the best advance since the fourth-quarter of 2011. And raise your hand if you think that the Federal Reserve had this information when they decided to push the tapering button two days prior.

The G.D.P. gains were a function of business spending increasing at a 4.8 percent rate instead of the 3.5 percent pace reported previously. Consumer spending, which accounts for around 70 percent of the economy, was also revised higher to a 2 percent gain, and business spending on equipment was pushed up to an 0.2 percent rate from previously being reported as unchanged. But a large increase in inventories still accounted for a good part of the gain, which means that a sharp slowdown in the pace of inventory accumulation could negatively impact the fourth-quarter G.D.P. rate. On the other hand, some observers believe that the inventory drag could be delayed until the first quarter of next year.

In another indication that investor nerves have been calmed to a great extent in the past week, the volatility index, known as the VIX, which I had mentioned last week had been rising as stocks were declining during the first half of the month as a result of fears over Fed tightening, has finally started to drop once again in its traditional inverse relationship to equities.

Last week it appeared as if the S&P was going to disappoint those who had expected it to at least match its December reputation for being the second-best month of the year with an overall monthly gain of 1.5 percent versus a gain of 0.6 percent for any month since the construction of this index back in 1928. As we are approaching the final days of 2013, it has made a remarkable comeback from what had been a 1.5 percent decline and is currently ahead for the month by 1.2 percent.

We have still gone 25 months without a 10 percent downside correction in the market despite cries heard throughout the land that we are long overdue for one, and this is the longest such stretch of this nature since 2007. Market experts are almost universal in their belief that such an event is going to take place in 2014, but if profit growth continues on its recent upward path and interest rates remain at these record low levels, then investors really are going to still have no alternative to achieve above-average returns than by placing additional funds into equities, which can continue the bull market for the coming year as well.


 

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.