When Good is Bad

Let’s see if we’ve got this straight: the U.S. economy is recovering faster than expected. GDP will grow between 2.3% and 2.6% this year and then rise steadily to between 2.9% and 3.5% in 2015. Meanwhile, unemployment will drop to 6.5% by the end of 2014, a year earlier than previously forecast. By the end of 2015, it is expected to fall further, to between 5.8% and 6.2%, all this according to the Federal Reserve Board.

That has to be great news, right?

Not according to the stock market. The Dow Jones Industrial Average proceeded to plunge by more than 200 points on the day after the news came out while the S&P 500 lost 1.4%. And the carnage continued from there as investors hit the sell button on almost everything in sight – stocks, gold, bonds, oil – everything was being dumped.

For starters, it’s essential to realize that the U.S. market has been running ahead of itself for several months – effectively living on the steroids administered by the Fed’s massive quantitative easing (QE) program. The three major indexes had far exceeded their forecast gains for all of 2013 by mid-May. Even now, after the selling binge, they are still comfortably in double-digit territory for the year.

Stock markets have always been seen as leading indicators. So the run-up was really a matter of investors anticipating that the recovery was taking hold and acting accordingly. Now the Fed has confirmed it, triggering a “buy on rumour, sell on news” response.

The sell-off was not unexpected. In May I warned readers of my Internet Wealth Builder newsletter about the likelihood of a pull-back followed by a period of consolidation over the summer. At the time, I advised some selective selling to take profits off the table and raise cash.

Shortly after that, U.S. stocks began to turn down as anxiety grew that the Fed would soon begin to ease its stimulus program. That drove bond yields higher, putting pressure on defensive securities such as utilities and REITs in the process. We should expect more of the same in the weeks to come.

There are a number of reasons for this optimistic view. For starters, look closely at the language of the Fed’s statement and the words of Chairman Ben Bernanke. What they boil down to is tightening if necessary but not necessarily tightening. There are a lot of caveats in the Fed’s position. Just check out the words used by Mr. Bernanke in his opening statement on behalf of the Open Market Committee.

The economy will continue “to grow at a moderate pace, notwithstanding the strong headwinds created by current federal fiscal policies”.

“The unemployment rate remains elevated, as do rates of underemployment and long-term unemployment.”

“Inflation has been running below the Committee’s longer-run objective of 2% for some time and has been a bit softer recently” – an indication the Fed governors are still worried about the threat of disinflation.

As for quantitative easing, which is currently pouring $85 billion a month in new money into the U.S. economy through the purchase of bonds and mortgage-backed securities, the Chairman said the current level will remain unchanged for now. If conditions improve as expected, the Fed would begin to ease back on purchases later this year and in “measured steps” through the first half of 2014, ending the program around mid-year.

But, he stressed, “our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook, as well as on the cumulative progress toward our objectives. If conditions improve faster than expected, the pace of asset purchases could be reduced somewhat more quickly. If the outlook becomes less favourable, on the other hand, or if financial conditions are judged to be inconsistent with further progress in the labor markets, reductions in the pace of purchases could be delayed; indeed, should it be needed, the Committee would be prepared to employ all of its tools, including an increase in the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.”

What it boils down to is that the Fed is saying it will hold the line on interest rates for the next two years while adopting a pragmatic approach on its quantitative easing measures. It’s a reasonable approach. However, based on the reaction of the markets, it seems like investors expected QE to go on forever.

In fact, we should hope that the Fed is right and that the U.S. economy will indeed improve as expected. Investors will be much better off in an environment where market advances reflect real-world improvements in corporate profits and employment gains rather than one which relies on a series of drastic and unsustainable measures to stimulate growth.

The problem is one of adaptation. We have become used to a climate of low rates and stimulus programs. Now, like drug addicts, we need to be weaned off this addiction and get back to reality.