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.

So what’s going on? The Fed tells us that the U.S. is finally, after five long years, pulling out of its worst financial crisis since the Great Depression and investors go ballistic? You’d think people would be buying stocks in anticipation of the next great boom rather than acting like doomsday has just been announced. How do we explain this seemingly paradoxical behaviour?

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.

As usually happens in these situations, I believe the sell-off has been overdone and that bargains are quickly emerging. Once investors come to their senses and take a long, hard look at the situation I believe markets will stabilize and form a base for a new, strong upward move.

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.

Mr. Bernanke went on to emphasize that any easing of current stimulus policies would be gradual and would only be implemented if economic conditions improve as forecast. There is to be no slamming of the brakes on quantitative easing and record low interest rates are likely to continue until at least 2015.

As far as interest rates are concerned, Mr. Bernanke reaffirmed that the “current exceptionally low range for the funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2%, so long as inflation and inflation expectations remain well-behaved”. Since unemployment is not expected to fall to that level until sometime in 2015, it appears we can expect another two years of low rates. And even then, he hedged his bets saying “a decline in the unemployment rate to 6-1/2% would not lead automatically to an increase in the federal funds rate target, but rather would indicate only that it was appropriate for the Committee to consider whether the broader economic outlook justified such an increase. All else equal, the more subdued the outlook for inflation at that time, the more patient the Committee would likely be in making that assessment.”

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.

This means reviewing portfolios and making necessary revisions to adjust to the coming changes. Don’t be panicked by the sell-off into thinking you have to do this immediately. The markets will rebound once people have time to rationally assess the situation. In the meantime, if a stock you’ve been watching plunges into bargain territory, take advantage of the situation.

We are not on the verge of another 2008 – quite the contrary. Things are getting better, not worse. Don’t allow the market gyrations to lead you to believe otherwise.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, visit www.buildingwealth.ca