Fed Taper

In our last commentary we suggested the recent bipartisan budget agreement may not be good for stocks in the near term and bonds in the near or longer term due to the fact the agreement likely paved the way for the Fed to begin tapering its bond buying activities. So far it looks like we were only half right. Yesterday the Fed announced the beginning of its tapering plan. The announcement was a bit of a surprise for the market (most expected tapering to begin after the first FOMC meeting in 2014); but, while it was more than expected it was probably less than many feared the first round of tapering would be. Most importantly, the announcement was accompanied by the Fed’s own forecast for the economy, employment and inflation. Based on the Fed’s forecast investors can expect short-term interest rates to be anchored near zero percent through the end of 2016 and possibly beyond. The stock market rallied nearly 2% on the news; but, intermediate term interest rates increased roughly 0.10% (i.e. intermediate bond prices declined approximately 0.5%).

While we were a little surprised with the Fed’s forecast, particularly the part where they don’t see core inflation exceeding 1.75% (their minimum target is 2%) at any time in the next three years, we weren’t totally caught off guard with the likelihood of short-term interest rates remaining anchored near zero percent for the foreseeable future. Bond yields increasing was expected; but, as we mentioned in last week’s commentary, we also expected the first announcement of Fed tapering to lead to the long anticipated correction in the stock market. We obviously got that one wrong—at least for a day. The last two times the Fed ended its bond buying activities (QE I and QE II) the stock market proceeded to decline 10%-15% in the following months. We still think that is more likely to happen than not but it may get postponed until the new year.

Other than a much needed and somewhat overdue correction, we believe in the intermediate- and longer-term that stocks offer far greater value to investors than bonds. The Fed forecast described an environment in which short-term interest rates remained at zero percent, inflation was virtually non-existent (below the Fed’s minimum target rate), the employment market was steadily improving and the economy continued to advance—that’s nirvana for stock investors. As we said before, we believe there is at least one more big move left in this stock market rally—any corporate top line growth (sales/revenues) will likely be accompanied by the expansion of price-to-earnings multiples. The S&P 500 currently has a price-to-estimated earnings multiple of 16.3x—a one multiple increase (to 17.3x), all other things being equal, would be worth 6% in total returns for stock market investors. It is not uncommon for price-to-earnings ratios to expand several multiples in the late stages of a bull market.