Ouch! Investors did not like what they read in the Federal Open Market Committee meeting statement last week nor did they respond well to Fed Chairman Bernanke’s follow-up press conference explanation of the statement. Chairman Bernanke explained in his press conference that the Fed would taper back quantitative easing (the Fed’s purchases of longer-dated Treasury and mortgage bonds in the open market) as the economy showed sustainable signs of improvement. Based on the Fed’s current outlook, that would mean cutting back on QE toward the end of this year and reducing it to zero by the middle of next year. The markets have focused exclusively on the “date” put forth by the Fed despite the fact Bernanke repeatedly stated that the process was “data” dependent—if the data doesn’t show continued signs of improvement then the tapering of QE will be delayed until it does. By any measure the Fed’s current outlook for the economy and employment is much more optimistic than any of the other economists surveyed—that could have been viewed favorably by stock investors except for the fact the Fed has consistently been overly optimistic for the past 4 years. We doubt (although we hope we’re wrong) the data will support the tapering of Quantitative Easing any time soon. Economic activity has been lackluster at best, the unemployment rate recently ticked higher and the Fed’s own favorite gauge of inflation, the Personal Consumption Expenditures Index (PCE), just hit a 50 year low—hardly the ingredients for a data dependent tapering of QE.
Regardless of our interpretation, markets will do what markets will do and it hasn’t been pretty. Since 2:00 last Wednesday when the FOMC statement was released stock markets across the globe are down 5% or more. Longer dated US Treasury yields are up 0.4%, and they are up a full 1% since the Fed first started talking about QE tapering at the end of April. Something is definitely amiss when stock prices and US Treasury bond prices are both falling at the same time—stocks typically represent the “risk on” trade and US Treasuries typically represent the “risk off” trade. When both are falling it generally means everything in between is also getting clobbered—that has definitely been the case this time.
While we don’t agree with the overall market’s interpretation of the Fed’s comments, we believe there are some logical limits to the duration and depth of this current market move. With regard to longer-dated Treasury bonds we could see yields going to the pre-most recent round of QE level of 2.8% (we are currently at 2.6%). If the market were to become totally irrational and spooked we could see those yields go to the pre-any QE level of 3.2%. We don’t see the S&P 500 falling below its 200-day moving average of 1500 (the S&P is at 1568 as of this writing), that level would also represent a 10% correction from the recent high. As for duration, once second quarter earnings season begins (roughly two weeks from now) the stock market will go back to focusing on fundamentals—we believe corporate earnings will continue to be a positive for the markets.
This has been a painful few days for all investors, and markets will probably remain volatile a bit longer until the rise in US Treasury yields slows. Candidly, this is the type of market where diversification simply doesn’t help—all asset classes are highly correlated and all moving in the same direction. But, because of that panic selling this type of environment does create great opportunities to identify mis-priced asset classes once the dust has settled. We are working hard on your behalf to do just that.