(09/06/13) Taper Talk and the Wall of Worry

There is no shortage of worries for investors in the stock market these days. If interest rates have risen sharply just in anticipation of Fed tapering, how high will rates soar when tapering actually starts? asks John Boyd, editor of Fidelity Monitor & Insight.

With the debt ceiling looming again, will we see a repeat of the partisan wrangling that caused the S&P 500 to fall more than 17% in just two weeks, back in 2011?

Are we about to be dragged into the Syrian conflict with unknown consequences? With GDP growth anemic and growth in corporate earnings slowing to under 4% in the second quarter, are P/E's about to contract? That is just a sampling, I could go on.

It's no wonder that fear has gripped the retail investor. Recently, the American Association of Individual Investor's weekly survey of its members, showed 49% to be bearish, versus a long-term average of 30.5%. While bearishness since ticked down a bit, it had moved higher for six straight weeks.

And things are no better among the pros. The Sell Side Consensus indicator, developed by Bank of America Merrill Lynch (which measures the recommended level of equities from nine major brokerage firms), sits at just 52.3%, well below the average of 60.4%.

But the market is a perverse entity. As the old saying goes, “the market tends to move in the direction that causes the most pain to the most people.” In this case, with most everyone waiting for the next shoe to drop and the market to crack, that would be for it to move higher.

In fact, if we look at AAII sentiment data, Bespoke Investment Group points out that, historically, when bearish sentiment has increased for five straight weeks, the market has been higher by an average of 9% over the next six months.

Furthermore, Bank of America notes that when their Sell Side indicator has been as low as it is now, total returns on the S&P 500 over the next 12 months have been higher 95% of the time, with a median return of 27%.

Meanwhile, since the Federal Reserve first made it known that they were considering scaling back on their $85 billion a month of bond purchases (The Taper) on May 22, interest rates have risen and the stock market has stalled. Both of these developments are somewhat curious responses.

On the surface, it might seem to make perfect sense that, if the Fed slows their buying of bonds, rates should go up, simple supply and demand, right?

Only one problem with that—whenever the Fed has started a round of bond buying, whether in QE1, 2 or 3, interest rates actually went up, and when they stopped buying, they declined.

What has happened is that when the Fed has stepped in to buy, private bond-buyers have stepped away, not wanting to compete against the government over those assets.

And when the Fed has exited, they have come back in. So once the Fed actually starts to taper, it seems unlikely rates will rise much higher, and they could even reverse course.

On the stock side, obviously the market is driven by other concerns than the potential removal of stimulus, but it definitely has been a significant factor in holding back stock performance in recent months. This makes even less sense.

The Fed has made it quite clear that they will only begin to taper should the data on the economy show it was strengthening enough to warrant them to begin to gradually remove the stimulus.

Also, they would be just as ready to add more stimulus if the data showed the economy was weakening. Under those conditions, we should welcome tapering with open arms!

Imagine you had a loved one in the hospital with a serious illness that required supplemental oxygen, because they were not healthy enough to breathe on their own.

Then the doctor tells you she is encouraged by the progress your loved one has made, and if it keeps up, she will begin to gradually reduce the amount of supplemental oxygen.

If they respond well, she will keep reducing the oxygen, if not, she will add it back. You would be rooting very hard for that oxygen to be removed. In short, we believe the reaction to tapering on the part of both stocks and bonds has been overdone.

We continue to like stocks for the balance of the year. And while we do prefer stocks to bonds, we continue to recommend bond exposure as a means to reduce risk in your portfolio, as we do not think yields will move substantially higher from here.