To taper or not to taper?

If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks. – John Bogle, founder and retired CEO of the Vanguard Group

Will they or won’t they? That is the question on all investors’ minds heading into this week as the Federal Reserve Open Market Committee meets to assess the economy and decides whether or not to begin tapering its $85 billion-a-month bond buying program that has kept interest rates low and helped prop up the stock market this year. With no economic news of any consequence on Monday, three Fed presidents stepped up to fill the void by proclaiming that the tapering process should begin at the earliest possible opportunity, i.e. the Fed meeting on Dec. 17^th and 18^th, with a small, token reduction to get the ball rolling. The week before, investors embraced a strong jobs report by sending stocks soaring 1% on the belief that a stronger economy would actually be beneficial for stocks and allow the Fed to gradually remove its stimulus. But the mere mention of Fed tapering by those supposedly in the know, Fed officials, sent investors scurrying for cover as they feared that such a move would lead to higher interest rates and lower stock prices. To be sure, the economic news last week was decidedly mixed. Higher jobless claims were offset by strong retail sales but wholesale prices declined slightly as inflationary pressures remain very subdued. Low inflation should actually give the Fed pause and allow them to maintain their asset purchases. Perhaps after trading at or near all-time highs, stocks were overdue for a minor correction and investors used the possibility of a December taper as an excuse to sell.

Last Week

The rise in jobless claims last week was the largest increase since November 2012 but could have been the result of seasonal volatility. Retail sales in November rose 0.7% and represented the largest increase in five months due primarily to strong automobile sales. The producer price index (PPI) fell for the third consecutive month while the core rate, which excludes food and energy, inched slightly higher.

Congress actually agreed on something as negotiators reached a compromise budget deal that will avoid a government shutdown. The agreement was passed by the House and should be passed by the Senate this week. Though very limited in scope, it does reduce the deficit without raising taxes and also eliminates the sequester. Lastly, according to the Fed, the net worth of U.S. households reached a record level at the end of the third quarter as a result of a soaring stock market and increasing home prices, both of which could help economic growth going forward.

For the week, the Dow Jones Industrial Average dropped 1.65% to close at 15,755 while the S&P 500 Index also fell by the same percentage to close at 1,775. The Nasdaq Composite Index declined 1.51% to close at 4,001.

This Week

Without question, the most anticipated news this week will be the announcement by the Fed on its decision whether or not to begin reducing its monthly bond-buying program. With the economy still expanding at a modest pace and the inflation and employment data still running below their targets, the consensus forecast still calls for Fed tapering to begin early next year. The meeting will mark the final press conference for Ben Bernanke as head of the Federal Reserve as Janet Yellen will take the helm on Feb. 1^st.

Other news pertaining to the economy will be October housing starts and November existing home sales and leading economic indicators, all expected to confirm continued modest improvement in the housing sector and the overall economy.

Earnings reports on the calendar next week include those of General Mills, Con Agra and Walgreen in the consumer non-durables sector as well as Oracle and FedEx.

Portfolio Strategy

 The losses suffered last week for both the Dow Jones Industrial Average and the S&P 500 Index were the largest declines in three months and were not the result of any specific negative news or event. In fact, the economic data was mostly positive and indicative of an economy that is improving and capable of sustained growth. Even a budget deal that will avert a government shutdown next year was greeted with only a muted response. Recently, it seems that every piece of good economic news is viewed negatively as it provides more ammunition for the Fed to begin unwinding its monthly stimulus program. The biggest question mark facing investors right now is the uncertainty over the timing of the tapering process and its effect on interest rates. While the vast majority of observers believe a January or March move is in the cards, a December move would be surprising and could lead to increased volatility in the markets, even though this process has been talked about and telegraphed for months. But investors seem obsessed with the thought of tapering and terrified of its consequences.  But whether it happens this month or sometime early next year, there is nothing to fear as the Fed tapers its bond buying program. As the Fed has emphasized time and time again, it will only reduce the stimulus program if the economy is sufficiently strong enough to handle it. And it’s not like the punch bowl will be taken away entirely. Any reduction will be in small increments that will solely depend on the economy’s ongoing strength.