Fed postpones taper, stocks applaud news

Roaming the world as a foreign correspondent for more than a decade, I was able to observe how a variety of vastly different nations organized themselves economically. The inescapable conclusion was that no politician anywhere on the planet has ever actually created a rupee’s worth of prosperity. – Louis Rukeyser, Nov. 1996                                                                                                                    

In a surprise move that stunned most economists, strategists and market observers last week, the Federal Reserve decided not to tamper with its stimulus program and will continue its $85 billion-a-month bond buying program for the time being. By doing so, the Fed hopes that the wealth effect created by rising stock prices will be enough to cause consumers to spend more and lead to faster economic growth. While the odds were heavily in favor of a modest reduction in the purchases, Fed Chairman Bernanke cited numerous reasons for postponing the tapering process awhile longer. Among these were a stubbornly high unemployment rate of 7.3% that has shown some improvement but does not take into account the number of people that have simply dropped out of the workforce and are not counted as unemployed by the government. The Fed also admitted that economic growth has been slower than expected, with government spending cuts a probable cause. Another reason for standing pat has been rising mortgage rates, which seem to be hurting the housing recovery. In conclusion, the Fed wants to wait for more evidence that the economy is on solid footing before withdrawing its stimulus. If this statement sounds familiar, it is. This has been the Fed mantra for months but no one apparently has been paying attention. While stocks closed at record highs on the day of the Fed announcement, by Friday stocks retreated as investors realized that weak economic growth and higher interest rates are not necessarily conducive to higher stock prices. The next obstacles for the markets will be government budget talks and the debt ceiling as the politicians do what they do best: agree to disagree.

Last Week

The news that Larry Summers withdrew his name from consideration to replace Federal Reserve Chairman Ben Bernanke in January caused investors to rejoice on Monday as stocks rallied. He has been a long-time critic of the Fed’s easy monetary policy and his decision was viewed favorably as Fed Vice Chair Janet Yellen now becomes the prohibitive favorite to replace Bernanke. She is a strong proponent of the Fed’s current policy and would likely keep it in place until the economy can stand on its own.

Economic data related to the housing sector last week was mixed. Higher mortgage rates might have been the reason for both good and bad news. Housing starts increased less than expected due to higher mortgage rates but those same higher rates may have caused existing home sales to rise as buyers hurried to lock in current rates before they increase any further.

For the week, the Dow Jones Industrial Average rose 0.5% while the S&P 500 climbed 1.3% and the Nasdaq gained 1.4%. 

This Week

Washington will be the center of attention this week as Republicans and Democrats will attempt to find common ground on the Federal government’s budget. Both parties must also reach an agreement on the nation’s debt ceiling in order that the government’s bills can be paid and the country does not default on its debt. While we have been through this process before, never underestimate the ability of politicians to manufacture a crisis and cause volatility in the markets. Keep your fingers crossed for a successful and timely resolution.

In terms of economic news, the calendar is rather sparse this week. New home sales should continue to show improvement and housing prices should post increases in 20 U. S. markets tracked by the Case-Shiller Index. Both releases will lend support for the ongoing housing recovery, which has been one of the few bright spots in the economy. On the corporate earnings front, Nike, Bed Bath & Beyond, Accenture and Carnival Cruise Lines are among the companies that are reporting.

Portfolio Strategy

If nothing else, the markets can expect to be volatile in the weeks ahead as the focus will be on fiscal policy and not monetary policy. When a similar situation confronted the markets in 2011, there was considerable bumpiness but through it all, stocks weathered the storm and closed higher after all was said and done. Hopefully, the politicians will come to their senses and finally do what is best for the country instead of their own self-interests. While there seems to be positive momentum in stocks and room for the market to move higher, there is greater likelihood that stocks will consolidate their gains and move sideways until the situation in Washington is resolved. By the Fed’s own admission, economic growth is likely to be less than 2% in the third quarter but is expected to rebound and be faster in the near future. Patience should be rewarded, too, as studies have indicated that in similar years where stocks have risen by about 20% by this time in the year, there have been additional gains of over 3% for the remaining three plus months of the year.

The Fed’s acknowledgement that the economy is still fragile and not strong enough to withstand tapering was good news for bondholders. The yield on the 10-year Treasury note declined to 2.73% from 2.90% the previous week and prices on fixed income securities and other interest rate sensitive investments increased. The primary beneficiaries of this decline in rates should be investment grade corporate bonds, high yield bonds, municipal bonds and, to a lesser extent, real estate investment trusts (REITs) and above average dividend-yielding stocks. With the Fed’s tapering on hold for the foreseeable future, these investments should continue to do well.