Stocks surge on Fed tapering

This company looks cheap, that company looks cheap, but the overall economy could completely screw it up. The key is to wait. Sometimes the hardest thing to do is to do nothing. – David Tepper, American hedge fund manager and founder of Appaloosa Management

In a move that surprised most market observers, the Federal Reserve Open Market Committee decided last week to begin the much-dreaded tapering process by reducing its $85 billion-a-month bond buying process by $10 billion. After weeks of nail-biting and fretting over what effect a reduction in stimulus would have on stock prices and interest rates, it turned out that investors actually welcomed the news with open arms as the stock market soared to an all-time high and interest rates behaved as the 10-year Treasury yield settled at 2.88%, only slightly higher than the previous week. In hindsight, investors should have heeded the words of Franklin Delano Roosevelt in his famous speech when he said that the only thing we have to fear is fear itself. The Fed softened the blow by stating that tapering does not imply tightening and that interest rates would remain low until at least 2015 if not longer. Even if the unemployment rate reaches 6.5%, it is likely the Fed will continue its accommodative policy, especially if inflation stays below its 2% target. The fact that the Fed made this announcement also removes the uncertainty over the timing of such a move, another positive as the markets abhor uncertainty. And keep in mind that the Fed will still be buying $75 billion in securities, a massive amount of stimulus. All in all, Ben Bernanke and his cohorts at the Federal Reserve gave investors an early Christmas present as the Dow Jones Industrial Average jumped 3% for the week.

Last Week

While the Fed decision to begin the tapering process was the big headline last week, there was economic data released that also contributed to the merriment on Wall Street. Industrial production in November climbed 1.1%, the biggest percentage increase in a year, and housing starts rose 22.7% in November, the fastest pace since early 2008. Despite higher mortgage rates, a measure of homebuilder confidence also rose in December to the highest level in four months. The consumer price index (CPI) was unchanged in November and has only risen by 1.2% over the last twelve months.

Perhaps the biggest surprise last week was the revision in the U.S. third quarter GDP growth number to 4.1% from 3.6%, which is the strongest growth in two years. The increase was primarily due to much stronger consumer spending and business investment on the part of corporations. Most economists are cautious about growth in the fourth quarter, though, as much of the good news in the third quarter was due to inventory buildup. Lastly, jobless claims rose last week to the highest level since late March but likely reflect seasonal volatility more than anything else.

For the week, the Dow Jones Industrial Average rose 3% to close at 16,221 while the S&P 500 Index added 2.4% at 1,818. The Nasdaq Composite Index climbed 2.6% to close at 4,104.

This Week

Now that the much-anticipated Fed tapering announcement is in the rear view mirror, investors can look forward to two consecutive holiday-shortened weeks with little in the way of economic news. More attention will likely be paid to dozens of college football teams playing in thirty-five bowl games through January 6^th, the date of the BCS national championship game. Fresh off an all-time high in the stock market last week, the Michigan consumer-sentiment index should reflect this milestone with a higher reading. Durable goods orders and new home sales for November should also both be indicative of an improving economy. Weekly jobless claims may prove to be an unreliable indicator again as seasonal volatility will be a factor and long-term unemployment benefits are due to expire for more than one million people. Further confirmation that the week will be slow is the absence of any corporate earnings reports.

Portfolio Strategy

With the increase in the S&P 500 Index last week to an all-time high, the benchmark is now up 27.5% for the year while the Russell 2000 Index, a measure of small-cap stocks, has risen 35%. With very little in the way of economic news scheduled over the next two weeks, it’s likely that stocks should be able to hold on to their gains through year-end. A Santa Claus rally may even be in the cards, despite last week’s strong showing, as uncertainty over Fed tapering has been removed and investors generally feel upbeat about the economy and its prospects for the future. The biggest impediment to economic growth seems to be the lack of wage growth and the growing disparity between the haves and the have-nots in terms of income and wealth accumulation. While Wall Street and most wealthy Americans have benefited from the surging stock market, most people on Main Street have suffered from lack of meaningful wage growth and still high unemployment and underemployment. Economic growth will likely be modest until these conditions change. But for those invested in stocks, it’s likely to be a happy holiday season as the path of least resistance for the stock market appears to be up, at least until the calendar changes with a new year and market-moving economic data resumes again.