To taper or not to taper

This is my first weekly market commentary of what will be many, many more to come at Hinsdale Associates. Each week I’ll recap the week’s key market moving economic data and preview what to expect from the market in the coming week. I’ll also discuss the effects of the data on portfolio strategy and any changes that may result in our investment strategy going forward.

Last Week

Any fan of William Shakespeare’s works knows that the opening phrase in the play Hamlet reads as follows, “To be, or not to be, that is the question.” To taper, or not to taper is also a question that could summarize the week’s events in the financial markets. Federal Reserve Chairman Ben Bernanke stole the show on Wednesday by saying that the Fed may begin to taper the $85 billion a month bond purchases later in the year if the economy strengthens. Any such reductions in the stimulus would be gradual and only if certain economic targets were being reached. With inflation running at about 1.1% on an annualized basis, the unemployment rate hovering at 7.6% and GDP growth plodding along at about 2%, none of the targets are anywhere near being reached. The fed funds rate will likely remain near zero until at least 2015 and any change in this rate is dependent on economic data in the future. While investors were looking for clarity in the Fed’s policy, Bernanke was clear that reducing the stimulus would strictly depend on the economic data and trends; however, investors chose to ignore that and, instead, misread the Fed chairman and overreacted by dumping stocks and bonds.

To be sure, there was enough positive economic data last week that led investors to believe that quantitative easing may not last forever. U. S. housing starts rose 6.8% in May; the home builder sentiment index rose in June and reached its highest level since 2006; small business confidence rose and the consumer price index rose just 0.2%, excluding the volatile components of food and energy.

For the week, the Dow Jones Industrial Average closed at 14,799, down 271 points or 1.8% while the S&P 500 lost 2.1% or 34 points to close at 1,592. The Dow is down 4% and the S&P 500 is off 4.6% from their all-time highs reached last month.

This Week

Investors are already looking ahead to the next Fed meeting in late July to get a further reading on the possibility of a reduction in the bond buying program. This uncertainty with regard to the Fed’s timing of its tapering will likely lead to continued volatility in the markets as investors try to stay one step ahead.

As we head into the last week of June and the end of the calendar quarter, the economic data scheduled to be released is fairly light. May durable goods, final GDP for the 1^st quarter, May new home sales and June Chicago purchasing managers index highlight the week’s economic data. Japan’s finance minister will also address the outlook for Japan’s economy, whose efforts to revitalize the economy through cheap money have even outdone those of the U.S.

Among companies reporting earnings this week are Walgreen, Monsanto, General Mills and Nike.

Portfolio Strategy

After a very volatile week in which stocks lost over 500 points in a two-day period, the stock market looks to regain solid footing to close out the quarter. Although there is the potential for a reduction in the Fed stimulus, it will only occur if the Fed believes that the economy is strong enough to stand on its own. As the economy gathers steam, it’s likely that interest rates will rise gradually, reflecting the improving economic conditions. Many investors have been spooked by the sudden rise in rates as the 10-year Treasury yield has gone from 1.60% to 2.50% in a very short period of time. This rapid increase has adversely affected many sectors of the equity market that have been popular investments for yield-hungry investors, such as utilities, REITs and other above-average dividend paying stocks.

While it is generally assumed that rising interest rates are harmful to stocks, the evidence is far from conclusive. When rates rise sharply or when inflation is heating up, stock prices are vulnerable. Slowly rising interest rates in conjunction with faster U. S. economic growth may actually be good for stocks. As the stimulus is gradually removed, we will have to wait for the economic data to see if this scenario develops.

For investors who are underweighted in equities and other risk assets such as high yield bonds and REITs, the correction in the stock market last week could be used as a buying opportunity to increase exposure to these asset classes. For those investors with excess cash, the rising yields for corporate bonds and municipal bonds are looking more attractive and could be used as an opportunity to put some money to work. Shorter-maturity bonds with maturities less than 5 years should be considered. It is important to keep in mind that despite the huge two-day sell-off in stocks last week, the S&P 500 is still up more than 12% on a year-to-date basis.

Finally, I’d be remiss in not thanking my predecessor and former colleague, Andy Fitzpatrick, for his help in making this transition as seamless and as smooth as possible. I wish Andy nothing but the best as he pursues another opportunity and look forward to working with him on an ongoing basis in his new role as a Director of Hinsdale Associates.