Federal Reserve policymakers have been sending out signals loud and clear since spring that they are prepared to pull back on the monthly $85 billion of purchases of mortgage-backed bonds and other securities. Those purchases have helped keep interest rates at or near their lowest levels in the memory of most market participants.
This so-called “tapering,” Fed Chairman Ben Bernanke and others have emphasized, will take place when they can be reasonably confident that their actions won’t derail economic growth or result in a spike in the unemployment rate. With the minutes of the Fed’s July meeting scheduled for release Wednesday, the buzz on Wall Street is that the axe will fall sooner rather than later – as soon as September.
We’re already seeing the market succumb to anxiety about what might lie ahead. Monday’s stock-market selloff – in which the Dow Jones Industrial Average and the S&P 500 index fell 0.5 percent and 0.6 percent, respectively – is one indication of the unease that investors feel about the comfortable prop being removed from financial assets and the economy. Monday’s losses extended the losing streak for both indices to four days, the worst so far this year. The yield on the 10-year Treasury security, meanwhile, climbed to 2.884 percent, the highest level recorded in just over two years.
What does all this mean for investors, and how should you be prepared?
1. Stock up on motion sickness pills, and anti-anxiety medication. Uncertainty brings with it not only the kind of selloff that we have witnessed in recent sessions, but also an increase in volatility, which has recently languished at absurdly low levels. That has suggested investors have been lulled into a sense of complacency and false security by this year’s bull market.
In the current environment, as Gary Thayer, chief market strategist at Wells Fargo Advisors, pointed out in a recent report, the way that markets react to news is made more complex than usual. Typically, stocks react to strong economic data (or data that is better than anticipated) by rallying; in light of the Fed’s looming threat to “taper,” “good economic news is perceived as bad” for securities prices of all kind, as it increases the likelihood that the Fed will move sooner rather than later.
2. Higher bond yields aren’t necessarily toxic for stocks. This might be easy to forget in the midst of a jittery market. Still, Jeff Kleintop, chief market strategist at LPL Financial, reminds us that rising bond yields in periods of economic growth historically have tended to be good for the stock market. Over the last 20 years, he calculates, interest rates have risen steadily for more than 12 months and by more than a full percentage point on four separate occasions. In all of those 12-month periods, the S&P 500 index posted gains. “This was not setting up for an eventual fall,” Kleintop adds in his recent client note. “Stocks rose in the following 12 months, as well.”
3. Keep your eyes on what matters, and off the headlines. This is a perennial reminder, of course, but it’s particularly important during periods when investors are agitated and policymakers are preparing to make a change with unclear ramifications for both the economy and financial markets.
Investors appear to be unloading bank stocks, at least in part because of fears that they might face some headwinds in a higher-rate environment. Focus instead on the fact that this sector saw a dramatic increase in profitability (30 percent, according to Thomson Reuters – six times the average of all ten S&P 500 sectors) and a rise in revenues that was threefold greater than that of the S&P 500 as a whole. Similarly, even as interest rates have risen, the equity risk premium (which captures the expected additional return that stocks offer over and above Treasury yields) remains attractive.
4. Don’t overreact. After such a long period at such low interest rates, any change is going to be dramatic. But rates are likely to remain at levels that would have made folks hunting for a mortgage or a business loan during the 1980s and 1990s jump up and down with excitement. As Richard Hoey, chief economist at BNY Mellon, pointed out recently, the Fed isn’t shutting down all support for the economy but only “contemplating a move from aggressively stimulative to merely stimulative.” It is a big fat hairy deal, but it’s not the end of the world as we know it, however hyperbolic the market commentators become.
Remember, too, that the stock market sectors that are the most interest-rate sensitive – telecommunications and utilities – make up only about 6 percent of the S&P 500, and aren’t the groups that have been leading this year’s rally, anyway.
5. Consider taking some profits. Yes, you’ve probably lost some of your paper profits in the last week or so of selling in the stock market. But unless you have been very unfortunate indeed, the odds are that you are sitting atop a double digit gain in your portfolio. Depending on the tax consequences, it’s worth taking a hard look at the stocks that have seen the biggest gains, on those parts of the market where valuations may be out of whack, and in segments that might be vulnerable to higher rates. BlackRock’s chief investment strategist, Russ Koesterich, points to small-cap U.S. stocks and consumer discretionary investments as examples of overstretched valuations, and says long-dated Treasury securities, inflation-protected bonds (TIPs) and bond market proxies (like those pesky utilities) are examples of rate-sensitive assets.
This also is a good time to take a look at your asset allocation and assess the degree to which it may have been knocked off kilter by this year’s market performance. That includes delving into your stock portfolio: If you own Hewlett-Packard (NYSE: HPQ), which has nearly doubled this year, and you’re not completely convinced that it can reinvent itself, well, this might be the chance to reallocate your gains to some other idea.
Times of change are never particularly comfortable for investors to navigate, and the more the looming policy moves are discussed and analyzed ahead of time, the more time we all have to become agitated and uneasy. Unless the Fed bungles it, the Great Taper could be something that we look back on a bit like the Y2K threat – something we can’t ignore but that we end up viewing, in hindsight, as more feared in anticipation than events warrant. That is, if we’re prepared for it all.