David Evanson and Oliver Pursche
Minyanville.com, Summer, 2013
Why a significant shift in Federal Reserve policy seems unlikely.
Wednesday afternoon, the Federal Reserve released the July FOMC meeting minutes. Bond and stock markets immediately sold off on the headlines that the Fed was one step closer to tapering its asset purchases and could do so as early as September. I have a slightly different take, and certainly am drawing a different conclusion.
First of all, I’m a pretty quick reader, and everyone listened to and read the same report at the same time. I have no idea how people can read, digest, analyze, and verbalize an investment thesis or conclusion within seconds or minutes of a release. But I digress….The report showed very little in terms of new direction or thinking. Moreover, if anything, the argument can be made that the Fed reduced the probability of tapering at the July meeting.
To wit: Several members of the committee expressed doubt regarding the sustainability and strength of the economic recovery. Moreover, since the July meeting, economic news (domestically and internationally) continues to be mixed at best. Although there are indications that the Fed will likely make a third attempt at rebalancing its monetary policy away from asset purchases (anyone remember Operation Twist, or statements that there would be no further QE after QE2?), such a policy shift is almost guaranteed to be very gradual and measured.
Moreover, Fed officials, in particular Dr. Bernanke, have a keen understanding of the importance of the wealth effect. While the S&P 500 (INDEXSP:.INX) has more than doubled since the March 2009 lows, investor sentiment is still tepid. Moreover, the last two times the Fed attempted to reverse or change monetary policy, the market suffered a significant (albeit temporary) correction, falling over 20% in Q3 2011 and nearly as much in the spring of 2010.
Market forces are at play: The yield on the 10-Year Treasury has jumped from below 1.75% to over 2.8% in the past few months, pushing bond and bond fund prices down and serving as a live case study to market observers and policymakers as to how equities and other asset classes react in such scenarios. When digging a little deeper into the data (for stocks), investors might be surprised to learn that the impact has been concentrated in traditionally defensive sectors of the market such as utilities, telecom, and consumer staples shares. While the S&P 500 might only be down 3.5% or so, the previously mentioned sectors have corrected by more than 6%. I believe this will prove to be a temporary phenomenon as the earnings power for many of the stocks in these sectors (especially telecom and consumer stocks) is very much in tact, and their dividend yields continue to be far more attractive than those of bonds.
The bottom line is that investors should not be too concerned about a deep or prolonged market correction. Smart investors will take this opportunity to rotate some of their current holdings into cyclical stocks and large technology names that offer attractive valuations and an above-market dividend yield (at my firm, we like Apple (NASDAQ:AAPL), Boeing (NYSE:BA), IBM (NYSE:IBM), and Visa (NYSE:V) at these levels). Investors should also consider some European multinational companies such as Total SA (NYSE:TOT), and Novartis (NYSE:NVS) as alternatives to US companies. The bottom line – headline risks and market overreactions are a plenty, but a significant shift in policy or market direction is very unlikely.