To taper, or not to taper – that is the question

Posted by Shyam Moondra

The biggest uncertainty in the financial markets right now surrounds the question of when would Federal Reserve Board (Fed) start winding down (i.e., taper) the Quantitative Easing (QE) program in which the Fed buys treasuries and mortgage-based securities at a rate of $85 billion a month. This unprecedented monetary program was designed to keep the long-term interest rates low, which, in turn, would stimulate economy, especially the housing sector. The Fed was forced to undertake this aggressive approach because the Congress and President Barack Obama were deadlocked on providing stimulus to economy on the fiscal front. The QE has had some success in giving a boost to economy via housing boom and in bringing down the unemployment rate to 7.4% from the peak of 10% at the height of the 2008-2009 financial crisis. The critics of the QE program have argued that easy money would recreate bubbles (e.g., in the housing and bond markets) and also increase inflationary pressures. While low interest rates have created a bubble in the bond market and boosted interest-sensitive stocks such as utilities, inflation continues to be in check (in fact, some fear that we may be in a prolonged deflationary environment similar to the one that Japan had during the 1990's).

Ben Bernanke, the Fed Chairman, has indicated that the goal of the QE program is to bring down the unemployment rate to 6.5% at which time the program could be terminated. The low interest rates and low inflation have boosted the equity prices; DJIA as well as the broader index, S&P 500, have both set all-time records. However, the key question now is when would the Fed start tapering the QE program. The Fed is expected to first reduce their purchases from the current rate of $85 billion a month and then start selling what they already purchased to bring down their balance sheet to more traditional levels. The whole process of tapering and selling their holdings could take years to complete.

It is generally believed that when tapering begins, interest rates would go up and stock prices would go down. The financial markets are beginning to show increased volatility as the possible tapering moment gets closer. The increase in interest yields on bonds and decline in stock prices in the last week reflect the uncertainty as to exactly when the QE tapering would begin. Bernanke is on record saying that the Fed could begin tapering when the unemployment rate goes down to 7% (currently at 7.4%). Many investors believe that tapering decision could be made as early as next month when the Federal Open Market Committee (FOMC) would meet. However, given that unemployment is still not at the level the Fed desires (next unemployment report is due on September 6, 2013) and inflation continues to be within the Fed's target range, the FOMC may decide to defer the decision on tapering to their next meeting in December. If a decision is not announced after their September meeting, the stock markets could soar to new record high and long-term interest rates could get a reprieve from recent run-up.

Given how sensitive financial markers are to the timing of tapering, it may be better if the Fed pulls back from its recent policy of transparency and not be so open on what their plans are. Below are some principles that the Fed could adhere to:

• Tapering and unwinding of their balance sheet should be done in a very gradual fashion, spread over several years. This would minimize severe volatility in the financial markets.

• The Fed should bring their transparency down a notch and not talk about their plans publicly. They should not pre-announce when they would begin tapering and at what rate. If investors don't know, they wouldn't react and that will help minimize volatility and reduce chances of flash crashes in the financial markets. If the Fed tapers gradually without public fanfare, it's possible that it might have very little negative impact on economy, to the point that people might not even notice that taper has already begun.

• The Fed should give out information on tapering and unwinding of their holdings after the fact and only in less dramatic way (e.g., making a vague reference in their meeting notes rather than Bernanke talking about it prominently at a press conference). The less the information given out in a low-key fashion, the better it would be.

Regardless of what the Fed decides on unwinding QE, the long-term prospects for the stock markets continues to be positive. Yes, the interest rates would increase, but given we are so far down from the normal interest rate levels that existed prior to the financial crisis of 2008, one should exercise caution in not overstating the impact of rising interest rates. In any case, given record cash hoards on the corporate balance sheets, their capital expansion plans may not be negatively affected by higher interest rates. Second, the end of QE would also signify significant improvement in the job market, which means increased consumer spending. Since consumer spending accounts for two-thirds of economy, corporate profits would increase even more from their current record levels. Also, higher interest rates would finally burst the bond bubble and some of that money would end up in stocks. Therefore, the recent decline in the stock prices caused by uncertainty surrounding the timing of tapering, could in fact be a good buying opportunity for the long-term investors.

DJIA down 550 points – Hysterical reaction by investors to Federal Reserve policy creates a huge buying opportunity

Posted by Shyam Moondra

The DJIA has gone down by 550 points in just two days, the largest two-day decline this year. Last Wednesday, Federal Reserve announced that, for now, they would continue to buy mortgage-based securities and Treasuries at the rate of $85 billion a month; however, the Fed also said that they were prepared to phase-out the QE program later this year if the unemployment rate fell to around 7% from the current 7.6%. The Fed announcement also pushed the yield on 10-year Treasuries to 2.42%, the highest since 2011. The announcement was hardly a breaking-news; everybody understood that if economy strengthened, the Fed would phase-out QE to ensure that inflationary expectations did not get out of control. It's almost as if the investors had already decided to dump both stocks and bonds regardless of what the Fed said. The expiration of stock options this week may have also contributed to this unexpected market crash. Interestingly, gold, silver, and oil prices also crashed, suggesting a total panic among the investors. They would rather hold on to cash and earn close to zero interest or less than the inflation rate, thereby losing ground in terms of real value.

When faint-hearted investors panic, smart investors aggressively move in and start buying good quality stocks at fire-sale prices. The crowd is so much focused on the tapering of QE and rising interest rates that they are completely ignoring the reasons behind the Fed's QE policy. As the Fed Chairman Ben Bernanke explained in his press conference on Wednesday, if the Fed started to taper off QE it would be because of improving underlying fundamentals of economy. An improved economy means higher sales and profits for corporations and that, in turn, means higher stock prices. Since corporate balance sheets are the strongest ever (with the current cash hoard of $5 trillion), they don't really need to borrow much to support their capital investment programs and are thus relatively unaffected by higher interest rates. Also, as Bernanke pointed out at his press conference, increase in mortgage interest rates would not necessarily reduce the demand for housing because the increase in monthly payments would be relatively small. Let's not forget that the current levels of interest rates are no where near the normalized levels that existed before the 2008 financial crisis. Therefore, investors' worries over increasing interest rates are somewhat overblown.

The current stock valuations are very attractive. The WSJ reports that the current estimates of forward PE for DJIA is 13.62, S&P 500 is 14.88, and NASDAQ is 16.22. It's hard to imagine a huge selloff at such low PE ratios at a time when economy is strengthening. If economy continues to improve, as the Fed expects, corporate profits will also increase and these estimates of PE's could in fact prove to be too conservative. At previous market peaks, we have had PE ratios in the high 20's to low 30's range. While no one expects that we would get back to those levels any time soon, the current PE ratios are hardly excessive to have triggered a huge selloff.

This is the time to buy stocks of high quality companies that are positioned to experience growth in revenues and profits as the economy improves. The current market crash may have created one of those rare opportunities for the long-term investors who tend to buy and hold stocks. Also, as the interest rates rise, the bond bubble will finally burst and some of the bond money will end up in equity funds, creating one of the greatest rotations of recent times. In fact, the DJIA could very well hit 18,000 within a couple of years.

This is not the time to panic - this is the time to buy quality equities for the long-term.