Will The Fed Kill Economic Growth?

“When the market is going up, there is a tendency for investors to become more risk averse. Research shows that people tend to be risk-seeking when dealing with losses and risk averse when dealing with gains. As a result, with the market hitting all-time highs, individuals surprisingly are starting to become a little more nervous with regards to the future direction of the market. It is important to remember that market movements are time independent events. The fact the market is hitting new highs has no statistical bearing on what is going to happen next. The market is no more likely to go up or go down given it has appreciated in the past. If anything, there is some data that shows if a market is exhibiting long-term momentum that momentum tends to persist for a few months. The odds of investing in the equity market, over long periods of time, are in an investor’s favor.

Generally speaking the market tends to appreciate at a rate that is roughly 600 basis points, or 6%, above the risk-free rate. The risk-free rate is the rate of return on 3-month treasuries. This rate of growth is surprisingly stable over time and is likely to persist in the future. As a result, on average, an equity investor should plan on having an investment in the market double every eight to ten years. This means if you perform as well as the market has historically, a $1 million investment should grow to roughly $2 million over a ten year period when factoring in the reinvestment of dividends.

The rational course of action is to remain invested over long periods of time and ignore the daily, monthly and even yearly fluctuations in the market. No one can successfully time the market over long periods of time. As a result, the best course of action is to bet on the base rate over time and to continue to hold equities through the periods of euphoria and despair. The time to sell is when an individual’s assets have grown to a level that is needed in order to buy or consume something.

Where individual investors run into problems with equity investing is that they tend to need money in the depths of a recession, which is exactly when the market is selling off the most. When the economy is collapsing and layoffs are rampant, the market will fall precipitously.  This is what stops individuals from allocating to equities and brings us to my obsession regarding the economy.

Basically, stocks, in aggregate, tend to perform well when the economy is expanding and poorly when the economy is contracting. This by no means is always true. There are many examples of years when the market did quite well while the economy did not and vice-versa. However, over longer periods of time, the market needs increasing earnings to appreciate and increasing earnings are generated by a growing economy. While economic growth and the market are not heavily correlated, it is very clear that stocks perform poorly when the economy is contracting and interest rates are rising.

Right now, there are two major issues weighing on the economy. First and foremost are the rising interest rates. Whether it is from the Federal Reserve pulling back its bond buying, increased Fed Funds rates, inflation, or a growing economy – interest rates are likely headed higher. The key issue the market is grappling with right now is what effect the Fed’s tapering will have on interest rates. If you talk with economists who study the Federal Reserve, they will insist that what drives interest rates is the amount of treasuries and mortgage backed securities that the Federal Reserve currently holds, not their purchases. It is not the $85 billion per month of securities that the Fed is buying that causes rates to be pushed lower, it is the $3 trillion+ of assets that are currently held. If this is in fact the case, whether the tapper occurs in September – or three months earlier or three months later – the effect on interest rates will be negligible. The reason is the total amount of bonds the Federal Reserve owns will not change dramatically based on a few extra, or fewer, months of bond buying.

However, the market seems convinced that the flow is what is important. Just look at the effect that a change in the perception of the Federal Reserve’s flow had on the market over the past few weeks. One concern is that market will over-react to a change in treasury buying and, as a result, the higher interest rates will cause economic growth to slow. Of bigger concern, in terms of the economic growth, is the toll the pullback in government spending is starting to have on the economy. Most likely, the second quarter GDP growth number is going to come in much lighter than expectations. The reason is that government spending is down and taxes are up. I believe that part of the reason we have recently seen such dovish statements out of the Federal Reserve is that they too are seeing the second quarter GDP number coming in weaker than what they expected. As a result, the Fed likely wants to make sure the market realizes that quantitative easing will continue until there is some real employment growth or inflation.

Right now employment growth remains relatively lackluster, with the unemployment rate projected to decrease slightly to 7.4% by the end of 2013 and down to 7% by the end of 2014. Unemployment likely will not hit the Federal Reserve’s threshold level of 6.5% until the third quarter of 2015. As a result, the Fed funds rate will not likely be hiked until the first half of 2015. Ultimately, the current bond buying is likely to continue until mid-2014, with cumulative purchases of bonds by the Federal Reserve in the neighborhood of $1.25 trillion. At the end of the day, I expect the expansion to remain on track but I feel this is already reflected in stock prices. As I have said previously, the majority of the gains in the market this year have likely already been made. The second half of 2013 is going to be much rougher than the first half.

Quite simply, in order for the market to continue at its current pace we would need to see economic growth surprise to the upside. There are very good things going on in the economy from increasing housing prices, to a huge shale gas revolution lowering energy prices,  to a consumer who is growing increasingly confident and has the lowest debt service obligations since the mid-eighties. Furthermore, the market remains fairly valued. Inflation seems to be under control and wealth levels are now at all-time highs. All of this bodes well for consumer spending. Ultimately, the economy should expand at 2% in 2013 and 3% in 2014. While the lion share of equity gains are likely behind us, the market should continue to trend upward in the intermediate term as long as the economic expansion continues.

In the near term, small-cap stocks should continue to benefit from an appreciating dollar. Many large-cap stocks have extensive revenue and profit overseas, which come under pressure when the dollar appreciates. Small-cap stocks are more exposed to the domestic economy and it is increasingly looking like the U.S. expansion is on track while the rest of the world is experiencing elevated uncertainty. Listen, trees don’t grow to the sky- this market is due for some selling. But the long term fundamentals are solid and if the economic expansion holds the market should continue to appreciate, just not at the torrid pace of the last six months”.

 

by Mitch Zacks, Senior Portfolio Manager, www.zacks.com

Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.

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