Dealing With the Taper Tantrum

by Ed Elfenbein | June 23, 2013 8:00 am

“The best thing that happens to us is when a great company gets into
temporary trouble … We want to buy them when they’re on the operating table.”
– Warren Buffett

In last week’s CWS Market Review[1], I said there’s an unacknowledged member of the Federal Reserve who has the most important vote of all—the market. On Thursday, Mr. Market got a chance to vote, and he gave a massive thumbs down[2] to the Fed’s most recent policy decision.

In this week’s issue, I’ll explain what happened and what investors should do now. I’ll also review some of our recent Buy List[3] earnings reports. Oracle just gave us a big disappointment. But first, let’s review Thursday’s damage.

The Taper Problem

On Thursday, the stock market had its worst day in 19 months. Ugh, it was just ugly. The Dow lost 353 points and the S&P 500 dropped 2.5%. There was no refuge in bonds, either. The yield on the 10-year Treasury jumped to 2.45%. That’s up more than 80 basis points from last month’s low, and it’s the highest yield in close to two years. But stocks and bonds got off easy compared with the super-atomic wedgie gold was given. The contract for June delivery plunged $87.70 on Thursday, or 6.4%. Gold fell below $1,300 for the first time since 2010. Check out this weekly chart going back two years.

[4]

So what happened? The Fed held its two-day meeting this past week on Tuesday and Wednesday. The anticipation was that the Fed would discuss scaling back on its asset purchases. I didn’t think they would stop any bond buying just yet, and the post-meeting policy statement proved me right.

But in the post-meeting press conference, Ben Bernanke talked about downsizing the bond buying, and that caught everyone’s attention. He said that the Fed expects to continue buying bonds as long as the unemployment rate is over 7%.

More specifically, Bernanke said that if the economy continues to improve, as they expect, the Fed will start to moderate bond purchases later this year and wind down the purchases by the middle of next year. I was a bit surprised that he’s apparently not concerned about inflation trending below his targeted range.

Bernanke was clear that this outline isn’t set in stone, and they’ll keep an eye on the data. The key here is that the Fed sees the economy doing better going forward. Bernanke used the metaphor of a car—they’re taking their foot off the gas, not slamming on the brakes. Incidentally, Bernanke also made it clear that he’s out the door when his term expires this January so he’s not going to be making these QE-ending calls.

On Wednesday and Thursday, the financial markets reacted dramatically. The movement in the five-year Treasury was most interesting. The yield jumped from 1.07% on Tuesday to 1.31% on Thursday. The maturities shorter than that showed almost no change.

I think the markets are making a few mistakes here. First, too many people assume that without the Fed’s help, the stock market is toast. The Fed has obviously helped the market so far, but that started when the economy was flat on its back. That simply isn’t the case now.

The other mistake is thinking the Fed is running away. Not so! Short-term rates are still going to be near 0%. The bond buying is going to continue. It will just be in progressively smaller amounts. Remember that all of this is predicated on pretty optimistic economic projections. In the policy statement, the Fed said that downside risks to the economy have diminished. Let’s hope they’re right.

What To Do Now

In the near term, I think the market will be a bit rough. We had a strong run this year, so it’s natural to take a breather. I don’t think the bulls will be back in charge until the S&P 500 breaks above its 50-day moving average, which is currently at 1,618.

Investors should expect more volatility in the next few weeks. We’ll know a lot more about how our stocks are doing when second-quarter earnings season begins next month. Don’t expect stocks to surge like they did earlier this year. Investors should focus on high-quality stocks like the names on our Buy List[3].

I should mention that our stocks tend to show their mettle when the rest of the market gets nervous. While the S&P 500 fell -2.50% on Thursday, our Buy List only fell by -1.88%. Obviously, our goal isn’t to be less worse than everyone else but I want to show you how investors gravitate towards high quality when they get nervous.

Some of the names on the Buy List I like right now include Microsoft (MSFT[5]), Cognizant Technology (CTSH[6]), Ford (F[7]) and Wells Fargo (WFC[8]).

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