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How To Use the Fed’s Double-Talk to Your Advantage

Get ready for a rally to 'quality' dividend stocks

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What a difference a month can make.

This time last month, the Federal Reserve stated that it would continue buying $85 billion in bonds each month, but that it could start to cut back on those purchases by the end of the year and end them altogether in 2014. That was the shocker, as previous expectations were for an end in 2015. This was a case of “be careful what you wish for.” We got some clarity, but it was not what the market wanted to hear. In the two days following the announcement, the Dow gave up over 3.6% and the S&P 500 fell nearly 3.9%.

Overnight, my inbox filled with questions about whether this was the death knell for the stock market. I responded with an emphatic “no.” I stand by that to this day. Whenever the Fed releases statements like this, we have to remember that this is not stated policy, just hints at what the Fed might do. While Wall Street remains obsessed with whatever comes out of Chairman Ben Bernanke’s mouth, I prefer to read between the lines.

The subtext is that the Fed isn’t going to pull the plug until it’s sure the U.S. economy can stand on its own. Specifically, the unemployment rate needs to fall to 6.5% before the Fed will raise its benchmark interest rate. Back in June, the Fed hinted at tapering its accommodative policy based on economic projections that were much rosier than private economists’ estimates. And it turns out that the Fed missed the mark: Just recently first-quarter GDP growth was revised down to a 1.8% annual rate. Meanwhile, the June Unemployment Rate didn’t budge from 7.6%. At the rate the economy is inching along, it is highly unlikely that the unemployment rate will hit its target by 2014.

That brings us to the latest FOMC minutes, which were released Wednesday afternoon. These are the minutes from the very same meeting after which Bernanke claimed that QE could start to wind down. The minutes didn’t show a whole lot new. There remains disagreement among Fed members about the future of QE, but it was clear that most Fed officials need to see more robust hiring before they’ll agree to taper asset purchases.

But here’s the real irony: In the question-and-answer session after a speech late Wednesday afternoon, Bernanke sung a different tune. He went as far as to proclaim: “Highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy.” Investors loved that. After all the market is addicted to QE, and Thursday we saw new all-time highs on the Dow and S&P 500.

Bernanke’s latest comments echoed what I said a month ago, even after he scared the pants off investors with his end of QE talk:

I expect the Fed will continue its massive money pump as long as Ben Bernanke is Chairman.

And because Bernanke’s eventual successor is expected to be a strong dove, the Fed’s accommodative policies could carry on even longer. So I think the market was premature in its panic over the end of QE. One thing is for sure: Investors need to get used to the idea of QE ending, and as long as the timeframe remains uncertain, this transition period may be bumpy from time to time.

So we have a choice to make:

We can resign ourselves to the market’s obsession and get caught up in the selling action whenever the Fed alludes to the end of QE and the buying pressure whenever it says QE can continue. Or we can plan ahead for what’s to come: a flight to quality.

I’m sticking with the second option and I recommend you do the same. The first half of 2013 belonged to the crap, if you’ll pardon my language; the second half should belong to the quality. Believe it or not, the best performing stocks in the first half of the year were in the bottom 10% of market capitalization (i.e., micro caps), with the lowest dividend yields (essentially 0%), the most negative analyst earnings revisions (bottom 10%) and the highest short interest (top 10%).

That can’t last. The biggest winners the last six months profited from a tremendous “short squeeze” that propelled many thinly-traded stocks higher as wave-after-wave of money flowing into index funds and ETFs caused the shorts to cover their positions, which increases institutional buying pressure. Whenever low-quality stocks lead the way and a “crap rally” occurs, the stock market historically reverses itself and a flight to quality ensues, typically within seven months.

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