‘U.S. stocks rose, with the Dow Jones Industrial Average capping its best week since January, as disappointing economic data fueled bets that any Federal Reserve stimulus cuts this month would be moderate.‘ – Bloomberg News
The old ‘bad news is good news’ trade is back on.
You know the story. If the economic data is bad it means the US Federal Reserve is less likely to ‘taper’ its bond-buying program, and that’s good news for stock prices.
But wait a minute. Who says ‘tapering’ is bad news for the markets? It seems investors may not be too troubled by it at all. In another report by Bloomberg News:
‘An anticipated reduction in stimulus by the Federal Reserve that has roiled the financial markets for months will be seen as no big deal if it goes ahead next week, according to a Bloomberg Global Poll of investors.‘
For all its faults, is it possible the Federal Reserve is doing something few thought possible — successfully weaning the market off stimulus?
Ever since the Federal Reserve cut interest rates to near zero in December 2008 and shortly thereafter began buying government bonds as part of its money printing program, many wondered how the Fed could ever withdraw from the market without causing stocks to crash.
The market had become addicted to stimulus.
You’ve seen QE1, QE2, Operation Twist, and QE3. As one stimulus program ended the market rally stalled, and so the Federal Reserve had to start another.
That trend changed with QE3, which some also dubbed ‘QE Infinity’ due to the open-ended nature of the program.
So, what do we make of it? According to the Bloomberg survey, 73% of respondents say the Fed will begin ‘tapering’ this year. But if ‘tapering’ is such bad news for the market why are US stocks at a record high and why has the Australian market hit a new five-year high today?
Brushing Aside ‘Tapering’
You can see on the chart below that since stocks bottomed out on 26 June the Aussie market (blue line) has doubled the return of the US S&P 500 index:
Click to enlarge
Source: Google Finance
Stock markets are in an interesting position right now. Theoretically, stock prices reflect future events. In other words, investors are saying that they know the Fed will begin ‘tapering’ its bond buying, but that it won’t have a negative impact on stocks.
If investors thought ‘tapering’ would be bad news for stocks then you would likely see stock prices fall on even the suspicion of ‘tapering’.
This is all so different to just a few months ago in May when world stock markets tumbled on the very idea that the Federal Reserve would slow down its bond buying. If you recall, bond yields soared from record low levels and many thought there could be a repeat of the 2008 stock market crash.
But now with exactly the same talk doing the rounds, investors seem to be brushing those concerns aside. What can explain it?
The optimist in us would like to think it’s simply because the Fed isn’t needed anymore. We’d like to think that economies worldwide are moving towards being able to stand on their own feet without central bank intervention.
We try to look on the bright side whenever possible.
However, we’re not quite so naïve to believe that’s what the market really thinks.
Beware the ‘Fool’s Rally’
What’s more likely is that investors know that even if the Federal Reserve starts ‘tapering’ its bond buying program this year, it will crank up the bond buying again if the market needs more stimulus.
In other words, investors rightly believe that the Fed will always be ready to provide an emergency dose of liquidity into the market in the event of poor economic data.
That’s the real nature of ‘QE Infinity’. It’s the same tactic the Bank of Japan (BoJ) has used for more than 20 years. This isn’t so much the market weaning itself off central bank stimulus, instead it’s about the stimulus becoming more ingrained into the market.
That’s the ultimate goal. The Federal Reserve would like its stimulus attempts to be just as readily acceptable to the US market as the BoJ’s are to the Japanese market.
When the BoJ stimulates it makes an announcement, the yen weakens and Japanese stocks take off. Sometimes the effect lasts longer than other times. After over 20 years of doing this it’s second nature. No one names the BoJ’s stimulus efforts QE1 or QE2. Heck, if they did they would be up to QE30+ by now.
There is a cautionary tale in this. You shouldn’t assume this means that stocks will go up forever. At some point investors will look far enough ahead and decide that any potential stimulus isn’t enough to support stocks at the prevailing high prices. That’s when you could see the market take a big fall.
When will that happen? Well, if the market really is prepared to brush off the first stage of ‘tapering’, then it may not be for a while yet. But don’t believe everything the market tells you. It has a habit of making you think one thing only to quickly change direction and do the exact opposite.
Even though we’re still bullish on stocks, we advise buying with caution. There’s still a chance this is a ‘fool’s rally’ sucking in unsuspecting investors right at the top of the market.
Cheers,
Kris+
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