Consumers are undeniably feeling modestly better because of the “wealth effect” resulting from increasing property prices and stock markets and continued low mortgage interest rates. Consumer confidence is up as more consumers are opening up their wallets online and at retail stores during this holiday season and at real estate offices around the country generally over the past couple of years.
How long can this keep going? The Fed’s QE program has been a boon to the stock market. With interest rates so low – and virtually no demand for loans either because businesses are uncertain or consumers have had difficulty qualifying – investors have had little choice but to go out on a limb buying riskier assets for any kind of return or yield.
Now there’s the prospect that the Fed will “take away the punch bowl” by tapering leaving investors holding the bag on assets – bonds as well as stocks – that may lose value as interest rates rise.
While my crystal ball is cloudy, there are two things that I’m certain of: Eventually – and I think sooner rather than later given the age of this bull market in stocks – there will be a correction – and the Fed will taper and eventually end its Quantitative Easing (QE) program. No surprises here about the “what,” just the “when.”
This is the conventional wisdom that all of us – advisors, investors and the media – all seem to accept. And there’s a strong camp of believers that says that all of this monetary policy has put too much cash into the markets and will just lead to inflation. Now, conventional wisdom could be wrong. It’s been wrong before. But it’s certainly prudent to take steps to protect your portfolios even if it’s not full-proof.
So how does one “prepare for the bear” in bonds or a correction in the equity markets generally? Sure, diversification is key. But so is adding a risk-managed strategy – a more “tactical” approach. But first let’s look at the risk we’re trying to protect against – higher interest rates.
Well, I’m of the opinion that rising interest rates may not necessarily be a bad thing for the economy. It’s a sign of growth and the Fed’s belief that the economy can be taken off life support. And if rising interest rates accompany economic expansion, then that’s not a bad thing. There’s research that supports this line of thought.
And for the monetarists out there worried about too much cash, that really is only an issue when there’s too much cash chasing too few goods. We’re nowhere near that point given the capacity of manufacturers and businesses right now and demand lower than where it would be under full employment. This is measured by “velocity” or how many times that dollar circulates through the economy. Now, there’s no real velocity to speak of.
And right now, I still think that there is still a risk of slipping back from the progress made and possibly flirting with deflation again.
Let’s face it: Inflation expectations are close to nothing. If you measure by TIPs with a rate of about 1.1% now, your real rate is negative.
And the economy is nowhere near the Fed’s own inflation target of 2%. As measured by the Fed’s favorite yardstick – the Commerce Department’s personal consumption expenditures index, it recently fell to an annualized rate of 0.70%.
So what we’re really trying to protect against is our fear. In my next post, we’ll review some ways to not fight the Fed but keep a watchful eye on that punch bowl.