- 5 Stocks Ready for Breakouts
- 5 Toxic Stocks to Sell in March
- 3 Stocks Under $10 Moving Higher
- 4 Stocks Under $10 Triggering Breakouts
- 3 Stocks Under $10 Making Big Moves
Timing the Fed's Taper - views
BALTIMORE (Stockpickr) -- First there was the fiscal cliff, then came the sequestration, and now the Fed's taper is threatening to usher in the next stock market apocalypse. Or is it?
For the last five years, we've been junkies -- all of us. Markets have rallied on every hint of Federal Reserve stimulus, and they've sunk on the prospects of an end to Chairman Ben Bernanke's buying programs. In short, stock investors are addicted to the Fed's cash. And like any addicts, we're not reacting well to the idea of getting cut off.
The "taper," as it's come to be known, it the Fed's attempt at rehab.
By gradually slowing down its $85 billion in monthly asset purchases, the Fed is planning to wean the market off of the cash and get things functioning normally again. That's actually a bigger deal than it sounds. For the last five years, the Federal Reserve has pushed a very accommodative set of policies. By slowing them, Bernanke and company are saying that the recovery is finally robust enough to stand on its own two feet again.
No matter whether you agree with that prognosis or not, if you're an investor, you can guarantee that the taper will effect assets that you own.
The real question is when.
Don't bother reading the Fed minutes -- they won't tell you. For the last five years, one single chart has been my go-to barometer for Fed QE efforts, and right now, it's suggesting that the Fed could very soon be shutting off the faucet. Take a look:
The chart above is the Fed's five-year forward inflation rate. It's a pretty narrow definition of inflation that the Fed uses internally as a QE gauge, and for the last five years, this chart has been able to predict big stimulus programs like clockwork: Every time the Fed's five-year forward inflation rate falls below 2.2%, Bernanke and company have pumped cash into the system.
Last year, the Fed got even more aggressive with QE programs, announcing QE3 and QE4 even though our chart was well above that critical 2.2% level. But the Fed has been a lot less aggressive lately, and a taper at least looks plausible up around 2.6% right now.
Still, I think that this chart, not unemployment or stock prices, is going to dictate the Fed's stimulus efforts in 2014.
Of all the economic metrics out there, why should the Fed care so much about inflation? In short, it's because the Fed has been quietly fighting a major battle against deflation for the last five years. Deflation is the single destructive force that Bernanke fears the most -- he's an expert on the Great Depression, after all.
The Fed has done its best to keep interest rates low to help spur on cheap growth. To help achieve that, it's pushed the fed funds rate down near the floor at zero. But that's actually not enough -- according to the Taylor Rule, the fed funds rate should actually be negative right now. That means that the Fed needs to use quantitative easing to keep things in check.
It's important to remember that the Fed isn't an all-or-nothing organization. Even though rates are at taper-friendly levels right now, another round of QE is pretty likely if things start to fall apart again.
Meet the New Fed, Same as the Old Fed
Up until now, I've been talking a whole lot about Ben Bernanke. The thing is, he's only Fed chairman for another 63 days. After that, a new boss takes over. But the new boss is a lot like the old boss.
Fed Board of Governors Vice Chair Janet Yellen is the presumptive replacement. As of this writing, she's in the confirmation hearing process. And she's every bit as dovish as Bernanke -- maybe moreso. That means that if the Fed does indeed go through with a taper here, it'll be done with one anxious finger on the "buy button."
In spite of the market's addiction to stimulus money, Mr. Market doesn't need to head lower just because of a taper. In fact, stock prices could get buoyed by it. Remember, stocks don't move based on facts. Instead, they move based on how investors feel about facts. That's a crucial distinction.
So right now, with investors feeling anxious about a taper, protecting stock gains becomes a question of painting the move in a positive light. And you can bet that the Fed is going to be using all of the PR tools at its disposal to make a QE taper sound wonderful. Press conferences are going to be every bit as important as the Fed's checkbook in 2014.
The Great Rotation
There's no two ways about it: At some point, the Fed is going to have to taper its asset buying programs. And if Yellen makes it clear that they're ready to step back in at the first sign of shakiness, my guess is that they can pull it off without pulling the rug out from underneath stock prices.
But the taper is going to have a profound effect on the assets you own, starting with a "Great Rotation" from fixed income to stocks.
Oh yeah, the Great Rotation. Remember that buzzword? A year or two ago, the rotation was the big catalyst that every equity investor was eager for. But it never happened -- nor should it have. Looking back from a historical standpoint, major asset class shifts from bonds to stocks have typically started around five years after a major stock bottom. In other words, investors should start thinking about a Great Rotation now -- and the taper is the catalyst that could bring it on.
Bond investors have been in a toxic environment for the last several years. It doesn't take hyperinflation to create that sort of situation -- the fact that inflation rates are higher than Treasury yields is enough to punish bond owners. But their pain threshold hasn't been high enough to spark a selloff in bonds, largely because the bond market is no longer a free market. That's because of the "Bernanke Put," a floor in bond prices established by the Fed's nonstop buying.
With a taper in effect, though, that floor goes out the window, and suddenly bonds look a whole lot riskier. With stocks already yielding a higher spread over bonds for the first time in four decades, income investors are already better off with stocks before capital gains come into the picture. Add a whole lot of new risks to bonds, and a Great Rotation makes a lot of sense.
To be clear, a lot of money coming off the sidelines is a very good thing for stock investors.
But some stocks stand to benefit more than others.
HR Outsourcers, Brokers Win From the Taper
Want to profit from a taper? Buy a big human resources outsourcing company such as Paychex (PAYX). No, it has nothing to do with jobs growth. Instead, it has to do with interest income.
HR outsourcers earn float income on payroll balances from the time that employers deposit funds with them to the time employees cash their checks. That float income was a huge chunk of revenues for payroll firms that suddenly dried up when rates went to zero. They adjusted by focusing on fee-based add-on services, but float income has quietly been sitting as a revenue source yet-to-be unlocked. With a Fed taper bringing upward mobility in interest rates for zero-risk securities, any firm that earns float income has a big earnings boost that hasn't been priced into shares for five years.
Brokers are another group that stands to benefit in a big way from the taper.
Not only do brokers earn dramatically more profits when Treasury rates are higher, they also generate more commission fees when equity markets reach their secondary rally phase. With trading volumes slowly ticking higher, we're already seeing one half of that equation come alive -- the other half comes from the Fed taper. Equity-centric names such as E*Trade Financial (ETFC), TD Ameritrade (AMTD) and Charles Schwab (SCHW) are well-positioned to benefit.
Don't fear the taper. Even though the stock-pocalypse buzzword du jour is catching the headlines again, the Fed isn't going to start cutting back on buying programs without being ready to hit buy again. More important, a Fed taper lays the groundwork for big upside in a handful of interest-rate sensitive stocks.
-- Written by Jonas Elmerraji in Baltimore.
At the time of publication, author had no positions in the stocks mentioned.
Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.
Follow Jonas on Twitter @JonasElmerraji