The Taper is On; Will Stocks Survive?

The S&P500 managed to gain another 1.4% last week, even though most of the gains accrued at the beginning of the week, before the Fed made its latest policy announcement. Volume was light, and volatility dropped back to even more complacent levels.

The technicals are still screaming “over bought” on both the daily and weekly charts. But since most traders and investors believe that the Fed simply will not let the US stock markets fall, ever again, the technicals don’t seem to be scaring anyone into taking any precautions. Most investors are bullish and are on the same side of the boat—-they’re all-in with stocks—-making the market also “over bullish” relative to long-term historical surveys of bullishness vs bearishness. And at current prices, the US stock markets have reached valuations that, since 1929, have only been higher near the peak of the tech bubble in 2000.

But why worry?  The Fed will make sure stocks keep on rising, without any meaningful, if only temporary, corrections.

US macro data last week were weak, as usual. The Empire State survey disappointed. The housing market index missed. Existing home sales only met expectations, as did consumer prices—both headline and core. Industrial production beat expectations, and so did the Philly Fed survey.

But the big story of the week was the Fed announcement, which sparked a sell-off going into the close of the week. The Fed announced that it will taper its open-ended QE program by another $10 billion per month. And, in the post-announcement interview, the new chair—Janet Yellen—hinted that not only is QE on track to be shut down by year end,  but that actual short-term interest rates might rise—gasp—by 2016…….fully 8 years after they crashed to near-zero levels under Bernanke’s management.

But there’s one big problem with this ‘outlook’. Every time that the same projection has happened over the last 4 years (namely, that QE will be ending and that rates might rise), US stock markets promptly beat a hasty retreat.

So if this were to happen, then expect US stock prices to drop, possibly by a lot, given that they haven’t so much as correctly mildly for the past two years. And expect the hot money leaving stocks to rush into the ‘safety’ of US Treasuries. driving rates right back down.

So regardless of the plan, recent history suggests that the Fed may not have the stomach to withdraw the punch bowl for very long. And the main question becomes—how far will US stock prices have to fall before the Fed stops the taper, and even possibly ramps the QE program back up?

According to this latest announcement, it’s very likely that this test will occur this year….over the next six months.

And regardless of where equity prices finally do end up, it’s very likely that volatility will surge. So at the very least, equity markets should become much more interesting, instead of creeping up month after month in an almost mechanical way.

 

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