And more importantly, why should you care? Last December, Fed President Ben Bernanke assured the financial markets that the tapering of asset purchases under its Quantitative Easing program (i.e., pumping less stimulus into the economy each month) was not the same thing as tightening monetary policy. Traditionally, tightening has meant raising the short-term interest rates that the Fed controls.
The Fed has insisted in recent months that these interest rates will remain low for an extended period of time. The fact that the traditional mode of tightening wasn't occurring allowed Bernanke to try to draw a line between tapering and tightening. Unfortunately, that line appears to be imaginary. At least that would be the conclusion drawn by many emerging market economies, led by the "Fragile Five."
Without delving too deeply into the complicated relationships between emerging markets and our Fed monetary policy, these emerging markets have taken it on the chin since it became clear the Fed was in fact going to follow through on QE tapering. The wobbling of these emerging markets has been largely responsible for the early stock market pullback so far this year. (Here's a link to more on this relationship if it interests you.) And that's why it matters to you.
Let's take a step back. Last June, when the Fed had recently begun talking about eventually tapering its QE program, bond yields soared and the stock market started to slide. On June 5, after the stock market had been sliding for about two weeks, I wrote the following about the relationship between the stock market and Fed monetary policy:
The (multi) million dollar question is how smoothly the Fed will be able to exit these policies. In other words, are the financial markets going to capsize once it’s clear the Fed is scaling back? That fear is what has put the recent wobble into stock prices. The reality is nobody knows how it will play out, as the Fed has never done anything like this before.
But here are a couple of thoughts as to why I would be surprised if this really was the beginning of anything more than a routine correction. First, the stock market has been on fire for almost six months straight. When the market goes almost straight up 25% without a breather, it’s natural for a pause or pullback to happen. When it does, a rational explanation is generated. But something would have stalled stocks’ momentum before long even if Bernanke hadn’t said what he did. The market was due to at least pause, if not correct a bit.
Second, it’s important to note that the Fed is way out at the extreme edge on the monetary policy spectrum. The normal range involves moving the Fed Funds rate up and down. The multiple QE initiatives only came about because the Fed had already pushed its normal level all the way down. So far, none of the QE stuff has officially been scaled back, but even after that’s all wrapped up, monetary policy would still be extremely loose by pre-2009 standards. Bull markets typically don’t die until the Fed tightens monetary policy a bit.
Again, no one knows how the reaction this time may differ, but there’s a lot of room between talking about scaling back QE (where we’re at today) and actually reaching anything resembling non-loose monetary conditions.
Sure enough, the market continued to drop for a couple more weeks, bottoming out on June 24 at a total loss from its prior high of about -5.8% (which is roughly the same total drop we've seen this year from the high at the beginning of the year). Given that the market then rose 17.5% through the end of 2013, I'll give myself a pat on the back for suggesting that pull back was unlikely to turn into anything significant.
All kidding aside, that does reinforce the point I made last week about there not being any way to prepare for or side-step the relatively frequent pullbacks and corrections that are just an unfortunate part of investing in stocks. It also serves as an illustration of why we continually implore you to follow your plan and allow SMI's mechanical strategies to handle any defensive measures you might take. This is a vastly superior approach (and much easier on the emotions) than having you try to figure out what changes to make to your portfolio every time the news turns or the markets change direction.
DAA has strong protection against the worst declines built right into it. Upgrading has less, but still has the functionality built in to gradually move us from aggressive funds to conservative ones as market conditions deteriorate. Even Sector Rotation shifted us to a conservative fund that had half its assets in cash during the financial crisis, resulting in better performance than the market during the last bear market, despite its higher risk/return profile.
With that directive to let your plan dictate your investment decisions firmly in mind, I want to try to connect some big picture dots. But this type of analysis is never intended to persuade you to "do something" different with your portfolio! Ultimately, I don't think there's any question that tapering is, in fact, tightening. What I wrote last year was intended to say, in essence, that even after tapering begins, there will still be a long way to go before monetary policy (which is primarily the state of interest rates) conditions could be considered "tight." But — and this is the important part — tightening monetary policy almost always ends in recession and tears for investors. The question is one of timing. Super-bear Albert Edwards recently reminded his readers of this cause-effect relationship:
Edwards says he’s amazed that the Fed ever managed to convince anyone that tapering doesn’t equal tightening. He then offers up a list of previous recessions and crises that came in the wake of past tightening cycles: 1970 Recession/Penn Central Railroad 1974 Recession/Franklin National Bank 1980 Recession/First Penn/Latin America 1984 Continental Illinois Bank 1987 Black Monday 1990 Recession/S&L and banking crisis 1997 Asian currency collapse/Russian default/LTCM 2007 The Great Recession/Collapse of almost the entire global financial system 2014 Emerging Market collapse/deflation/recession/another banking collapse etc., etc.?
Once again though, even if it's true that tapering is the beginning of tightening, and tightening is the most likely eventual cause of the end of the current bull market, the question is still "when?" The markets are forward-looking, which is why the emerging markets are suffering from the impact of tapering already. And there are no guarantees that we don't go straight from here to the next full-blown bear market. But as was the case last summer, that's not something you can predict with any degree of certainty.
There are any number of scenarios under which the current bull market could continue onward after digesting its huge 2013 gains. That digestion may take a few more days, weeks, or months, if it even happens at all. The timing of investment events is always uncertain, even if you get the overall direction right. Since it is irrational to expect to be able to figure out in advance when the market is actually going to drop into a bear market (as opposed to all the many times when it seems like it could but doesn't), your best course it to create a plan that you can live with in the event that the market does, in fact, fall into a bear market. Because it will eventually.
My personal investment mix is normally a blend of Upgrading, Dynamic Asset Allocation, and Sector Rotation. That blend has some downside protection built in already, but my plan specifically calls for me to shift a portion of my Upgrading and Sector Rotation holdings into DAA when DAA replaces its two stock components. That's something I added along with DAA when it was first introduced, in part so I could invest a little more aggressively in Upgrading and Sector Rotation than I otherwise would.
I wrote last May that two more years seemed like a reasonable guess for this bull market, given the extreme liquidity the Fed has injected (and continues to inject). That still seems about right to me (meaning it would end sometime in 2015), but I realize I could definitely be wrong about that. This is the best way I've figured out to have my cake and eat it too. If I'm right and the bull market continues, my portfolio does great. But if I'm wrong and we get a bear market much sooner, my plan will shift me toward a more conservative stance before too much damage is done. Given that I'm still many years away from needing that retirement money, it's a "sleep well" level of risk that I'm comfortable with for myself.
You can build similar safeguards into your own plan. Just be sure to do so when things are relatively calm and you can think about any adjustments rationally, as opposed to making changes under emotional duress when the markets are already under siege.
To sum up, I think the Fed's tightening monetary policy will likely be the thing that ends the current bull market. That tightening has begun taking baby steps in recent months as the tapering was introduced. However, I do not think this bull market is going to roll over and die right away — I expect a period of time before conditions tighten enough to kill it. Again, these are the very first steps away from the loosest monetary position the U.S. has ever had.
But regardless of what I think, my investment plan is governed by more reliable, non-emotional factors. And yours should be too.