The stock market has powered ahead over the past four-and-a-half years, even as the economy limped along. Now, this relationship is about to flip the other way.
Scared? Don’t be: The shift is unsettling markets, but the return to some degree of normalcy is exactly what we need.
With employment rising, the housing market recovering and inflation still low, the U.S. economy has gained enough traction to drive speculation that the Federal Reserve will soon start to unwind some of the extraordinary stimulus it has provided in recent years.
Observers now believe the Fed will slow its bond purchases – known as quantitative easing, or QE – later this year, wind down QE altogether some time in 2014 and then raise its key interest rate in 2015.
These are monumental changes and the impact hasn’t been pleasant so far. U.S. stocks have retreated from record highs and emerging market stocks have slumped to nine-month lows. Yields on U.S. Treasury bonds have been rising, threatening to end a 30-year bull market in bonds, pummelling dividend-paying stocks in the process.
As portfolio values shrink ahead of potential Fed policy changes, investors are no doubt worried that things can only get worse over the next few years as these changes are made.
Well, relax. Investors have been living in a bizarro world where bad economic news has been embraced by the market as a reason why more Fed stimulus is required. Conversely, good economic news has been booed as a reason why stimulus should be removed.
“Bad is not good,” said blogger Joshua Brown at The Reformed Broker, in a recent post. “Good is good, unless your time frame is the lifespan of a fly.”
There is only so much that stimulus can do. Eventually, companies need healthy consumers to drive their sales and profits – and a thriving economy is the best way to accomplish that.
Sure, the stock market is going to complain at times as stimulus is removed. But that’s only because stimulus drove the market higher in the first place; the fear is that its removal will send stocks down again.
However, the stock market needs to get back in line with corporate fundamentals to move forward, and the transition doesn’t have to be messy if the Fed takes its time in removing stimulus and does so only as the economy shows improving strength.
That’s an “if” worth betting on. For all the impressive gains stocks have made in recent years, the S&P 500 is a mere 4 per cent above its pre-financial-crisis high in 2007 and it trades at a reasonable 16-times earnings. That looks like a decent foundation upon which to build the bull market’s next phase.
Prospects for fixed income look even better, though proper timing will require some deft footwork. If monetary policy returns to something approaching normal, bond yields will continue to rise from generational lows.
Higher yields mean more income, making bonds look far more attractive to balanced portfolios and reducing the temptation to hide out in zero-yielding cash.
Not everyone likes change. But when the change is toward normal, leaving extraordinary stimulus and all its side-effects behind, it should be embraced.