There are many reasons to feel skeptical about the stock market right now. Perhaps the end of Fed stimulus isn't one of them.
Sure, stimulus has done wonders for the stock market: Observers have compared ultra-low interest rates and bond purchases – known as quantitative easing or QE – to everything from steroids to rocket fuel as the S&P 500 has risen some 140 per cent since 2009.
It is understandable, then, that the removal of stimulus is making investors a touch nervous and driving them to hope for economic news that is no better than lukewarm.
However, a number of observers believe that the fuss is overblown. Given a choice between a weak economy with ongoing stimulus or a strong economy with no stimulus, the latter is the better one.
"Investors are very worried about a potential reduction in QE programs," said strategists at Pavilion Global Markets, in a note. "However, history tells us that the first tightening in a recovery does not lead to bear markets."
The Federal Reserve has held its key interest rate at zero per cent since the financial crisis and has been providing additional stimulus by buying Treasury bonds and mortgage-backed securities during three rounds of quantitative easing.
The current round of QE, launched in September, is the most aggressive yet, with the Fed spending $85-billion (U.S.) a month in an open-ended commitment to holding down borrowing costs and driving down the unemployment rate.
The thing is, the economy is recovering and markets are starting to ponder the end of stimulus – or at least the beginning of the end, marked by the Fed tapering its bond purchases as early as this year.
So far, the impact on markets has been modest, though alarming nonetheless. The S&P 500 has fallen about 3.9 per cent from its intraday high on May 22. The yield on the 10-year U.S. Treasury bond has risen to 2.2 per cent, from 1.62 per cent in early May.
That's based on nothing more than speculation that the Fed could slow its bond purchases, which makes you wonder what markets will do when the tapering actually begins and QE ends.
John Higgins at Capital Economics expects the tapering to begin in September, with QE ending in the first half of 2014. But he believes there is no reason to panic: Foreign investors will likely step into the bond market as the Fed steps out.
"Their demand for U.S. government bonds as a safe haven could be rekindled if the tapering of QE3 prompts more upheaval in 'risky' asset markets or by a different event altogether – such as a flare-up of the euro-zone crisis," he said in a note.
But the Pavilion strategists expect that even the stock market will remain healthy as the Fed shifts policy toward monetary tightening.
For one thing, inflation is low, giving the Fed no reason to act too quickly in removing stimulus. For another, history is bullish: 12 months after the first rate hike, markets are usually higher, by an average of 4.7 per cent.
"It is important to understand that rate hikes usually happen when the Fed is convinced that the economy is robust enough to warrant higher rates," the strategists said.
Of course, history doesn't necessarily provide the best template for today's conditions. Fed policy has been extraordinary in recent years. QE in particular has been an experiment in how to stimulate an economy when interest rates can't be lowered any further.
Its impact on the economy is open to debate, but most observers agree that it has been very good for stocks: The S&P 500 rose 36.4 per cent during the first round of QE, 24.1 per cent during the second round, and 12.5 per cent (so far) for the third round.
Investors are no doubt worried that the end of QE will reverse these gains. The hope is that an improving U.S. economy will prevent that from happening.