The market doesn't seem to like the level of clarity provided
by the Fed on Wednesday. The Fed sees the economy doing just fine
and if it continues on this pace, then the QE program would end
by the middle of 2014.
I have been talking about this issue along those lines in this
space for month now, but investors are surprisingly 'surprised'
by this, causing turmoil in the stock, bond, and currency markets
all over the world. The overnight weak factory sector reading
from China amid persistent questions about that country's banking
sector doesn't help matters in today's session
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The outlook for China remains problematic, indicating that the
growth pace has likely stalled, if not reversed, in the current
quarter. The HSBC Bank's preliminary PMI reading slipped further
into contractionary territory in June at 48.3 from May's 49.2
level. This indicates that second quarter GDP growth could come
in below the first quarter's level. The growth worries have
weighed on capital flows into the country, which has resulted in
unusually tighter liquidity situation in the inter-bank funding
market. What this means is that the country's growth picture
doesn't look that promising, unless the monetary and fiscal
authorities directly intervene.
But it's not about China or the jump in initial Jobless Claims in
the U.S. this morning - it's all about the Fed today. As I have
said here many times before, 'taper' doesn't necessarily mean
tightening. But markets are forward looking beasts and they try
to look ahead to the time when QE will end and the countdown to
interest rate increases will begin. Looked at this way, the taper
becomes the first shot in a drawn-out normalization process that
does look like tightening. But even if taper was no tightening,
it is nevertheless the first sign of monetary policy change since
2007. And changes in monetary policy always have a direct bearing
on asset prices, including stocks.
Why is that? Because asset prices are, in the end, the present
values of all expected cash flows from the asset, discounted at
an appropriate discount rate. One could argue about what this
discount rate should be, but everybody agrees that it has to be
in some way related to long-term risk-free rates, like the yield
on the 10-year Treasury bond. And just as an example, if
investors were willing to pay 15X next year's earnings for stocks
when the 10-year Treasury was yielding 1.6%, the they will
completely be justified in demanding a lower multiple when the
yield goes higher - say to 2.6% or even 3.6%.
I am not suggesting that the stock market bull run that started
in March 2009 has come to an end. But it does mean that the
market needs to find a new level of equilibrium - at a lower
level. Hard to tell how low the market's new equilibrium
point will be, but I would expect it to be at least 10% to 15%
below the May peak. Get ready for a rough summer in the