What's the real effect of the Fed's proposed "taper?"
I'm sure you noticed the hard sell in stocks that started a
couple of weeks ago. In just two days, most of the major
stock-market barometers were down 2.5% to 3%.
The drop in equity prices gave more than a few pundits the
vapors. "Was this the end of the great four-year rally?" many
At the same time, "tapering" went viral and was soon crossing
investors' lips from Tokyo to Toronto and points in between. As
often happens, within a 48-hour span the word "tapering" became
overworked, overused, overrated and overplayed. Such is the
disseminating and repetitive nature of our modern media
With that preamble, permit me to flog the word a bit on my
Tapering, as you now know, refers to the Federal Reserve's
withdrawal from the Treasury and mortgage-backed securities (MBS)
A fortnight ago, investors were fearful the Fed was
stealthfully reducing its monthly multi-billion dollar MBS
purchases. Thus, the Fed was lowering demand for these
securities, which raised their yield. The effect would cascade,
and general interest rates would rise.
Equity investors were spooked by the prospect of rising
interest rates lowering equity values. After all, interest rates
are a discounting mechanism - the higher the rate, the lower the
But all we need to know is that higher-yield and high
dividend-growth stocks tend to be less sensitive to changing
interest rates than their lower-yield, low dividend-growth stock
The Fed's money creation further muddies the water. The Fed
purchases MBS (or other securities) with newly minted money. Thus
the Fed's unprecedented foray into money creation raises the
question of what drives value. Are equity values driven by money
looking for a home or by company fundamentals?
The two graphs below - one of M1 money stock, the other of the
Wilshire 5000 - reflect an obvious correlation between money
supply and stock prices. Both money stock and equity values are
decidedly up over the past four years.
Now, I'm not saying that money stock and company fundamentals
aren't mutually exclusive - it's not one or the other. Yes,
fundamentals contribute to value, but fundamentals are influenced
by money creation and money flow.
Consider a company with long-lived assets. If the dollar value
of its revenue is rising because of increased money supply
(inflation) and it doesn't need to replace assets at the rate of
its money-induced revenue growth, its margins will expand.
Fundamentally, the company will look better and command a high
P/E multiple. But economically little has changed, except that
its customers are paying more for its products in inflated
dollars while the company itself has not yet entered the market
to replace depreciated, worn assets by purchasing new assets with
inflated dollars. (Its costs would rise when it did.)
What we have is a company with rising revenue but stable
costs, which leads to widening margins.
I'll admit this is eye-glazing stuff, but it's important to
understand that markets are complicated ... and that what
seems apparent rarely is. The point I want to emphasize is that
money supply obviously matters.
And this takes us back to the Fed and tapering: Is the Fed
tapering? Because if it is, then the rate of money growth will
As a policy, I don't believe the Fed is tapering.
The Fed's net purchases of MBS have declined modestly over the
past couple of months, but the reports I've read suggest this has
more to do with lack of MBS supply than a change in Fed policy.
Fewer mortgages were originated in February and March; in April
and May volume picked up, so more MBS will have been formed for
the Fed to purchase.
Ultimately, the Fed will need to cease propping the economy
with low rates and easy money. But that's yet to occur, and I
doubt it will occur this year. Many market participants have
taken a similar view, which is why most major barometers have
To that, I can add that many of the
High Yield Wealth
recommendations have also recovered. I'm not surprised. The
fundamentals remain sound, which is why I believe most
recommendations still display superior risk-to-reward
At this point, I'm both cautious and vigilant. If change is in
order due to market circumstances, I'll be sure to let you