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Don't Fight the Fed but Stay Alert

By: Martin Tillier
Posted: 3/12/2014 10:38:00 AM
Referenced Stocks: QQQ;SPY;DIA

Here we go again. After a couple of down days and indications of a lower opening for a third straight day, the chatter has started again. Talk of “a major correction” is everywhere. Bubble spotting has become a national pastime; biotech, alternative energy, social media... somebody, somewhere can be found to shout “Bubble!” whenever a sector is doing well. To some extent, I’ll hold my hands up and admit some guilt.

Valuations in the periphery of social media in particular are somewhat worrying and some kind of slowdown or correction in that area looks overdue, but here’s the thing about bubbles; they inflate before they pop. Some of us are old enough to remember that at the end of 1998, after the Nasdaq composite had risen 38.9% in a year, the warnings that this represented a bubble. In the end, I guess they were right, but the index climbed over 100% from there before collapsing.

Nasdaq CompositeNasdaq Composite

People have been calling the current market “frothy” or “overvalued” ever since talk of the infamous “double dip” began back in early 2010, when the S&P’s march towards 1200 was offered as evidence that the market was overvalued. How did that work out? The S&P 500 is up over 50% since then which means that those that ignored the doom-mongers could absorb a 30% collapse from here and still be better off than those who stayed on the sidelines and worried.

The tendency of some in the financial media to be more bearish than the situation warrants is understandable. After two bursting bubbles in recent memory caused a lot of pain, investors are frequently worried, and you will never be out of work if you play to their fears. Nobody wants to be seen as the cheerleader for Wall Street when everything falls apart, but the sustained recovery in the stock market over the last few years has really been based on general economic recovery, not unwarranted optimism or overpowering greed.

Multiples of earnings have increased along with earnings during that time and are now just over average levels, suggesting that the market is fairly valued and any further increase will have to come from increased earnings. That is possible, but with current conditions, there could be more multiple expansion to come as well based on one simple thing; the Fed is still supporting the market. Obviously, despite tapering the amount of bond purchases, QE is still with us but even as that reduces, the prospect of a sustained zero interest rate policy (ZIRP) lends support to stocks. Faced with negative real returns from short term rates the big money is coerced into the market.

Obviously, that creates a volatile situation. Money that is effectively forced into stocks (or anything for that matter) is nervous money and will exit at the first hint of a change in policy. That day will come, but given signs of renewed weakness in the housing market and an overall economic recovery that is steady at best, it is unlikely to be soon.

So, in an environment where some sectors and individual stocks look to be fully valued, even overvalued, but the market as a whole still has upside, what is a poor investor to do? Conventional wisdom, which I have heard often, particularly from mutual fund managers, is that active management (i.e. mutual funds) is the way to go. It is, so the stock pickers say, a stock picker’s market. I disagree.

There is likely to be some volatility in individual stocks and sectors, but overall the market is likely to stumble upwards. In that scenario broad exposure makes more sense. Given that any indication of a change in Fed policy could cause a rapid sell-off at some time in the future, the liquidity that index ETFs such as QQQ, SPY and DIA offer is also a plus.

Over the next couple of years, however, investors cannot fall into the trap that many do when invested in index funds. Buying them and then forgetting about them will probably be fine over a couple of decades, but, as I said, at some point the Fed’s implied support for the market will end, so those with a shorter time horizon than that should stay alert to news. You can ignore much of the noise in the interim, but is there is any indication of the Fed abandoning ZIRP, at the very least some profit taking will be wise. I short, don’t fight the Fed and stay invested, but stay alert!