Fed testimony last week addressed burning economic and policy questions for investors. How did they respond? Fearfully, joyfully and indifferently. Just as they have to nearly every news item so far this year.
Fear: As expected, the Fed announced last Wednesday that it will reduce its monthly asset purchase program by $10 billion to $55 billion beginning in April. Additionally, Chairwoman Janet Yellen suggested that the Fed may increase short-term interest rates six months after it concludes its asset purchase program. With the program on a glide path toward completion in October, this set the stage for a potential rate hike in April 2015. This more aggressive timeline surprised investors, prompting an immediate 200 point selloff in the Dow.
Joy: After sleeping on it, investors recognized that a more aggressive Fed might foretell a more robust economy. Within her testimony, Chairwoman Yellen attributed recent data disappointments to the weather and not to a fundamental shift in economic momentum. She also projected that the unemployment rate will fall to near 6.2 percent by year end, two-tenths lower than previously forecasted. The committee also projects that year-end GDP growth will approximate a fairly stout 2.9 percent. Inflation remains a non-issue at 1.5 percent rising to just below 2 percent in 2016. This bullish array led investors to promptly reverse course and erase Wednesday’s 200-point decline by noon on Thursday.
Indifference: So should you buy or sell? Both and neither! Higher rates make bonds more competitive with stocks and put pressure on valuation multiples and eventually diminish earnings. That’s bad. However, more GDP and less unemployment will further boost earnings. That’s good. Were these the only competing variables, GDP growth would likely hold the advantage. However, with valuations high, the threat of valuation compression due to higher rates receives extra weight. By the close of business Friday, markets stood roughly where they began Wednesday, making last week’s Fed announcement a non-event.
Crimea: It was already Russia’s. The economic fallout will be minimal. The bigger impact may be felt at the ballot box as the U.S. “lead from the rear” foreign policy tactics have unfortunately emboldened our adversaries.
Bottom Line: As the year began, we expected 2014 to fluctuate around the flat line in order to digest the valuation expansions achieved in 2013. After one quarter of play, this forecast holds true. Neither the Fed’s shifting guidance nor Russian aggression alter our forecast; they actually reinforce it. A surprise QE policy in Europe, a GDP beat in China or evidence of a more durable economic expansion in Japan could reawaken the slumbering bull. Conversely, an inflation scare or credit event could summon the bear. Absent one of these outlier events, we expect this hibernation to continue. Yawn.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.