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Wednesday, June 18, 2014 - 14:30
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Wednesday, June 18, 2014 - 14:30

Could The Fed's Next Move Put Your Portfolio At Risk?

Wednesday, June 18, 2014 2:30 PM

It's awfully quiet out there. Perhaps too quiet.

The S&P hasn't made a 1% move -- in either direction -- since April 16.

How unusual is it for the market to go 43 trading sessions (and counting) without a one-day move of 1% or more? Going back to 1980, the market has only had three longer streaks, according to MKM Partners' Jonathan Krinsky. If we reach 48 straight days without a 1% move, this current streak will move into third place.

What happens when such streaks end? The market has invariably dropped at least 3% within a month of the streak's end, according to MKM.

As you'd expect in such a quiet market, investors are exhibiting little fear. In a weekly survey of investor sentiment, the American Association of Individual Investors (AAII) noted that roughly 45% of responders were bullish. That's the highest reading yet for 2014.

And the VIX, also known as the fear gauge, has fallen back to very low levels. "The perception of U.S. equity market risk is as low as it has been since 2004-06 when Fed predictability peaked," notes UBS's Maury Harris.

Indeed, the Federal Reserve's announcement earlier this year that it will steadily reduce its amount of bond buying has led to a clear view of predictability, as far as investors are concerned. And this week, we were treated to more of the same, as the Fed reiterated its strategy, with few headline-worthy signs of a change in its plans. (If you're keeping score, the Fed is now buying $35 billion in bonds per month, and the process should end early in the fourth quarter.)

In prepared remarks, Fed Chairman Janet Yellen noted that the U.S. economy is getting healthier, but not at such a pace as to alter the current course on interest rates.

Fed economists now think we'll hit 6% unemployment by year's end and move below 6% early next year. The national unemployment rate has dropped from 6.7% in March to 6.3% in May, a bit faster than many (including Yellen) had assumed at the start of the year.

Predicting that the unemployment rate will drop at a slower pace for the remainder of the year seems to be intended to reassure investors, but if that accelerated pace remains in place, then we're getting to 6% unemployment a lot faster than Yellen says. If the move in unemployment below 6% happens in the fourth quarter, look for a much louder discussion about the need for imminent rate hikes.

Yellen seemed to help investors prepare for such an alternative scenario, saying that "if the economy proves to be stronger" than anticipated by the Federal Open Market Committee, "resulting in a more rapid convergence of employment and inflation, then increases in the federal funds rate are likely to occur sooner -- and be more rapid than is currently envisaged."

You can't say she didn't warn you.

Why should you care about rate hikes? Researchers at Bespoke Investments note that in the three most recent eras of rising rates, "the S&P 500 saw a peak-to-trough pullback of between 8% and 10% in the months surrounding the first hike in rates." The key word there is "surrounding," as the market anticipates a rate hike in advance.

Yellen also noted in her remarks that inflation remains dormant. The core Consumer Price Index did rise 2% in May, the strongest pace in more than a year. To be sure, few alarm bells go off at the thought of 2% inflation, but if this figure maintains an upward trend in coming months, there is simply no way that the Fed can maintain ignore inflation as it ponders when to start hiking rates.

The good news: After the market digests the bad news of rate hikes, stocks tend to rally higher in the subsequent year. But we still have a bridge to cross first. As I noted last week, the Fed's steady course of ongoing bond-buying -- albeit in a reduced fashion -- is creating an artificial backdrop for many asset classes.

Junk bonds, for example, have been rallying, in large part to the Fed's efforts to retain the liquidity spigot. Any assets that have benefited from the Fed's helping hand will be the first to respond to the headwind of rate hikes.

Risks to Consider: As an upside risk, accelerating U.S. economic growth could offset concerns about rising inflation and interest rates. For instance, the Fed boosted rates in 1997, and the S&P rallied sharply in 1998 as investors embraced the prospects of robust growth.

Action to Take --> The quiet market action implies investors have little to be concerned about. But all signs are pointing to an increasingly robust employment market, and the early stages of growth in inflation. Despite a broad view of a benign Fed over the next year, it is becoming increasingly apparent that the central bank will need to reduce accommodative monetary conditions sooner rather than later. That means one of the most powerful catalysts for stocks over the past five years -- Fed liquidity -- will soon be gone.

Once the invisible hand of the Fed is gone from the market, short sellers will feel newly emboldened, junk bond holders will demand higher rates for the risk they are taking on, and the yield curve will start to take on a more traditional slope, implying a tougher road ahead for any dividend-paying stocks.

Is it possible to ignore the financial media, say goodbye to your broker and Wall Street, and still make money in the markets this year? Absolutely. Our research shows that you can find a winning investment roughly 85% of the time and see returns of 18% in two weeks... 43% in nine months... and 58% in 11 months -- all while glancing at the market just 12 minutes per month. Follow this link to find out how...

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.