Has the Long-Overdue Correction Begun?

I have held the opinion for months that the stock market's meteoric rise has been fueled primarily by the Fed's easy money policy. I found several articles and videos which substantiate this thesis, with quotes from Warren Buffett, Carl Icahn, Marc Faber and others, all saying that this looks like a bubble. Was last Thursday and Friday the beginning of a correction? If so, it is long overdue. In this post I'll make a few comments on the state of the financial markets, the Fed, and discuss positioning your clients’assets. 

 Stocks, Bonds, Cash

There are three primary asset classes: stocks, bonds and cash. Of course I'm well aware of alternatives such as currencies and commodities, and perhaps real estate. Aside from that we're left with the big three. Before we discuss these further, let's take a brief look at the Fed. 

The Fed has three primary tools to influence the economy. They are interest rates, the money supply and bank reserve requirements. We also witnessed Operation Twist, which created additional demand for longer-term Treasury securities, placing downward pressure on the 10 Year Treasury and mortgage rates. This helped stimulate refinance activity. After all, when people refinance, it creates additional cash flow to invest or make purchases. At least that was the hope of the Fed, and it was largely successful. Successful, that is, until the market began to consider a reduction in QEIII. This reduction would reduce demand for bonds, causing yields to rise and prices to fall. An improving economy would also cause the bellwether bond yield to rise.

Hence, investors were unsure what was causing yields to rise, a reduction in demand or an improving economy. In fact, last May and June, rates rose farther and faster than they had since the 1960s, which brings me to my point. What's an investor to do?

Cash is paying nothing, bonds are only immune to rising interest rates at the short end of the maturity curve, but unfortunately, there's not much yield left there. Intermediate- and longer-term bonds will lose value if interest rates rise. That leaves stocks! The Fed has been trying to steer investors into stocks for quite a while. Why? Just Google, "The Wealth Effect." Most agree that stocks have been one of the few beneficiaries of the Fed’s excess liquidity. This has caused an increase in demand which has pushed stock prices higher! Of course, they have also benefited from stock buyback programs and low-cost borrowing. 

With stocks at such high levels, there are two options. You can go to cash, which is greatly unattractive, and wait for the pullback, or you can buy stock ETFs (on the dips) with stop orders, preferably trailing stop orders to protect your downside.

I have done the latter, and when this all washes out, assuming this is the long awaited correction, and the bubble does burst, there'll be an excellent buying opportunity. 

Has the "Wealth Effect" run its course? For the sake of our economy, I certainly hope not. Because if it has, and this is all the GDP we can squeeze out, even with all the Fed’s help, then our economy may be in far worse shape than anyone thinks. Of course, by the time you read this, it's also possible that the correction will be finished and stocks will be rising once again. 

The Fed’s recent ‘tapering’ reduction of $10 billion per month is a mere 0.4% of total federal government spending and 0.3% of total revenue. It's really nothing at all! It was only a trial balloon to see how the market would react.

Moreover, the Fed’s balance sheet is well above $4 trillion. That's a lot of bonds to unravel! We're clearly in uncharted waters. There has never been a time in U.S. history like today.

Is there a sign we can watch for to indicate that a change in Fed policy is close? One indicator might be if the Fed stops paying interest on bank reserves, something it began in 2009 for the first time in history. However, doing so would only provide an incentive for banks to lend more and then Marc Faber's prediction of U.S. hyperinflation will come true. Oh, what an interesting time we live in!

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