We all know the market loves clarity, and we got a little dose of that this week when Larry Summers withdrew his candidacy for the Federal Reserve chairperson role in 2014. This sent both stocks and bonds soaring higher on Monday as both markets are digesting the potential for further transparency and guidance in the weeks ahead. The consensus is that Janet Yellen will be announced as the front runner for the top Fed post. There is also a small possibility that a dark-horse candidate will emerge as well.
The stage is now set for another showdown this week as the Federal Reserve monthly statement is released on Wednesday amid some trepidation by the investment community. There has been a great deal of speculation on whether the Fed will ultimately begin tapering its asset purchase program and wind down its accommodative monetary policies. Any modest tapering will likely be favored by the markets and keep the uptrend intact, while a heavy hand may send stocks and/or bonds lower.
(See also: If the Fed Doesn't Taper, What Happens to Gold, Stocks, Real Estate, Treasuries?
While I am not making any drastic portfolio changes ahead of this announcement, I think that it will pay dividends to be aware of the risks and opportunities in the market. Here are a few things to consider as we make our way through the week:
1. Don’t Fight the Trend.
With stocks re-testing their highs, it’s very tempting to go short at these levels. In fact, I have been tempted to add a small hedge in the ProShares Short S&P 500 ETF
(NYSEARCA:SH). However, the ultra-resilience of stocks this year is nothing to sneeze at. If the market gets what it wants, don’t be surprised if we see stocks blast off to new highs. The convergence of strong momentum, a bullish uptrend, and a supportive Fed may be just what this market needs to push to new heights.
On the flip side, if you are concerned about the impact from a Fed misstep, it may make sense to pare down exposure to high-beta stocks or underperforming companies and keep low-volatility or dividend-paying names. In addition, having some dry powder on hand will allow you some flexibility if we see additional opportunities present themselves.
2. Don’t Dump All Your Bonds
The Fed is very closely watching the bond market and will likely want to support bond prices at these levels. Any significant move higher in rates will likely leak over into the stock market and put a lid on further economic expansion. We have already seen the 10-year Treasury yield hit 3.00%, which will be the ceiling that bond market participants will be watching closely from any change in policy.
Despite the move higher in interest rates, not all bonds are behaving badly. We have seen short-duration high-yield, senior loans, and convertible bonds continue to perform well amid fixed-income investors looking for shelter from Treasuries.These sectors of the bond market are throwing off current income and benefitting from high demand for lower credit quality. If you have been following my suggestions, then you are likely already positioned in ETFs such as the PowerShares Senior Loan Portfolio
(NYSEARCA:BKLN) or the PIMCO 0-5 Year High Yield ETF
3. Don’t Let Conviction Override Your Discipline
Whether you agree with the Federal Reserve policies or not, the Fed is still the 800-pound gorilla in the room and carries a great deal of weight. Try not to become overly optimistic or pessimistic about the future of the economy or direction of the market. Instead, trade what you see and make investment decisions based on sound fundamental or technical factors that are in line with your philosophy. I always recommend that you considering using a stop loss on all invested positions so that you define your risk and have an exit strategy regardless of the outcome.
No matter how you decide to play the Fed this week, remember to stay balanced and nimble with your portfolio. The first moves may be quick, but they are often false flags that reverse or fade later. Make changes within the context of your personal risk profile or time horizon, and don’t be afraid to take advantage of new opportunities as they present themselves.
Read more from David Fabian, Managing Partner at Fabian Capital Management:
5 Mistakes to Avoid With Your ETF Portfolio
How to Strengthen Your Portfolio Core
How to Play the Sweet Spot in High-Yield Bonds
No positions in stocks mentioned.