The stakes continue to get higher and higher for the Federal Reserve as it looks to navigate the tricky exit from quantitative easing next year. Each month, we are witnessing improving economic statistics, strengthening employment numbers, and low inflation metrics that would seem to support the notion of a recovering economy. It seems as though every successive Fed meeting narrows the odds of when it will begin tapering its asset-purchase programs. Some market watchers even believe that we could see a modest reduction in monthly purchases as soon as this week.
That has prompted a lift in the CBOE 10-Year Treasury Note Index
(INDEXCBOE:TNX) from 2.5% to nearly 2.9% during the last six weeks. This shift is largely a result of active investors trying to anticipate the threat of sharply rising interest rates when the Fed ultimately takes its foot off the gas pedal. We are also seeing continued outflows from bond ETFs and mutual funds as money shifts to cash and equity positions.
If history is a guide, this shift in asset allocation may prove to be a fatal mistake. At the end of QE 2 in mid-2011, the S&P 500 Index
(INDEXSP:.INX) lost more than 150 points, and interest rates fell as investors sought the safety of Treasuries over the risk of stocks. The end of the first round of quantitative easing in 2010 produced similar results.
It seems as though stocks are hooked on the liquidity and support that the Fed has gotten us accustomed to for the last three years. When it does decide to taper, it will more than likely assert a long-term game plan for keeping the Fed funds rate near zero for several more years in an effort to calm fears of rising interest rates. Whether that produces the intended results of supporting both stock and bond prices is anyone’s guess.
So what should you watch out for as we head into 2014 to make sure that your portfolio doesn’t get trampled by the Fed?
The first step is to not get too predictive and make big allocation shifts based on theory as opposed to fact. That can quickly get you in trouble if the market continues on its stated course or reverses direction at a moment’s notice. You should instead focus your attention on a few key indicators that will give us some idea of how the global markets will perceive a change in central bank policy.
The SPDR S&P 500 ETF
(NYSEARCA:SPY) is near all-time highs and has been above its 200-day moving average for over a year now. We have seen some subtle shifts in momentum recently, but not enough to convince me that a top is in place. I would examine your portfolio closely as we close out the year and look to set trailing stop losses to protect your gains. Portfolios that are overweight high-beta stocks may want to consider paring back highly appreciated positions and having cash on hand to take advantage of any new opportunities that emerge.
Treasuries have been inching lower, and I have been advocating reducing exposure to long-duration holdings such as the iShares 20+ Year Treasury ETF
(NYSEARCA:TLT) all year long. However, a volatile move lower in stocks may ultimately send money flying back into the safety of high-quality bonds if deflation takes hold. I would be closely monitoring the interest-rate environment and watching TLT when the Fed begins to make changes. If bonds have already priced in the concept of tapering, we could see money flow back into this asset class as a form of protection.
Another sector that has had a rough 2013 has been commodities. Investors have been shunning hard assets in favor of equities, but will that trend reverse in 2014? It’s hard to determine the impact that tapering will have on precious metals such as the SPDR Gold Shares ETF
(NYSEARCA:GLD). Demand for the yellow metal has been waning and production costs have constrained the upside of gold miners. However, a deflationary scare could breathe life back into this sector, similar to bonds. It’s definitely something to keep on your radar.
My final advice is not to get caught up in the hype of certainty of a specific outcome when tapering ultimately begins. You should make changes to your portfolio
based on your investment objectives and sound risk-management principles. With a little vigilance and fortitude, you can be prepared for almost any scenario that you encounter in 2014.
Read more from David Fabian, Managing Partner at FMD Capital Management:
Don’t Let 2014 Predictions Turn Into Conviction
Don’t Get Caught In A Bear Trap
Reducing Interest Rate Risk With Equity Income ETFs
No positions in stocks mentioned.