Taper Terror: Markets Fear the End of Fed Stimulus

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Playing the markets isn’t easy, even for the most experienced investors. But in the wake of the financial crisis and the Federal Reserve’s subsequent efforts to stimulate the economy, understanding securities markets has in some way become even more complicated.

Take, for example, a headline that appeared in last week’s Washington Post, which read “Stocks go weak following strong economic reports.” Anybody with a basic understanding of how the stock market is supposed to work should read such a sentence suspiciously. After all, the stock market is supposed to reflect the future profitability of businesses, and businesses make higher profits when the economy is doing well.

The reason for this dissonance is the Federal Reserve and the extraordinary measures it has undertaken to support the economy over the past several years. Through its quantitative-easing policy, the Fed has been buying large sums of government debt and mortgage-backed securities in an effort to force down interest rates and boost home prices. By driving up the price of bonds and lowering interest rates, the Fed’s stimulus also has had the effect of raising stock prices by making them more attractive for investors to buy relative to other securities.

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And lately, Fed Chairman Ben Bernanke has been signaling to the market that the Fed might begin to “taper” the pace of its stimulus in coming months, in response to incoming data that say the economy is improving. Later today, the Fed will release minutes from its July meeting, which many market participants hope will bring some clarity to the timing of the Fed’s planned pullback. According to media reports, this impending release of information is giving the markets agita and helping to contribute to the Dow Jones’ recent five-day losing streak.

But again: If the Fed’s taper is based on data indicating an improving economy, shouldn’t the market be headed higher? One explanation for this seeming contradiction lies mainly in the fact that daily market movements don’t offer a lot of conclusive information. Over the long run, the stock market will indeed reflect the health of the economy — but from day to day, or even week to week, the market can say as much about sentiment as it does about economic reality.

Second, the media can at times oversimplify the causes of market movements. Markets are the nexus where bits of information from all across the real economy are synthesized. They are by their very nature incredibly complex, and much of the time their behavior doesn’t lend itself to simple analysis. This has been less the case in recent years when big, global events like the U.S. real estate bubble or the European debt crisis threatened to drag the global economy into depression. These events caused stocks in general to become more correlated — meaning that when one stock goes down, it’s likely that others will too, and for the same reason.

(MORE: What Happens When the Fed Really Does Run Out of Ammunition?)

But according to a report this week in the Wall Street Journal, the market is returning to a more normal state of low correlation. In other words, stocks are beginning to rise and fall on their own merits, rather than because of large global forces.

Finally, those who are selling off because the Fed plans to cut back on stimulus are most likely overreacting in the face of the unknown. As Robert Shapiro, an economist with the advisory firm Sonecon, says, “People have focused on the timing of the taper without thinking very much about the extent of the taper.” Just because the Fed decides it will begin to curtail its stimulus efforts, doesn’t mean it will do so all at once. If, for instance, the Fed decides to pare back its asset purchases by $10 billion a month, that leaves $70 billion per month in stimulus — a significant sum indeed. Shapiro remains convinced that Bernanke and his successor will be able to manage an orderly and gradual exit from quantitative easing.

That being said, markets’ consternation over the central bank’s next moves isn’t completely irrational. The overall effect of quantitative easing isn’t fully understood. For instance, Robbert van Batenburg, director of market strategy at brokerage Newedge USA, has told Reuters he believes that by lowering interest expenses for businesses, quantitative easing can be given the credit for 47% of the rise in earnings growth for S&P 500 companies since 2009. In other words, it’s not just that investors find stocks more attractive because of low interest rates; companies may actually be earning far more because it’s drastically lowering their expenses. Other analysts are skeptical that quantitative easing has done much to boost the stock market, and argue that corporate earnings would have risen significantly without stimulus.

This lack of understanding of the effects of quantitative easing means that market participants are uncertain as to what its curtailment will mean for their investments. And in the face of uncertainty, many investors would rather sell than be victims of forces they don’t understand.

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