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.
