Anyone doubting the skittish mood in the financial markets was brought back to reality last week when a generic and predictable statement from the Federal Reserve triggered a rush for the exits across most asset classes.
The sell-off that started right after the Wednesday afternoon comments by Fed Chairman Ben S. Bernanke swept across stocks, bonds and most commodities.
The Dow Jones Industrial Average lost more than 500 points, the S&P 500 dropped more than 60 points, gold fell to its lowest level in more than two years and the 10-year Treasury yield shot up to 2.5% — an 87-basis-point gain over the May 3 low.
Even though most market watchers describe the sell-off as an overreaction, it wasn't entirely surprising, suggesting more volatility as the Fed moves closer to reducing its unprecedented five-year-long quantitative-easing policy.
“All of this came from the fact the Fed made some constructive statements about the economy,” said Lee Partridge, chief investment officer at Salient Partners LP. “This will test the resolve of the Fed to see how much they will let some of these asset classes pull back.”
Although the Fed hasn't provided specifics as to when and how it might start reducing its policy of purchasing $85 billion in Treasury bonds each month, the market reacted as if it were a done deal. Even with short-term interest rates at near zero, any reduction in a Fed policy that so far has accumulated $3.4 trillion worth of bonds is going to look like a tightening strategy, Mr. Partridge said.
“We've had such accommodative Fed policies for so long, any move at this point will look restrictive,” he said. “That's going to cause pain in the markets, particularly for riskier and high-cash-flow components like dividend stocks and emerging-markets bonds and equities.”
REITERATING STATEMENTS
To be clear, Mr. Bernanke's comments last week only reiterated previous Fed statements that as the downside risks in the economy diminish, the Federal Open Market Committee will re-evaluate its QE policy.
“The Fed has been trying hard to communicate and be transparent because it doesn't want to surprise the markets, but all they are saying is that the economy seems to be recovering,” said Brian Gendreau, a market strategist at Cetera Financial Group Inc. and professor of finance at the University of Florida.
“This doesn't mean the economy is fine or that the Fed will not continue to support it,” he said. “But the market interpreted the comments as the beginning of a sea change, and some investors decided they didn't want to wait around to find out what happens.”
Mr. Bernanke is sticking to his strategy of keeping rates low at least until the unemployment rate drops to 6.5%, from 7.6%, but the market sees a reduction of quantitative easing as the first step toward higher rates.
What that means is the typical ripple effect across some of the strongest components of the recovery, including housing, Mr. Partridge said.
“Rising rates will impact the housing recovery, and commodities will be next, but the bond market has already made its move,” he said. “But I don't think the Fed has the resolve to really pull away from quantitative easing, because whenever there's an impact on the wealth effect, they go right back into easing mode.”
In some respects, the recent Fed comments gave the market the breather it was looking for, said Jeff Middleswart, a senior analyst at Ranger International.
“Considering that we've gone from 10,000 to 15,000 on the Dow, I'm amazed that the sell-off wasn't worse than it was,” he said. “The funny thing is, when it was first introduced, quantitative easing was almost universally accepted as a bad thing.”
Investors will need to navigate the markets when rates do start to rise, Mr. Middleswart said.
“Rising rates will hurt anything with a fixed coupon, like bonds and gold, and we think the 10-year Treasury probably stays below 3% in the near term,” he said.
As the market reacts to what might happen in the future, one near-term strategy is to take advantage of what is expected to be increased volatility across most asset classes, said Paul Schatz, president of Heritage Capital LLC.
“The fixed-income market has been decimated, so the odds favor a fixed-income rally,” he said. “On the equity markets right now, if they rally significantly, I'm a seller, and if they don't push through to new highs shortly, I think that ushers in a 4% to 8% pullback within the next month.”
Matt Lloyd, chief investment strategist at Advisors Asset Management Inc., doesn't think there is any reason to wait to pile into equities.
In addition to all the cash that moved to the sidelines, he cited a two-year pattern of about 1% of the float of the S&P 500 being bought back by companies every quarter.
“People are so panicked and they're reacting psychologically to the Fed comments,” Mr. Lloyd said.
