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The Case for Investor Optimism

  • Mark Biller Sound Mind Investing
  • 2013 7 Jul
  • COMMENTS
The Case for Investor Optimism

The markets have been somewhat volatile lately, which can make investors fearful. But a levelheaded look at what’s behind the volatility should help lay those fears aside.

The fact that recent losses have included bonds, which many people still think of as safe investments, may have heightening the fear. It also seems to me that the reasons for recent volatility have appeared more mysterious, and therefore scarier, than usual. “Something about the Fed and Quantitative Easing (QE) that I don’t really understand, but I’m reading that the worst is still to come and bond yields still have a long way to get back to normal, and, and…”

Relax. Yes, it’s somewhat unusual for both stocks and bonds to fall at the same time. But if you have a diversified portfolio, there are good reasons to expect you’re going to weather this storm just fine. Let me explain.

How The Fed Moves The Market

The Fed’s recent talk of taking its foot off the economy’s gas pedal has been driving the recent market turbulence. The bond market has taken this news particularly hard, given that the Fed’s QE purchases have been supporting unrealistically low interest rates for the past few years. As that support is eventually taken away, it’s natural to expect interest rates to rise.

And rise they have, even though the Fed hasn’t actually started tapering its purchases yet. The US 10-yr Treasury bond has gone from yielding 1.6% at the beginning of May to 2.6% less than two months later. That’s a huge move for this bond yield in a short amount of time. Given that virtually every other financial asset price is impacted in one way or another by this particular yield, this has created a ripple effect that has carried to every corner of the investment markets. It is this ripple effect, combined with a lack of understanding of what is driving it, and a subsequent fuzziness regarding where it might lead, that is causing so much fear.

But as I mentioned earlier, it really isn’t the case that most investors have suffered huge losses. No, it’s not the size of the losses that are driving the fear. It’s the apprehension regarding what comes next. So let’s walk that out and see what it looks like.

What If The Economy Gets Stronger, Or Weaker?

The Fed started all this drama because they wanted the markets to know that if the economy continues to improve, it will soon be strong enough to not need as much support from QE. So following that train of thought, if the economy continues to improve enough that QE purchases can be tapered later this year, one might expect interest rates to continue rising and bonds to continue falling. Stocks would also likely be volatile as investors try to figure out which is more important: the Fed’s liquidity as represented by QE purchases, or the fact that the economy is getting stronger, which obviously benefits business and company profits.

At some point, a stronger economy has to be seen as beneficial to stocks. So the very thing that would be harmful to bonds — that is, a rising, strengthening economy — should eventually boost stock prices. Keep in mind also that as interest rates rise, the shorter-term bonds in portfolios like Vanguard’s Short-Term Bond Index are going to be paying higher interest, so the higher income will begin to offset further rate increases to some extent.

That’s what should happen if the economy continues to get stronger. What if it gets weaker and the Fed isn’t able to begin tapering its QE purchases? Well, if the economy is weak enough that the Fed can’t slow its QE purchases, the reason for rising bond yields is taken away. In fact, a weakening economy is deflationary, which would likely cause bond yields to reverse course and begin falling again, pushing bond prices back up.

On the stock side, a weaker economy would probably be cheered initially strictly on the basis that it would keep the Fed from reducing the flow of liquidity (the bizarre “bad news is good” dynamic we discussed in Up Is Down and Down Is Up recently). Depending on how bad the economic news is, that initial reaction might give way to the realization that a weaker economy is typically bad for business and company profits, putting downward pressure on stock prices.

Reasons Not To Fear

So while the markets will likely continue to be volatile for a while, we’re left with a situation where if the economic news in the coming months is good, bonds will probably fall but stocks will likely start rising again. On the flip side, if the economic news in the coming months is bad, bonds will likely rise from current levels, while stocks could go either way. It seems unlikely that both stocks and bonds will continue to fall for an extended period of time, because what is good for one is bad for the other, and vice versa.

Once again, we’re left in a situation where basic diversification seems likely to dilute the pain of a market adjustment. Sure, it could take a while longer for these fundamentals to trump the initial knee-jerk reaction to the Fed. But the more asset prices revert to “normal” (which is what has been happening the past two months), the more fundamentals should kick in and the less weight the Fed’s “extraordinary” policies should carry. And that is a development we’ve been looking forward to for a long time.

Mark Biller is the Executive Editor of Sound Mind Investing. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

Publication date: July 15, 2013