Fence-sitting fund managers

At the moment it seems that it is financial markets that are in “tapering” mode, rather than the Federal Reserve.

Stock markets around the world are maintaining a distinctly bid, but slightly more docile tone, as the uproar over the initial “tapering” comments by the Federal Reserve Chairman Ben Bernanke steadily subsides to a mere whisper. It is difficult to imagine how many more different ways Ben Bernanke could describe his plan to end quantitative easing, a process know to the whole world now as “tapering”. From the very beginning markets over-reacted, and did so in a perverse way. The news of an end to quantitative easing should always have been treated as a positive for the stock market. Yet people consistently failed to listen to what the Chairman was saying.

It really is very simple: if quantitative easing is no longer required because the US economy is growing strongly in a self-sustaining fashion, then said quantitative easing will be steadily, cautiously, wound down.

From this evolving situation of overly-cautious “tapering”, we can only deduce that quantitative easing, the flow of billions of dollars into the economy on a monthly basis, will continue for far longer than it is actually needed.

In fact I have always argued it was not necessary in the first place, that QE1 and QE2 had done the job, and both the US economy and stock markets would be exactly where they are now in any case. However given that the Fed did decide to go for round three of stimulus on top of near zero official interest rates, stimulus has now become almost a form of dependency among Wall Street economists and traders alike. In actual fact they are covering their tracks for missing one of the biggest bull markets in history, but nonetheless the majority of market participants have come to mistakenly believe the strength of the stock market is in large measure due to QE3.

As a result, the Fed is seeking to wean the markets off QE3 as gently as it is possible to, so as not to cause any serious dislocation, particularly to capital markets. This means over the top reassurances verbally, and the most gentle of reductions in stimulus when the first steps are taken. It is impossible for such an approach to correctly lead, stay ahead of the curve, of an economy that continues to strengthen significantly. What this approach by the Fed, and it must be admitted it does seem appropriate given the markets inability to show maturity on the matter, ensures, is in fact a situation of over-stimulus!

It is now inescapable that a few things will be occurring simultaneously. These are a strongly expanding US economy, historically extreme levels of quantitative easing, and near zero official interest rates.

Given this heady mix which now looks likely to be experienced through much of the second half of this year, and perhaps into next, one can only see equity markets as being extremely under-valued. With, as I have highlighted before, the huge flows of money into equity funds continuing, global fund managers remain in the awkward position of being under-invested in this Grand Bull Market. The combination of an under-invested market, currently bid near historic highs, overlaying an increasingly robust and strong economy, while experiencing record levels of stimulus, suggests that while US rockets may not be going to the moon again anytime soon, their stock market probably is!

Market primed for strong rally

The US stock market has frequently experienced rallies over six month periods of as much as 15% to 25%, especially since March 2009. Given the recent hesitation in prices then, and the misguided sell-offs this year in response to sequestration and tapering have forestalled buying that may have otherwise taken place, there is clear potential for the Dow Jones Index to run as high as 18,000 by year’s end.

Once the market begins to understand that the US economy is fundamentally sound, that growth is indeed now being driven by the private sector, and therefore quantitative stimulus measures are no longer required, yet still being enjoyed, there will be a rapid reassessment of projected corporate earnings and profits for the coming year. This process will act as a loud warning siren to the fund management industry, that they urgently need to build their portfolios as quickly as possible. The current tapering of the market into relatively calm sideways consolidation price patterns is therefore unlikely to last long. There is simply too much good news about, and with a healthy helping of desert by way of stimulus as well.

The Fed Chairman has tried to explain to Wall Street that they have to come off the easy money feed, that it is no longer necessary for the economy to be healthy, but such have been the tantrums, he finds himself having to be far too cautious!