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A recent front-page article in The Wall Street Journal headlined “Global Tumult Grips Markets” opened with, “The tectonic plates of the world economy are shifting, moving the yield on the 10-year Treasury to the highest level in more than a year and shaking financial markets from Tokyo to Mumbai and Johannesburg to Sao Paulo.”
Yikes! If you were a Martian who just landed on Earth, you would be hard-pressed to tell from headlines like the above that U.S. stocks had posted their best first half since 1999 and that most economic indicators were also improving. While warnings of impending doom certainly sound authoritative and ominous, they are also perfectly predicted to arise every time the financial markets hit a rough patch.
Fed Chairman Ben Bernanke indicated the Fed is indeed becoming more confident in the sustainability of the economic recovery. Further, if subsequent data is consistent with the Fed’s expectation of continued improvement, the Fed would be in a position to curtail (later this year) and eventually eliminate (sometime next year) its monthly purchases of U.S. Treasury and mortgage-backed bonds (also known as “quantitative easing”).
In other words, the Fed signaled to investors the economic conditions precedent to the “tapering” of its emergency, crisis-induced program of quantitative easing.
In the eyes of the pessimists, stocks had reached record highs due solely to the extraordinary measures implemented by the Fed in the wake of the global financial crisis. They believe, incorrectly in our opinion, that the tapering of quantitative easing signals the beginning of the end for the stock market’s advance.
Our narrative is decidedly different. Stock prices follow earnings. Stocks are at record highs because earnings are at record highs. The economic recovery is broadening and strengthening. Quantitative easing is an unconventional program implemented when the economy and financial markets were facing an apocalypse. Fortunately, the program was a success and the normalization of Fed policy will be an unambiguously good sign for earnings and stock prices.
In other words, don’t fear the taper; embrace it.
Interest rates have spiked, but remain historically low. The absolute level of interest rates is more important than the direction. Thus, we don’t think rising interest rates are incompatible with rising stock prices. This is particularly true because the rise in rates is being caused by an improving economy, not higher inflation expectations.
Finally, it is important to note the Fed has stated it has no plans to increase its target for the short-term Fed funds rate. Whenever that does happen, you can be sure there will be no shortage of wailing and gnashing of teeth. However, as an article in The New York Times pointed out, the last time the Fed started raising rates was in June 2004, when the fed funds rate was 1 percent. The Fed raised the rate 17 times in the ensuing two years. During that period, the S&P 500 rose 11.3 percent. In fact, even in the year following the final rate increase, stocks continued to advance.
As Confucius said, “Life is really simple, but we insist on making it complicated.”•
This column was excerpted from Kirr Marbach’s second-quarter client letter, which appears in full at www.kirrmar.com.
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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.
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