Taper begins, stocks advance

2013 was one of the best years ever for stocks as the Federal Reserve has been pushing investors into riskier assets due to a lack of yield deriving from low interest rates.

At the end of the last week, the S&P 500 index was accumulating (or “amassing”) a gain of 26.9%, marking the fifth year of a rally that saw stocks double in price since the end of 2008. After declining 38.5% in 2008 at the height of the financial crisis, stocks inverted direction and fully recovered their losses.

Looking at history of the upturn we’re now enjoying, we find it is comparable to the great bullish market of the 1990s, when tech stocks attracted investment as never seen before, pushing all stocks higher.

But unlike the 1990s boom, the current rally is the result of a recovery from an abrupt financial collapse, and it is policy-driven, pushed by the intervention of the Federal Reserve.

In a matter of just a few years, the FED has spent trillions of dollars in asset purchases in an effort to keep short-term interest rates as low as possible,  a desperate attempt to entice investors and consumers to re-enter the economy in the form of expanded investment and consumption.

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Following a promise made earlier in the year and in his final speech as chairman of the FED, Ben Bernanke decided to taper the quantitative easing pace from $85 billion to $75 billion  per month.

Although the job market has been improving substantially, the future is still a bit fuzzy.  The FED carefully accompanied the taper notice with a dovish statement, aiming to assure that interest rates will remain low for the foreseeable future. The initial reaction in the stock market was positive, and the S&P 500 continued to climb towards record high levels.

We should note that even though the FED started this tapering, its policy continues to be mainly accommodative. A cut of $10 billion in asset purchases isn’t exactly an inversion in policy; the FED will continue to increase its asset portfolio by $75 billion a month rather than unfolding any assets in it. In the short term, the stock market will continue to show good conditions for investment and potential for further advance. At the same time gold and bonds will be out of favor for the next few months while inflation remains low. But we should be very careful, the price of assets is rising as a consequence of expansionary monetary policy and not as a result of an increase in investment and consumption. Price-to-earnings ratios are on the rise, and unless fundamentals catch up with prices, at some point prices will have to catch up with fundamentals. That means a bubble may be forming and we may be heading toward another crash.

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