When The Music Stops, What Does The End Of Fed Policy Look Like?

 |  Includes: DIA, SPY
by: David Braunstein, CFA

What happens when the music stops? What happens when the Fed stops its QE program? Has there been a historical precedent? In 1943, the Fed embarked on a "gloves-off" all-in effort to "do what it takes" in order to recover from the crash of 1941. This was a period after the crash in 1929 when the banking system failed and after new regulations were put into place to repair confidence in the banking system. The U.S. and other high debt countries capped interest rates below the rate of inflation. In other words, it was a period similar to today.

The Fed began QE in 1943 that lasted until late 1946. "The Federal Reserve Bulletin noted in February 1943 that the 'policy of the Treasury and of the Federal Reserve System has been directed toward the stabilization of prices and yields of marketable securities. Investors ... know that prices and yields are stabilized and that they will obtain no higher yields by deferring purchases. ... ' By the end of the war, the Fed had grown restive under these restrictions. In 1946 the Federal Reserve discontinued pegging interest rates for short-term securities. In March 1951, after numerous conferences, the Federal Reserve and the Treasury announced a 'Full Accord' on future policy. Bond prices and yields were gradually allowed to seek their own level as dictated by overall credit requirements."

The chart below shows how the Dow Jones Industrial Average performed from 1940 to 1951. Notice the sharp recovery in mid-1942 to 1946. Notice how neatly the years 2009 to 2013 map up. I am not implying that the market is at a top now, however, I want you to notice the drop from when the Fed stopped its QE program in 1946 to the next year when the market bottomed. The market fell from 212.50 to 163.12, a drop of 23%. After that the stock market remained range-bound from 162 to 193 for the next 3 years!

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(Click to enlarge)

In summary, low interest rates below inflation for an extended time is not new; it was used during World War II in the U.S. to get out of war debt. When the Fed believed that the economy reached its recovery targets in 1946, the Fed went back to a market based policy. The result was a sharp decline in the stock market followed by three years of a flat trading range. Many writers have postulated what today's stock market will look like when the Fed stops easing. Some feel that the Fed will never stop. Some feel the Fed will stop when its 2.5% inflation or 6.5% unemployment rate targets are met. Some believe we will get new stock and/or real estate bubbles as a result of a Fed policy that will drag on for years. Others believe that Fed policy is smoke and mirrors; the increased reserves cannot in and of itself without private and government policies stimulate loan growth. Without loan growth there cannot be an expansion of the money supply and the multiplier effect on the economic recovery.

Whatever the result, there is a precedent in history and the things could get ugly when the music stops. As Bill Gross in his wonderful piece "There Will Be Haircuts," eloquently states, there will be no free lunch. Bill Gross sees trouble ahead and he's gradually reducing his "risk-on" positions. I strongly recommend readers read his latest piece that gives insights into what investors can expect in the future. He calls into question the effectiveness of the Fed's current policy, writing: "Yet if there are no spending cuts or asset price write-offs, then it's hard to see how deficits and outstanding debt as a percentage of GDP can ever be reduced. Granted, the ability of central banks to avoid a debt deflation in recent years has been critical to stabilizing global economies. And too, there have been write-offs, in home mortgages in the U.S., for example, and sovereign debt in Greece. But the cost of these strategies, which avoid what I simplistically call "haircuts," has been high, and their ability to reduce overall debt/GDP ratios is questionable."

I too am taking a defensive position in my portfolios by purchasing utilities, healthcare stocks, consumer staples and selected energy names. In addition, I am purchasing bear funds to protect principal of my clients investments. I have stocks in other industries and a few special situations with excellent risk to reward characteristics in my portfolios, but they make up only a small portion of my portfolio. If one takes the position that the Fed will reach its target in the next 12 to 18 months, cutting risk in portfolios makes sense based upon history and the likely reaction that will occur when the music stops playing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.