by John Nyaradi
Major tremors roiled U.S. financial markets last week as investors began to realize that quantitative easing appears to really be coming to an end now. Before the closing bell on June 19, investors knew that the FOMC's tentative schedule calls for a complete cessation to its bond-buying program in mid-2014. However, at his press conference, Fed Chairman Ben Bernanke also explained that those who assume the program will end at that time have "drawn the wrong conclusion" because of the contingencies involved. The Fed plans to be flexible with its timetable, making appropriate adjustments, depending on the progress of the economic recovery. The Ben Bernanke Fed will begin to scale back its bond-buying program "later this year" although the federal funds rate will remain low until 2015.
The stock market handled the news reasonably well on June 19. The Dow Jones Industrial Average (NYSEARCA:DIA) sank 206 points to finish Wednesday's trading session at 15,112 for a 1.35 percent decline. The S&P 500 (NYSEARCA:SPY) fell 1.39 percent to close at 1,628. But when America's investors went to bed that night, the nightmares began and the reality of the end of quantitative easing began to set in.
Then Thursday brought the sell off. No asset class was safe. Bond yields (NYSEARCA:IEF) spiked higher. Gold (NYSEARCA:GLD) collapsed. Oil (NYSEARCA:USO) tanked. For more than four years, the stock market has been levitated by quantitative easing, and suddenly the prospect of losing that support chilled markets worldwide and investors began asking the question, "What are assets really worth without the Federal Reserve's liquidity program?"
Of course, no one really knows the answer to that question as the psychological importance of the "Ben Bernanke Put" has been huge ever since 2009, along with the real economic effects of the Federal Reserve's support of the housing market and U.S. economy.
A glance at the chart of the S&P 500 can give us a quick idea of where the decline generated by the end of quantitative easing could take the U.S. stock market.
chart courtesy of StockCharts.com
Looking back to March, 2009 when Dr. Bernanke rolled out his big guns, we can see that predictable retracement levels on the S&P 500, according to Fibonacci theory, would first be 1295, then 1176 and finally 1057. These levels would represent further potential declines of between approximately 18-34% from June 21st's close. Since the S&P 500 is currently 4.6% off its recent all time high, further potential declines of this magnitude would put the U.S. stock market firmly in bear market territory.
The important thing to realize here is that all of last week's negative action came on just the notion that quantitative easing might come to an end later this year. What will happen when the process actually begins is an entirely different question and nobody can be certain of the market's response when the taper gets underway. Another important factor is the upcoming earnings season scheduled to start in early July. Will corporate profits be able to support current valuation levels, or in the face of a slowing global and U.S. economy, will profits sink?
All in all, investors face a tenuous environment, at best, and a highly hazardous environment, at worst. After this year's fast start, which still sports nearly 9% in unrealized gains, now could be a good time to consider some defensive measures should markets not be happy with their new life without Ben Bernanke.
Possible strategies to consider:
Put options – Just because the "Bernanke put" is no longer there, doesn't mean you can't go out and buy your own.
Inverse ETFs – Inverse ETFs help investors avoid the risks of having to cover short sales and offer downside hedges to long positions should the market continue its decline.
Cash – As quantitative easing weakened the dollar, it seems likely that the taper could strengthen the dollar. If interest rates continue to rise, savings accounts and certificates of deposit might actually start paying something again. Beyond that, cash is the ultimate hedge in times of stress, and so raising cash is a strategy that many money managers are currently considering and deploying.
Bottom line: The post-quantitative easing era is no time for complacency. Life without Ben Bernanke is going to be different and it's quite likely that different strategies will be required to thrive and survive in the new environment ahead.
Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.