Don't Fret The Fed, Why It Does Not Matter

Includes: EEM, GLD, NLY, PCY, TWO
by: Efficient Alpha

The Daily Ticker was out with a dramatic piece over the weekend, luring investors with fear of a $4 trillion time-bomb surrounding the nomination of the next Chairman of the Federal Reserve. Fear sells and when there is a scarcity of drama, the pundits will produce it.

All the fear and positioning over the changing of the guard is a market sideshow and the increase in rates is overdone. Both inflation and unemployment data is pointing to accommodative policy for a very long time. Japan is just beginning its historic monetary gamble and Europe has come out of recession. The facts point to stronger markets into the end of the year and investors could do well to step back and position their portfolio for when the market comes off its Fed-induced frenzy.

Cage Match: Summers versus Yellen

Pundits would have you believe that the President's choice between Larry Summers and Janet Yellen could mean the difference between market calm and market calamity. Yellen is seen as much more dovish than Summers and would keep policy accommodative for longer while Summers may yank the punchbowl from the party.

First, though odds at internet betting-site Paddy Power have recently changed in Summers' favor, I doubt the former Treasurer really has a chance. His key role in repealing Glass-Steagall, which helped the banks grow too-big-to-fail, makes him a poor choice to oversee provisions of Dodd-Frank.

Further, Yellen has been a member of the Fed for a full economic cycle and has participated in the discussion over the historic policy. The Board needs this level of institutional knowledge if it is to guide policy out of accommodation without falling back into recession. Lastly, as probably the most dovish on the Board, Yellen is the most likely to leave monetary policy accommodative if Congress cannot control fiscal policy.

But does it really matter?

While a Yellen nomination may soothe the markets and a Summers pick may roil them, I don't think it really matters as the markets move into 2014.

First, both of the Fed's mandates point to accommodative policy for a very long time. After three rounds of quantitative easing and similar programs by the largest countries in the world, inflation is still well below the Fed's target of two percent. Bernanke made a point in the last meeting to say that 6.5% unemployment was not a target for rate increases but a threshold where the Fed would consider more restrictive policy. While unemployment has fallen this year, it is still nowhere close to the Fed's pressure point.

Only Kansas City Fed President George voted against easy money in the last meeting and the trend in economic data does not point to a large swing in the vote anytime soon. Even if it does, the global environment looks supportive of stocks in the near-term.

Japan has just started its massive easing program, doubling its central bank balance sheet in two years and targeting 2% inflation. Europe has just come out of six-consecutive quarters of negative GDP growth and the world's largest economic region could seriously add to export numbers across the globe.

While I do expect periods of market losses as we head into the Fed nomination and the debt ceiling negotiations, markets should rebound going into 2014 as investors realize the outlook is more positive than the media would have it appear.

Ultimately, the fear is that the Fed will abruptly reduce its $85 billion of monthly purchases and send the markets into a tailspin. The FOMC has been extremely measured in its policy changes and I just don't see this happening. The rate scenario and QE3 has been a long process and its resolution will be equally long.

5 Investments to Outperform

Shares of mortgage REITs have been hit hard lately as book values come down in the rising rate environment. This is largely because the fixed-rate mortgages that these companies hold on their books is worth less as rates rise, but the stocks have also been hit by fears that the Fed's pullback on MBS purchases may hurt prices further. More pain may be yet to come as we lead into the September tapering, but these shares should rebound sharply as fear subsides and are strong performers over the long-term.

Annaly Capital Management (NYSE:NLY), with a market cap of $10.7 billion, invests in mostly bonds guaranteed by government agencies like Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA). Book value has already fallen almost 20% from $15.85 per share in 2012 to $12.80 per share and the shares trade for just 0.88 times book. The rise in rates has been amplified by the need to sell off assets to maintain leverage exposure. The quarterly dividend has been cut 27% from last year but still provides an attractive 14% yield.

Two Harbors Investment Corporation (NYSE:TWO) invests in mortgages not secured by the federal government and bears the risk of default. Management has diversified the company's exposure with purchases of jumbo mortgages and mortgage servicing rights (MSRs). Further, the company repurchased one million shares in the previous quarter and is authorized up to 24 million shares in its buyback program. Book value has already fallen 11% from $11.55 per share in 2012 to $10.27 per share and the shares trade for just 0.90 times book. The quarterly dividend has been cut 17% from last year but still provides an attractive 13% yield.

Emerging markets may also outperform in the second half of the year. The regions have underperformed the U.S. market on stronger than expected domestic growth and fear that tapering will lead to a liquidity crisis. While EM is bound to be more volatile than domestic shares over the next couple of months, investors need to be where the growth is for long-term gains. Four years of underperformance has left many of the emerging markets extremely attractive on a valuation basis.

The 8.4% return to the iShares MSCI Emerging Markets (NYSEARCA:EEM) over the last four years pales in comparison to the 65% gain in the S&P500 but prices for the companies in the EM index are just 11 times trailing earnings compared to a relatively expensive 16 times for the domestic index. Shares are down more than 13% this year over relative economic growth and Fed fear. Export growth from a European rebound along with stronger Chinese data in the second half should drive EM higher, aided by the knowledge that Fed tapering will not be as abrupt as some fear.

Investors looking for bond exposure in the face of rising rates might look to the PowerShares Emerging Market Sovereign Debt (NYSEARCA:PCY) for yield and price gains. The fund invests in the dollar-denominated bonds of 22 emerging markets and pays a 5% yield. The fact that the bonds are in dollars should protect assets from dollar strength. The fund has underperformed the iShares Core US Total Bond Market (NYSEARCA:AGG) with a loss of 15% this year against a loss of 5% in the domestic index. Almost a third (61%) of the bonds are rated BBB or better by Standard & Poor's so the assets are fairly safe but have good potential for upside.

The price of gold has been one of the biggest losers as the market has built up to Fed tapering. SPDR Gold Shares (NYSEARCA:GLD) are down 19% this year and 27% off their 2011 peak. Though inflation does not seem to be a problem outside of a few countries like Brazil and India, the trend is upward and should be supportive of gold over the long run. At these prices, we are starting to see consumers come back into the market. Consumer demand in India and China, which accounts for 60% of the world's consumption, jumped more than 70% in the second quarter. Many of the miners look attractive on a valuation and yield perspective but the physical commodity should outperform as it has done in the past.

A laddered approach

Outside of the blood in the streets provided by bear markets blowups, it is nice to be able to trade these short-term issues. Stocks have been bid up nicely over the last several years and the lead-up to the nomination of the next Fed chief, along with the upcoming debt ceiling debates, could provide a good opportunity for investors to take advantage of a pullback. You might want to ladder your purchases at downturns of 5% and 10%, but I would not look for much more of a pullback before the markets realize longer-term upside.

Disclosure: I am long PCY, NLY, TWO. 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.