Countless commentators have bloviated about the impact of the Federal Reserve's planned tapering of asset purchases with most arguing that the less accommodative monetary policy could signal an end to the bull market. However if you are worried about tapering's impact on your portfolio, you are going to poorly position yourself into the fall. Consider the following chart:
The market actually held gains for several weeks after the end of QE1 and QE2 because these exits were well telegraphed, just as it is with the taper. Tapering is no longer news; in effect, it is priced in. Because markets are relatively efficient, they price in known events before they occur; tapering is a perfect example of this.
Looking at this chart, some of you may want to disagree with my view based on what happened after QE2. Sure, the market held on fine for about two months, but then the S&P 500 was absolutely slaughtered. That's true, but the cause of the sell-off wasn't QE2 ending. It was the game of Russian Roulette Congress and the President played over extending the debt ceiling. The potential for a US government default, which threatened the stability of the entire global financial system caused a swift sell-off, capped by a 500 point one day drop in the Dow.
That's why we should focus on the looming battles in Washington DC over debt and deficits. To summarize, by September 30, congress must pass a continuing resolution to keep the government operating, and sometime in October, they need to increase the debt ceiling or the government will default on its obligations. Over the past 4 years, Washington has lurched from crisis to crisis, striking last minute deals to avoid catastrophe. As such, there has been little coverage of these upcoming fights as the media assumes a last minute deal will certainly be struck.
However, we in the investment world know one thing: "past performance is no guarantee of future results." Just ask John Paulson. It would be reckless then to ignore Washington and assume everything will be alright. Based on rhetoric and votes over the past three months, I actually think a full blown crisis is the likeliest outcome. We need to prepare accordingly.
First, it is important to recognize that the House Republicans are more dysfunctional than they were in 2011. Two weeks ago, they pulled the THUD (transportation and housing) bill because they lacked the votes to pass it; half their caucus thought it appropriated too much, the other half too little. Similarly, a farm bill failed. Typically, these bills pass with overwhelming bipartisan support. The idea the republicans are preparing for a quick compromise ignores the reality of the House.
Some republicans are pushing to postpone Obamacare to keep the government operating, but this is a minority position after the disastrous shutdowns in the 1990s. As such, expect Congress to pass a CR before September 30 to keep the government funding with republicans using the debt ceiling to take their stand over spending cuts, which President Obama has no interest in. John Boehner has been preparing a debt ceiling brawl since January and is demanding an equal amount of spending cuts for debt ceiling increase, and his caucus will accept no less. Given democrats unwillingness to deal and Boehner's inability to control his caucus, there will be political theatrics on par with 2011. We will stare down the abyss once again and pull within 48 hours of default, which means that the first half of October will be rather messy.
In 2011, no one thought we would go to the brink, and amazingly in 2013, everyone assumes we will avoid it again, which is why the setup is so similar, especially with the withdrawal of the Fed a month prior both times. Therefore, we need to use history as our guide as we prepare for this event. The best performing stocks of August 2011 were the safest, least cyclical names like Verizon (VZ), Walmart (WMT), Coca-Cola (KO), and McDonald's (MCD) while high beta names like Netflix (NFLX), and Boeing (BA) were pummeled. Counter-intuitively, investors also flocked into treasuries while dumping lower quality bonds as spreads widened. I think we are likely to see a similar move this time.
History rarely repeats itself, but it does often rhyme, and fall 2013 will be similar to the summer of 2011 with a less accommodative Fed and dysfunctional Washington. As investors, I know we prefer looking at corporate fundamentals and hate having to focus on politics, but we must trade in the world we live in not the world we want to live in, and politics are a major market driver right now. We just need to deal with this sad reality.
As I think the Fed's impact is overstated, I would go long 10 year treasuries now and hold them into the September 17-18 meeting. I would then begin to roll out of treasuries and short high beta stocks, anticipating a steep sell-off in October as the market begins to understand the profound difficulty in reaching a debt ceiling deal. In particular, I would look at shorting Boeing and Lockheed Martin (LMT) who could suffer from a deal that cuts defense spending. Panicked selling would also make JP Morgan (JPM), Junk Bonds (JNK), and Cummins (CMI) good short opportunities while gold (GLD) provides an interesting long on the fear trade. Keep your eye on Washington and you can weather the upcoming storm well.