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Conflicting Statements And Mixed Messages

If you follow the markets closely, you have probably asked yourself at some point why does the Fed keep sending mixed messages? If we think in extremes, we can understand the Fed's rationale. Let's assume the Fed released either of the following statements:

Statement A: We have no plans in the foreseeable future to cut back our bond purchases.

Statement B: We will terminate our bond buying campaign effective immediately.

Statement A could fuel inflation expectations and encourage bubble-like behavior in the stock market. Statement B could spark a sharp and pronounced plunge in stock prices. The Fed does not want to see either outcome. Therefore, they try to forge a balance between statement A and statement B.

Fed In Full Mixed-Message Mode

Monday, James Bullard, president of the St. Louis Federal Reserve Bank, took a "small taper and we'll see how it goes" stance. From MarketWatch:

Bullard suggested a "small taper" in December might be the appropriate policy course. "A small taper might recognize labor market improvement while still providing the (Fed) the opportunity to carefully monitor inflation during the first half of 2014," Bullard said. "Should inflation not return toward target, the Fed could pause tapering at subsequent meetings," Bullard said.

Taking a much more dovish stance, Richard Fisher, president of the Dallas Federal Reserve Bank, said the Fed should taper now. From MarketWatch:

The Federal Reserve should begin to pull back the pace of its asset purchase program "at the earliest opportunity," said Richard Fisher, the president of the Dallas Federal Reserve Bank, on Monday. Fisher, who will be a voting member of the Fed's policy-making committee in 2014, has never been a fan of this round of quantitative easing, arguing that it comes at a cost that far exceeded its "purported benefits."

The Market Has To Correct Soon, Right?

With stocks pushing higher and higher, many investors are asking don't stocks have to correct soon? To answer that question, this week's video compares the observable, binary and unbiased evidence in December 2013 to periods just prior to stock market corrections in 2011 and 2012.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Investor Conviction Still Sides Will Bulls

How concerned are the markets about a possible Fed tapering announcement this month? To help answer that question, the charts below compare the present day to a recent major stock market peak. The market's pricing mechanism, based on the aggregate opinion of every investor around the globe, allows us to compare economic confidence in late 2007 to the present day. The aggregate investor opinion is based on the aggregate interpretation of the economy, earnings, Fed policy, etc. The previous sentence helps us understand the concept that the fundamentals are reflected in the charts.

Momentum indicators, like the widely used MACD, can be thought of as conviction indicators. When momentum is strong, conviction about positive economic outcomes is strong. Conversely, weakening momentum speaks to weakening bullish conviction about earnings, geopolitical events, monetary policy, and the global growth story. The monthly chart of the S&P 500 below shows momentum was waning as stocks pushed higher in late 2007. Weakening momentum (see thick red line) foreshadowed the 50%-plus decline in the S&P 500 (financial crisis).

The same chart looks much better in December 2013. Instead of a bearish "non-confirmation," present day momentum is rising with price, which speaks to ongoing confidence about future economic outcomes, earnings and Fed policy.

Investment Implications - More Comfortable With Taper

Unlike May 2013, when the term taper sent investors running for the stock market exits, the tolerance for tapering seems to be higher now. From Bloomberg:

"People are getting more comfortable with the idea of tapering and the concept that the reason for the taper is that the economy is getting stronger," Walter Todd, who oversees about $950 million as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina, said by phone. "At the end of the day that's a good thing, not a bad thing. For the next week it's just going to be speculation around the timing."

Over the last few months, investor bias has seen noticeable improvement, which speaks to a stock market that seems more accepting of a Fed taper. In the chart below, investor conviction was not strong enough to push stocks above points A and B. Recently, the same area of resistance (green line) has acted as support (see C and D).

If support above holds, the S&P 500 (NYSEARCA:SPY) may continue to march higher within the rising pink trend channel shown below.

The message from the market's pricing mechanism in 2013 is much more favorable for stocks than it was in late 2007. Since thinking in probabilities and flexibility are 2 of the 4 keys to portfolio management, we must understand how to use the charts above. If economic data, Fed policy and/or weak earnings result in a shift in the aggregate tolerance for risk, we must adjust our exposure to stocks in an appropriate manner. As long as the message is one of "risk-on," we will continue to hold our positions that were established between October 9 and October 18, including broad U.S. exposure (NYSEARCA:VTI), technology (NASDAQ:QQQ), financials (NYSEARCA:XLF), energy (NYSEARCA:XLE), foreign stocks (NYSEARCA:EFA) and emerging markets (NYSEARCA:EEM).

Source: Why The Fed Will Keep Markets Guessing On Taper