Tapering Could Be The Investment Event Of The Year

by: John Gilluly

Stimulants have special contingencies - pluses and minuses so to speak - when introduced into the human body to correct deficits. The most common corrective is for executive-functioning. The pluses are a steady focus (hyperfocus, even), lack of distraction, good decision-making, and the ability to run on a single track for a long, long time. The negatives are risk of addiction and the mental and physical "letdown" that occurs when the stimulus is removed.

It's not much of a stretch to see that stimulus could be applied to stock market sentiment, and by extension, to the economy, with similar results. Whether the Federal Reserve's stimulus programs are merely psychological support or real medicine, we're all human, just the same.

At the beginning of the current QE3, the stock market rallied from pillar to post in practically a straight line. At one point in 2013, the Dow's rally had stretched 125 consecutive days without as much as a 5 day letdown, the largest buying stampede in history.

How's that for hyperfocus and single-mindedness?

Meanwhile, in the real world of economics, there were violent swings in interest rates, a fixed-income collapse, emerging market catastrophes, the U.S. fiscal cliff, a government shutdown, and a debt-ceiling debate that was resolved the night before insolvency.

But the market didn't notice. It didn't even blink. It was on the pill and the bulls rolled forward, oblivious to it all.

But that all seemed to end the first day of 2014 when Taper-Talk ceased and instead became: THE TAPER. (One can almost see Japan's pop-icon Godzilla thrashing and smashing his way through Tokyo).

Nothing could be more different (thus far) in 2014 than what took place in 2013. Now we have consecutive 90% down days, the NYSE's 10 day moving average (M/A) drilling down 2 standard deviations; and as I write today, the Dow is down 280 points, having sold off 1,100 points in just 10 days and piercing its 200 day moving average to the downside.

Welcome to THE TAPER.

The last two times the Federal Reserve cut its QE1 and QE2 stimulus programs, the market tanked 15% and 19% respectively, in the summers of 2010 and 2011. It wasn't pretty. But it was also an amazing buying opportunity for the homebuilders back then. That was their valuation low for the decade, maybe two decades. A similar bottom may be shaping up for the MREITS now, who have had a spectacular January, 2014 thus far. (See: Is a Welcome Surprise Coming for Mortgage Rates?, January 31, 2014; and "Is it Safe to Return To the REITS", February 3, 2014).

After uncomfortably witnessing their May Melodrama of Taper-talk play itself out in the markets, the FOMC decided to remove the QE3 stimulus gradually this time, thus creating a steady-state of withdrawal in the economy.

I might liken this to a bicycle zooming along on a straight-away. The tires pick up a couple of thorns and the air slowly leaves the tires. The buoyancy recedes. The bicyclist (the economy) is still huffing and puffing along, but with each stroke of the pedals it gets a little tougher - imperceptibly at first, and then dramatically.

Tapering assumes a lack of stimulation, yes? That's why I think 5% mortgage rates in this kind of environment are a pipe dream, and have said so previously in my articles on monetary policy and interest rates. Instead, I believe rates could go sideways or slightly down, and mean reversion has begun.

If this plays-out for the duration of tapering in 2014, MREITs should stabilize; the lower mortgage rates would bring buyers back to the real-estate market for the Spring selling season, and home builders will sell an abundance of new homes.

This bodes well for Annaly Capital Management (NYSE:NLY), Western Asset Management (NYSE:WMC), New York Mortgage Trust (NASDAQ:NYMT) and other MREITs; and for the large, publicly-traded builders: Toll Brothers (NYSE:TOL), Lennar (NYSE:LEN), DR Horton (NYSE:DHI), KB Home (NYSE:KBH), Brookfield Residential (NYSE:BRP), Pulte Home (NYSE:PHM), Standard Pacific (SPF) and Rylant (NYSE:RYL). Thus far this earnings season, the builders have defied expectations and reported spectacular Q4 and 2013 results.

If there is a turnaround ahead in mortgage purchase originations, it would also benefit the hard-hit likes of NationStar Mortgage Holdings (NYSE:NSM), down 50% in the last 90 days. At today's lows, NSM has reprised ALL of its gains acquired during QE3. The homebuilders are anticipating a 25% rise in new home purchases this year, and that is reflected in the recent bump in their housing starts. Some of this will filter into new purchase originations, which should eventually benefit NSM.

These are heady times. Now that we are below the 200 day moving average, the next big test awaits the market - the 300 day moving average on the SPX. In a secular bull market, buyers find a way to engineer a "bounce" off the 300 day M/A, and then the market goes sideways. But a sustained drop below the 300 day M/A? Then its lights out and probably no one should be long - anything.

I don't think that's going to happen, but the weeks ahead will be the first test in 5 years of whether we have an economy that can sustain itself without monetary stimulus. The entire duration of this bull market can be sandwiched between 60 months of almost uninterrupted Federal Reserve stimulus programs. That's something to think about, and you can bet the Federal Reserve is thinking about that too.

Disclosure: I am long NLY, BRP, GFA. 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.