This you can bet on: The Federal Reserve will eventually stop its $85
billion-a-month bond-buying program, an economic lifeline aimed at
getting the country back on its feet after the financial crisis.
While no one knows when the central bank will start winding down the
quantitative easing that has pushed down interest rates, Fed Chairman
Ben Bernanke hinted last week that the taps may start running dry sooner
rather than later — perhaps as early as this summer.
The very thought sent a shiver through world stock and bond markets,
though investors took some comfort after a closer look at Bernanke's
remarks and reassurances from European and Japanese central banks.
Editor's Note: Economist Unapologetically Calls Out Bernanke, Obama for Mishandling Economy. See What They Did
Markets got back on track this week on the prevailing view that Bernanke
may not act all that soon after all. Still, the underlying message was
clear: All good things must come to an end.
That said, there are ways to protect your portfolio and perhaps profit
from the big shift. Experts recommend three strategies — a move into
cash, alternative bond funds and buying shares that have lagged the
recent run-up in stock prices — among other ideas.
Here are some tactics investors might consider as the era of quantitative easing ends:
CASH IS KING
The tapering off of the Fed's stimulus program — which has pushed
interest rates to historic lows — will cause bond yields to spike and
prices to slump. The 10-year Treasury bond is yielding 2.17 percent,
already up from 1.94 percent before Bernanke testified before a
congressional committee last Thursday.
In a note last week, Goldman Sachs said bond yields are "distorted" and
pegged the "fair value" — or the yield it would offer under normal
market conditions — of the 10-year Treasury at 2.5 percent.
"We're assuming that the yields are artificially low, and any kind of
rate increase will really damage those funds," said Chris Costanzo,
investment officer at Tanglewood Wealth Management in Houston, Texas, a
firm with $750 million in assets under management.
With that in mind, Costanzo has reduced his clients' positions in U.S.
stocks, increased the cash holdings of his conservative clients to as
much as 24 percent of their portfolios and has moved out of bond index
funds with large stakes in Treasurys. He said those moves will help
protect portfolios in case the ending of the Fed's stimulus program
isn't smooth.
DON'T ASSUME STOCKS ARE SAFE
The Standard & Poor's 500-stock index could tumble once the Fed
announces it is winding down its purchase program and bond yields start
rising, said Uri Landesman, who oversees $1.2 billion at the New York
investment manager Platinum Partners.
"When people pull out of the bond market, they are going to pull out of
everything," he said, adding that he believes the stock market has been
"insanely" inflated by the Fed's policies.
He expects the S&P 500 to trade at about 1,400 by October, a decline of almost 16 percent from Tuesday's level of 1,660.
BOND ALTERNATIVES HOLD PROMISE
There are alternatives to stocks. Costanzo is adding to positions in "go
anywhere" bond funds such as the $41.2 billion DoubleLine Total Return
fund, whose 5 percent stake in Treasurys is just a third of the average
of 16 percent among funds in its category, according to Morningstar.
Instead, that fund, whose three-year annualized return of 10.2 percent
puts it in the top 2 percent of intermediate bond funds, holds large
positions in "private label" mortgage bonds that are not backed by
Fannie Mae or Freddie Mac.
These bonds have rallied as the housing market rebounded, and supplies
have fallen to $909 million from a peak of $2.2 trillion in 2007. With
few new bonds coming onto the market, the lack of supply will likely
help keep prices steady even if the housing market cools, analysts say.
THE USUAL DEFENSES MAY NOT WORK
Typically, a stock market pullback helps boost prices of so-called
defensive sectors — such as utilities, telecom companies and consumer
staples — that are not as dependent as many other companies on a growing
economy for profits. But this year those sectors have led the market.
Investors already have turned to them as alternatives to the bond
market.
Defensive sectors are "extraordinarily expensive," said Burt White, chief investment officer at LPL Financial.
Slow-growing utilities, for instance, are trading at an average trailing
price-to-earnings ratio of 16.5, while the S&P 500 as a whole is
trading at a p-e of about 14. Over the last 10 years, utilities have
traded at an average p-e of 14.1, according to a Fidelity Investments
analysis.
By comparison, technology stocks, a growth sector in which investors
typically pay more for future earnings, trade at an average of 15.1.
Typically, that sector trades at a p-e of 20.
BETTING ON THE ECONOMY
If the Fed does retreat, it will be because the economy is picking up
steam. That is leading White and others to consumer discretionary
stocks, even though those are already up about 20 percent this year.
"The consumer names will continue to do well, given that any pullback
won't be economic in nature but much more around the tapering of the
stimulus," he said.
Investors who want to bet on the sector could opt for an exchange-traded
fund like the $843 million Vanguard Consumer Discretionary Fund.
Costing 14 cents per $100 invested and yielding 1.3 percent, the ETF has
its highest weighting in Home Depot, McDonald's and Amazon.
Alan Gayle, who manages $325 million invested in four target-risk
portfolios at Ridgeworth Investments, has been increasing his stake in
technology stocks and other cyclical sectors for the same reason. Tech
stocks are up about 9.9 percent for the year, lagging the broader
market, and are poised to push higher should a growing economy nudge
corporations into increasing their capital spending, he said.
BANKS WILL PROFIT FROM RISING RATES
Large financial firms may benefit from the end of the Fed's program over
the long term, said Ann Miletti, a co-manager of the $1.8 billion Wells
Fargo Advantage Opportunity fund, which focuses on mid-cap stocks.
Miletti has added to positions in financial firms such as Ameriprise
Financial and Lazard Ltd in anticipation of rising rates. Such a move
would make money markets and other interest-bearing accounts more
profitable without increasing costs, she said. Lazard is lagging the
benchmark S&P by about six percentage points for the year and trades
at a forward p-e ratio of 14.1.
Still, investors who make the "rising rates" play may have to wait for a
while before the payoff, she concedes. Nobody knows when the Fed will
act — just that it eventually will.
Editor's Note: Economist Unapologetically Calls Out Bernanke, Obama for Mishandling Economy. See What They Did
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