Fed Hints at End of Quantitative Easing, Maybe

In my E-Letter on Tuesday, I warned that the stock market could suffer a potentially nasty selloff if the Dow and the S&P fail to break out and make new all-time highs on this latest rally. With bullish optimism running so high in recent weeks, I pointed out how disappointing it could be if the Dow and S&P fail, once again, to break out to new record highs.

The thing is, it is never possible to know what news might come out that derails a bull market, or reverses a bear market, for that matter. Take yesterday for example. The Dow started off the day climbing above the magic 14,000 level yet again. Not a lot above it initially, but enough to make even the hard core bears consider that this could be the day when the Dow makes a convincing new all-time high.

But then there was some unexpected news. Imagine that! Going into yesterday’s market session, everyone knew that the Fed would release the minutes from its January 29-30 Fed Open Market Committee (FOMC) meeting around mid-day. Fed watchers always scrutinize these minutes closely, looking for any possible hints or surprises.

For the last couple of years, the minutes from these periodic FOMC meetings have continually confirmed that the Fed was intent on keeping up its “quantitative easing” (QE) program indefinitely. For most of last year, the minutes suggested that the Fed would continue these massive monthly purchases of securities well into 2014, if not longer.

Then in September, the Fed upped the ante by declaring it would significantly increase its securities purchases to a total of $85 billion a month, at least until the US unemployment rate falls to 6.5%. Even the most optimistic forecasters agree that the unemployment rate won’t fall to 6.5% for a couple more years. So the Fed would keep pumping, right?

So what was the big change yesterday? Basically the minutes from the January 29-30 Fed meeting revealed that there is growing disagreement among the 12 voting members on the FOMC as to how long to continue QE and how much more to swell the Fed’s bloated balance sheet. There was also some discussion as to when to end QE, perhaps even before the unemployment rate falls to 6.5%. Perhaps even by the end of this year.

If you were watching the stock markets yesterday, you saw that there was an immediate negative reaction to the FOMC minutes. The major stock market indexes turned lower within minutes of the release of the report. The Dow ended the day down 108 points. It is down again this morning.

It remains to be seen what happens next. If I had to guess, I would say not a lot. The markets will likely get over this in a few days at most. After all, the Fed did not make any hard decisions about when, or if, to end QE.

The problem, as I discussed at length in Tuesday’s E-Letter, is that if the stock market reverses downward at this critical juncture – just below the all-time high once again – a nasty selloff could follow. It’s a technical thing by and large (see chart below). But technical things can often matter a lot. A failure to make new highs at this point will be very disappointing. As this is written, the DJIA has failed to make a new high and has retreated to below 13,900.

The stock markets may shrug off this possible shift in Fed policy, if it is indeed a new shift – that remains to be seen. But my point is the same. If the stock markets fail to make new all-time highs on this run – whether or not the Fed is changing its QE policy – we could be in for another major leg down in stock prices.

John Hussman, founder of the Hussman family of mutual funds, wrote a very good article on the state of the US stock market yesterday. Hussman is a prolific writer, and his columns are always very long and granular. However, you need only to read the first section of yesterday’s piece to get his latest perspective on where the US stock markets may be headed.

Here’s the link: http://www.hussmanfunds.com/wmc/wmc130218.htm

As John suggests, a traditional buy-and-hold strategy in the current environment – especially if this rally fails to make new highs – may prove to be very painful. Keep in mind that there are actively managed equity programs that can move to cash periodically in an effort to minimize stock market downturns. Feel free to call us at 800-348-3601 for more details.