The Federal Reserve announced this week that it will provide $75 billion of quantitative easing (QE) in January, a massive amount, and will provide large though diminishing amounts of additional stimulus for months thereafter.
Yes, that is what it said, even though the headline news was that it will begin tapering back QE in January, by providing $75 billion rather than the $85 billion it has been providing monthly this year. If it continues to taper at the same pace it will provide an additional $65 billion of stimulus in February, $55 billion in March, and so on.
In September, 2012, just over a year ago, when the Fed announced it was increasing its stimulus program to $40 billion a month of QE purchases, the thought of $75 billion would have seemed incredibly massive. And that was when economic growth (GDP) was running at less than 2%.
So after stumbling several times this year just in reaction to hints the Fed might begin to taper soon, markets have apparently rethought their previous concerns about tapering.
They like that the Fed will still provide $75 billion of QE in January, and significant amounts monthly thereafter even though GDP growth was at 4.1% in the third quarter. That’s a lot of perhaps unnecessary extra liquidity going into the economy for several more months, potentially continuing to mostly go into paper assets instead.
The positive reaction to the tapering news was enhanced by Chairman Bernanke’s assurances that even though it will slowly reduce the degree of QE stimulus next year, it will continue to hold interest rates extremely low even longer than it previously indicated, probably well into 2015.
I was wrong, as were the majority of analysts, in expecting the Fed to delay tapering until its March meeting.
However, the announcement and the market’s reaction does not change my ongoing intermediate-term forecast, that the combination of favorable seasonality and the Fed’s support will keep the market positive until March or April.
But the market’s reaction does raise the risk.
Most economists and analysts, me included, were expecting a short-term correction, needed to alleviate the overbought technical condition, and to cool off excessive investor bullishness before the upside would resume into the spring. Otherwise the market and sentiment would become too bubbly.
The Dow pulled back only 2.2% in its decline of the last two weeks, finding support at its 50-day moving average and then launching this week into this rally up to new record highs.
So for the time being, I have to love the market’s positive reaction. Our Seasonal Timing Strategy remains in its favorable season and 100% invested in the Dow, and our non-seasonal Market-Timing Strategy remains on its October 23 buy signal.
However, without a short-term correction of any degree first, it does raise the risk.
Although the pullback alleviated the previous short-term overbought condition above the 50-day m.a., the minor pullback did nothing to lessen the longer-term overbought condition above the 200-day m.a., and the quick rally up to new highs is probably further over-heating the already high level of investor bullishness and optimism.
So we love it short-term, and it also plays into our forecast that 2014 will not be anything like 2013 (which may result in a volatility shock to investors who have become so confident after such an unusual year as 2013 has been).
Next year is the second year of the Four-Year Presidential Cycle. Since 1934, the average decline within the second year of the cycle has been 21%, more than the 20% threshold of a bear market. But the declines tended to be worse when there was no correction in the first year of the cycle, and when the market, investor sentiment, and valuations had become quite extreme as a result.
That’s the bad news for next year.
The good news is that since at least 1918, there has been a significant rally from the low in the second year of the cycle to the high the following year, a rally in which the Dow gained an average of 50%.
So we believe next year is going to also be an unusual year, but for very different reasons.
Rather than another unusual one-direction year like this year has been, next year should have a very important top, followed by an equally important bottom.
The Fed’s taper decision and the market’s spike-up reaction does not lessen the prospect for such a scenario, but enhances it.
But for now, let’s enjoy the rally.