After three straight days of losses in the overall market, bargain hunters stepped up to the plate yesterday with technology stocks leading the charge higher. The Nasdaq bounced back 1.8%, pointing towards hope of at least a short-term bottom after another mini-correction. The Dow closed up 0.5% and the Russell 2000 Small Cap Index gained 0.7%. At their low points during this 3-week pullback, the S&P and Dow Jones indexes failed to even reach a full 5% correction, while the Nasdaq dropped 8.5% before recovering. The S&P has not seen a 5% drop in 135 trading days, which is the 17th longest streak on record.

Federal Reserve meeting minutes finally showed a start to talking about talking about a tapering phase. Not to be confused with actually talking about it…or finally tapering the $120B monthly bond purchases, which all happens before we even talk about talking about raising Fed Funds. A few participants suggested that if these rebounding economic conditions continue to advance, “it might be appropriate at some point, in upcoming meetings, to begin discussing a plan for adjusting the pace of asset purchases.”

It is almost comical that we are continuing to expand Government balance sheets at this size when the economy is growing at double digit rates, but here we are. Note, the Fed didn’t say ending the bond purchases. It will come in phases, maybe dropping purchases to only $60B a month first. Fed heads do not want to stop this growth early, or anywhere near close to early.

Tapering will happen, most likely in early 2022 unless inflation extends past the summer months and it forces their hands earlier. Everyone expects supply chain disruptions, reopening efforts, cash-rich consumers and pent-up demand which exceeds supplies today. Transitory conditions, as they put it, should end soon thereafter. Therein lies the million dollar question of when.

Back in 2013, Taper Tantrum became a common phrase after Ben Bernanke announced that the Fed would, at some future date, reduce the volume of its bond purchases that started in 2008. The Fed didn’t stop their purchases at all in 2013. In fact, they increased them two years later. In a span of less than two months, when Bernanke openly discussed the possibility of slowing bond purchases, the S&P dropped nearly 8% and rates rose over 100bps from 1.61% to 2.66%. From that point, the S&P rose 35% in just two years. Two steps forward, one step back. That is how normal markets work, climbing a wall of worry. Tapering or tightening cycles are not times to sell everything and move to cash. Quite the opposite actually, especially today with a Federal Reserve willing to let things run hotter for longer. Anything they do will be slow-paced. An immediate reaction to sell stocks, historically, has proven to be the wrong move.

Let’s take a look at previous tightening cycles, which historically are times of Fed rate hikes:

Nearly every case was met with initial selling of equities for several weeks. Nearly every case also resulted in sizable gains afterwards. 2013 is not listed as the Fed didn’t do anything other than talk about tapering. It is still the best year for the S&P 500 in this century, even with the 8% drop noted above. Market timing is difficult and not recommended. Tapering phases bring a fresh bout of fear into the market and are opportune times to reposition for another leg higher, not go to cash. However, moving from early cycle leaders to mid or late cycle stocks is entirely prudent.

At some point, the Fed may be caught behind the curve from an inflation and risk-taking standpoint. However, containing inflation is a lot easier than ending deflation. Japan is a perfect case study. Numerous Government-sponsored plans did nothing to end the deflationary spiral over the past three decades. Stocks have languished along with their economy. We want to avoid deflation at all, or almost all, costs.

Extremely robust CPI numbers for April, more expected in May and June along with spiking earnings and supply shortages, are all leading markets to look towards tapering sooner rather than later, regardless of Fed speak. Futures markets are pricing in one rate hike next year, well before the Fed’s 2024 timeline. In just the past 2 weeks, 10 year yields jumped 24bps to touch 1.70% again.

Even though higher yields pressure go-go growth and long duration assets, higher quality stocks are holding their own. I was surprised when running the numbers, but FANGMAN is actually up 8%+ this year, similar to the S&P 500’s 11% return. Pressure in the market remains on the fringes and less so on fairly valued, higher quality stocks.

As long as earnings keep expanding, there is no reason to think that will stop. However, a correction can, and should, happen at any time. History says that will come when taper talk increases. Over the coming weeks great news can be taken as bad. By this I mean anything that shows strength over and above expectations will pull forward fiscal tightening. In a weird way, a stronger economy today could be the impetus for profit taking tomorrow. As noted, this is just another chance to reposition portfolios for the next leg higher.

The infamous Mr. T turns 69 today.

James Vogt, 610-260-2214

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