Wednesday, August 28, 2013

What to do in an Uncertain Market

The purpose of this post is not about predicting macro variables or how the market will perform in the short term. This post intends to provide general guidelines for investors given that more headline risks have emerged. I will provide a brief overview of the three main headline risks facing investors: the Fed's plan to taper QE, the debt ceiling debate and the geopolitical tension in Syria.  

Investors are growing fearful as the debt ceiling and the potential conflict with Syria increase near term uncertainty. The S&P500 fell from its high at 1709 to 1630 and the VIX, nicknamed the fear gauge, climbed 40% from 11.50 to 16.50. As investors grow more anxious, I suspect reactions from market participants will be more extreme in the next few months because of additional headline risks. 

The Taper Tantrum:

In June's FOMC press conference, Chairman Bernanke explicitly stated that the Fed is looking to reduce its asset purchase program (QE3) in the next few months. As the monthly job data get above the comfortable 200K level, most economists are betting on a September taper by the Fed. Many market participants worry that reduced stimulus would dampen future economic growth and could push long term interest rates even higher. Just after the Fed hinted at tapering, the 10-year treasury yield rose from 1.6% to 2.9% and the 30-year mortgage rate rose from 3.5% to 4.6%. The 10-year treasury rate is the base rate for most loans and the 30-year mortgage rate is a key interest rate for housing refinancing. Both are very important drivers of the underlying economy. In addition, with (PCE) inflation running near 1%, the Fed is not meeting its inflation mandate. The path of tapering implied by the market may be incorrect given that the Fed is missing its inflation target and there are still risks to the economic recovery. Even if the Fed tapers in September, the Fed may change the expected path of tapering to accommodate new developments, .i.e. if economy slows down, the Fed may signal that asset purchases could go beyond the expected mid-2014 date.  

Overall, tapering QE is beneficial for the long term and will benefit savers. Market participants' worry that the Fed may choke off growth with tapering is valid but the Fed could potentially reverse its policy if tapering impacted the labour market recovery. Thus, there is no need to panic because of the taper tantrum. Also, investors should remember to avoid long duration bonds and high yield stocks because investors are facing an increasing interest rate environment. 

Debt Ceiling 3.0: 

The U.S. treasury secretary delivered a bad news yesterday. Jack Lew told congressional lawmakers that the U.S. will hit its $16.7 trillion debt ceiling in mid-October and it must be raised. The first debt ceiling debate in the summer of 2011 was a total disaster, with S&P downgrading U.S.'s credit rating from AAA to AA+ after the 2011 debt ceiling deal.  The second debt debate, which occurred during New Year's eve, was more friendly and had less fireworks than anticipated. Now a third debate on the debt ceiling is within the next month and could add some near-term uncertainty to the markets. In my opinion, there could be more fireworks this time around but an 11th hour deal is likely to happen given politicians fully aware of the consequences of a political deadlock regarding the debt ceiling. That was why the New Year's eve discussion was more friendly than most political watchers expected. 

Geopolitical Risks:

The situation in Syria is getting more serious after the U.S. announced a possibility of a direct military intervention. The effects of this geopolitical risk is already being reflected in the market as stock markets declined and oil prices rose since U.S. announced its intentions on Monday (August 28). I think the 2011 Libya conflict could provide some guidelines on how the market would react in the next few months. Higher oil prices could potentially slow global economic growth but higher oil prices is only temporary. 

Most market reactions due to geopolitical events are mostly temporary in nature. Investors should realize this and should not panic, unless they are in Syria of course.   

Conclusion:

All in all,  investors must remember that trying to predict the specific outcome of these uncertainties is futile. As Buffett would say, "you only know who's swimming naked when the tide goes out". However, more uncertainty does not mean investors should hit the panic button and sell everything. More uncertainty calls for more caution, and more attention to the risks factors when making investments. Investors should ensure that they have adequate margin of safety.

Market uncertainty usually brings opportunities for patient investors who do not get caught in the negative headlines painted by the financial media. For those who holds a sizable cash in their portfolio, they will be handsomely rewarded with some good opportunities down the road as these events unfold. Investors, fasten your seat belts! The next few months will be bumpy. 

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