What Happens When Fed Exits From Stimulus?

By in Economics, Investing, Money Management, Personal Finance, Stocks | 21 comments

Is Stock Market Going to Crash?

Investors in the stock market have benefited from the recent Federal Reserve Bank’s low interest rate monetary policy. The years of quantitative easing were the Federal Reserve Bank’s efforts to stimulate the economy, encourage banks to lend, consumers to borrow, and employers to grow their businesses. The goal was for employers to hire more workers and reduce unemployment levels.

Since January 2010, the US economy, as measured by the Gross Domestic Product (GDP), reversed its negative trend and has been growing steadily. It seems as though the quantitative easing helped the economy grow.

gdp growth_2008-2014

So the economy is going in the right direction, why worry?

The quantitative easing is slowing down and interest rates will begin to increase. Investors are getting scared.

Here’s some help in understanding the current economic picture and suggestions on how to go forward.

Take a look at recent headlines:

Nasdaq Closes Below 4000, As Stocks Fall” WSJ.com

“Producer Prices Rise 0.5%; But It’s Too Soon to Say Whether Pickup Augurs an Inflation Increase”, WSJ.com.

CNN Money reports: “Stocks: Heading for the Exits”

Just as low interest rates promote economic growth, higher interest rates can stall growth. Growing sales and earnings propel stock prices upward, whereas slowing growth sends market prices south.

After several years of positive stock market returns, its normal for stocks to take a breather.

 

So If the Economy is Improving, Why is the Stock Market Falling?

Investors fear slowing growth and as the U.S. stock market is a leading economic indicator, when there’s a sign of rising rates, investors get scared and sell, pushing stock prices down.

Although the economic growth is clear, the economy is improving, albeit at a moderate pace, the headlines tell a story of fear and apprehension. The headlines underline investors’ tendency to panic and run at the first signs of higher interest rates.

What Will Happen to Stock Prices When Interest Rates Rise?

Given the fact that at some point in the future the Federal Reserve will raise interest rates and will stop completely the $85 billion per month bond-buying program, how should investors prepare?

What should investors do?

Will the markets crash?

I know for a fact that no one can predict the future. I also know that at some time in the future, stock market prices will continue to decline and they will also go back up. That is the nature of the investment markets. They go up and down. Over decades, the direction of stock prices has been up, but there is no guarantee that the future stock market performance will replicate the past.

If you want to be certain that you avoid any future downturn in investment markets, you can sell all of your stock investments now (which I do not recommend). Then you will avoid any future losses. Or will you?

investing_stay the course_don't jump in and out of markets

 

Devil’s Advocate Position; Sell All of Your Stocks Now (I do not recommend this position)

Here’s the outcome if you sell now.

  • You will miss any future upward price movement in the stock market.
  • Even if the stock market is overvalued right now (although I believe it is fairly valued), it can stay overvalued for a long time.
  • If inflation kicks up, your uninvested cash will lose purchasing power and be worth less.
  • You may miss further losses in the stock market, but how will you know when to get back in? 
  • If you sell now, you need to be right twice, first, when you sell, and second, when to buy back in.

Does this mean I’m telling you not to sell?

Not necessarily.

Should I Sell All My Stocks Now Because When Interest Rates Rise Stock Prices May Fall Further?

I cannot answer this question for you. If you hate to lose any money, then you shouldn’t be invested in the stock market at all. Stock investing is risky and values go up and down. Following is stock market data from the past. The difficult part of investing is that although there is an abundance of historical data, no one has developed the sure fire method of predicting the future.

 

Growth of $1.00 from 1926-2000

In 1926, invest $1.00 in the U.S. Stock Market.

In 2000, that dollar grows to $2,285.00. That’s right, your one dollar, invested for 74 years, increased over 10 percent per year.

Let’s assume that you were the worst investor ever and traded in and out of the market. And your trading caused you to be out of the market during the best 37 months of that 74 year period. In 2000, instead of $2,285.00 your $1.00 investment is worth $17.42. That’s correct, miss the best performing 3 years and the $1.00 investment is worth $17.42 for a 3.9 percent return.

If you are investing for retirement, or goals far in the future, and you want an opportunity for growth and can tolerate a few down years along the way, then consider stock market investing. If you need your money in the next 5 to 7 years, it should not be in the stock market! Stock market returns are way too volatile in the short run.

Any money needed in the next 5 to 7 years should be in a Government Inflation Protected (I Bond) Bond, savings account, or money market mutual fund.

When interest rates rise, it is possible stock market returns may fall further. It is up to you to decide whether to stay the course or panic and flee. 

What happens when the Fed exits from stimulus? We are quite certain interest rates will rise, and it’s likely we’ll see a tic up in the inflation rate. Yet, students of market history know that there are always events which cause markets to go up and down, and picking the right time to get in and out is quite difficult.

I’m sticking with my predetermined asset allocation, and if the market continues to fall, I expect to boost my investing a bit and capitalize on the lower prices.

What are your current and future investing plans?

Are you worried about a decline in your investments? Are you considering selling any investments now?

A version of this article was previously published and comments remain intact.

    21 Comments

  1. You say that, “If you hate to lose any money, then you shouldn’t be invested in the stock market at all.” I would extend it to “If you hate to lose any money at any point in time, then you shouldn’t have any money at all.” If you own stocks, bonds, commodities, real estate, or any other asset like collectibles, there is always the chance to lose money. If you keep all your money in cash, you are certain to lose money by loss of purchasing power as long as there is inflation (which there almost always is). So, the best option for people who hate losing any money at all at any time is not to have any money in the first place. How many of your readers will sign up for this sure-way-of-never-losing-money?

    ctreit

    May 28, 2013

  2. I am in it for the long run and I keep dollar cost averaging into the market. I may be one of the rare ones that will not need to use my investments when I retire. I am obligated to withdraw 2-3%, but I won’t need it to sustain my lifestyle.

    krantcents

    May 28, 2013

  3. @CTREIT- Well put. Life is full of peril. Losing money, accidents etc. No one gets out unscathed.A better approach would be to accept that you will lose money, get in an accident and have difficulties in life. There is one exception. US Government Treasure I bonds protect your principal from inflation and are a near perfect investment for those afraid of volatility.

    The important approach for money management is to keep an approach that you can live with. Personally, I prefer a balanced asset allocation in a diversified portfolio of stock, bond, real estate index funds along with a nice cash cushion. If you are terrified of volatility, keep less money in more volatile assets such as stocks.

    Barb

    May 28, 2013

  4. @Krantcents-You are more than fortunate, you are a hard worker, a good planner and an inspiration.

    Barb

    May 28, 2013

  5. I’m not worried at all. In fact, I could care less about what the market is going to do in the short term (the next 1-3 years). I don’t trade in and out of equities because I don’t believe anyone can time the market with any consistency.

    My portfolio is geared for long term growth and I’m very happy with the returns I’ve been getting.

    Anton Ivanov

    May 31, 2013

  6. @Anton, You have the attitude of a long term successful investor!

    Barb

    June 1, 2013

  7. This whole idea of creating money out of thin air is a farce. The only thing that the federal reserve has done over the last fifty years is devalue the dollar. Today a dollar buys one tenth of what it bought in 1960.
    Does anyone think that might just have something to do with the increasing income inequality that we see today.

    Favoring inflation over stable prices punishes the poor but rewards the rich. Everyone borrowing money to buy a home depends on inflation. A good example of this is reducing the value of a home loan compared to your income level. If I take out a fixed rate loan at say 4.50 percent for thirty years my payment stays the same but my wages increase at least at the rate of inflation their by reducing my debt burden over time. The percentage of your income used to make debt payments is slowly declining over time. While the value of a home increases over time. Talk about getting something for nothing.

    The notion that you need some inflation to have a healthy economy is a farce’ we had no inflation at all from 1947 to 1965 and the economy was just fine. Geting back on the gold standard is a must. Funny thing is 1965 was the same year that the federal goverment removed silver coins from circulation. Inflation exploded after 1966.

    Financial Directory

    August 14, 2013

    • @Financial-The reality about economic fiscal and monetary policy is that it is based on the study of the past and there is not one remedy for economic problems. Economists disagree all the time. You pointed out some interesting historical data as well. Although I don’t think returning to the gold standard is the answer, I expect that a certain degree of inflation will be in our future. Additionally, higher interest rates are inevitable. Only time will tell whether the fiscal stimulus will be considered a wise strategy.

      Barbara Friedberg

      August 14, 2013

  8. I think a correction of 20 to 30% is on the cards and buying long term puts is mandatory for saving portfolios. The overall trend is now downwards in my opinion – Start Insuring!

  9. I’m not going to do anything differently. I am just going to keep investing as usual. It’s fairly well known – if you do the math – when the Fed will stop the program based on the latest comments from them. I think that since I don’t know how the market is going to react, there is no point in guessing. After all, I only have a 50% chance of being right. Ignore the short term, focus on the long term.

    Jon @ Money Smart Guides

    April 14, 2014

  10. @Nick, How much are you paying and which puts are you buying?
    @Jon-So true, no one knows what the future holds and if the world doesn’t go to Hell in a handbag and former market trends prevail, staying the course is rewarded.

    Barbara Friedberg

    April 14, 2014

  11. Great & timely post!

    My question relates to cash position. Please assume one is retired and receives no income outside of investments.

    If the stock market drops then perhaps it is a great buying opportunity. This would imply that you have something to “buy” with.

    So, either buy with cash that was in a money market account or similar, or sell bonds or REITs to buy stocks.

    So taking in the above, how much weight should cash / bonds / REITs be in a portfolio now?

    Ralph

    April 14, 2014

  12. @Ralph, Do you receive Social Security yet?

    “If the stock market drops then perhaps it is a great buying opportunity. This would imply that you have something to “buy” with.”

    I always keep a rather large percent of cash. It gives me a sense of security that our family can handle unexpected emergencies, job loss, and won’t have to cash in investments at inopportune times. We keep enough “wiggle room” so that in the event of a downturn, and valuations becoming enticing, we can buy the undervalued assets.

    The only reason we sell is to rebalance our portfolio into the preferred asset allocation.

    What is your investing approach?

    Barbara Friedberg

    April 14, 2014

  13. @Ralph, I couldn’t begin to tell you how to allocate your portfolio in terms of percentages in cash and/or REITs etc. (It would be irresponsible of me without knowing a lot about you, your risk tolerance, age, and financial position)

    But, it’s not difficult to do on your own. Check out “How to Invest and Outperform Most Active Mutual Fund Managers” http://forms.aweber.com/form/87/2066025387.htm

    Barbara Friedberg

    April 14, 2014

  14. @ Barbara – I buy out of the money cheap puts so when the market falls and approaches a support level the rise very quickly in value.

  15. @Nick-How out of the money and are the puts on which index? And when was the last time you exercised the puts? I have a tough time shelling out the money for puts.

    Barbara Friedberg

    April 15, 2014

  16. Tough to find the ideal mix. During the last crash, retirement was a distant plan, and I slept through the crash and recovery like a baby. With a company layoff hitting my wife and me in Oct ’12, early retirement handed to us, I needed to be more conservative.
    A year later, end of ’13, a kind market put us above our “number” and two alternate careers I’d considered as a younger man both offered me part time work.
    Over the past year as the market rose, we moved 5 years’ spending to cash out of stocks. With my current income, it’s now more like 8 years’ worth. I’m not ‘market timing,’ just steering our allocation to the long term numbers we’re comfortable with.
    It’s odd to think about social security as being on the horizon, but 10 years away doesn’t seem so far. I’m glad we never counted SS when calculating our ‘number,’ as we preferred to look at it as an added buffer if the benefit wasn’t cut by Uncle Sam.

    JoeTaxpayer

    April 15, 2014

    • HI Joe, So what are is the “alternate” career? You were quite fortunate to take some money off the table when you did. I completely understand your desire to hold a (large) cash cushion. There is a certain security in knowing that there is cash available for living expenses for awhile. It removes a lot of money stressors. It looks like SS will still be there when you retire. At what age are you considering taking SS? I’m shooting for 70, in order to get the largest benefit, with the hope/expectation of a long life.

      Barbara Friedberg

      April 15, 2014

  17. I had spent 30 years in high tech sales, my undergrad was a BSEE.
    After 6 or month months of ‘retirement’, I took the exams to teach HS math in my state. I work 2 days a week in a High School math center, tutoring. The other 3 days, I picked up a real estate license, and work for a neighbor, and will be picking up a few properties along the way. I am enjoying being able to do interesting things and not worry about the money.
    I’m 51.5 (today!) and the mrs is 58, so we’ll keep an eye on spending and decide on SS start date further on. It’s probably the same 70 as you, I’d like to Roth most of our savings over the next 18 years.

    JoeTaxpayer

    April 15, 2014

  18. @ Barbare – I work out what where the market will fall to using technical analysis and then purchase that PUT strike. I think of it as compulsory insurance, I hate forking out for car insurance however it has to be done for protection.

  19. HI Joe,

    Sounds really fulfilling, your current pursuits. I didn’t realize you were an ee (like my dad :)). I sold real estate in my 20′s and it can be a lot of fun and quite lucrative. The math teaching also sounds like a wonderful gig. Please, keep me posted, you’re doing some great stuff!
    @Nick, Interesting. Keep me posted along the way about how things pan out. I certainly understand your approach.

    Barbara Friedberg

    April 16, 2014

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