Taper Time Tactics

Chidem Kurdas

No cold turkey, Ben Bernanke promises. The idea is to gently withdraw the emergency monetary stimulus instituted in the financial crisis and continued, in some form or another, ever since.

Even so, investors find themselves between the devil and the deep blue sea as the Federal Reserve makes noises about reducing the $85 billion air it has been pumping into asset markets every month.

Whether the Fed tapers off its extraordinary securities purchases slowly or quickly, bonds come with guaranteed capital losses while the interest is still pitifully low. That in itself should boost the stock market, because a mass exodus from bonds is in progress and some of that money is moving into equities.

But consider the following scenario. American economic growth weakens; thereupon the Fed embarks on yet another full-blast monetary stimulus—as Mr. Bernanke suggests they will if necessary.

Now recall all the talk about wanting to reduce the Fed’s bond purchases. They’ve said they will taper unless the economy tanks. Therefore coming back to all-out quantitative easing – the fourth such program? the fifth? – will be equivalent to announcing: “We, the august central bank of the United States, now believe the economy is tanking.”

Even if the economy were not weakening significantly, that message would make it go south. In any event, sooner or later the stock market will freak out.

Just a hypothetical scenario, but not implausible; in fact the latest GDP growth number was adjusted downward. Buying an S&P 500 index fund comes with this risk.

In short, bonds will lose if the Fed pulls back on QE, whereas if the pullback is seriously delayed because economic data looks bad, stocks are in danger. The investors’ dilemma is not knowing which will happen.

This is the kind of situation where short selling skills come in handy and a manager’s ability to respond quickly to policy and market changes is essential. No wonder more money seems to be moving into hedge funds. Some investors favor long/short equity, others are excited about distressed and other event-driven strategies.

Even funds of funds, until recently losing clients and apparently moribund with a few exceptions, are getting new money.

Yes, of course, you can hold your diversified but plain-vanilla stock-and-bond portfolio. How did that work for you in 2009?

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Tags: Ben Bernanke, Federal Reserve Policy, Financial markets