The last time that the Federal Reserve (Fed) was widely expected to start reducing, or “tapering,” its bond purchase program, earlier this fall, interest rates increased and the market tanked. Widely referred to as the “taper tantrum”—a term I wish that I had invented—the drop was quickly reversed when Fed officials came out and reassured the market that, in fact, they had no intentions of pulling back, ever. Really.
That was then. Since that time, the economy has shown improved growth, interest rates have ratcheted back down, and the stock market has recovered and powered up to new highs. With the recent good economic news—much higher levels of GDP growth than expected, higher employment figures and lower unemployment, and very positive business surveys, among other highlights—the Fed is at a point where a taper pretty much has to start soon. Maybe not this week, but soon. The budget deal in Washington also makes a taper more likely because the last reason for the Fed to continue its stimulus was worry about fiscal policy disruption.
At the same time that the real economy and political environment are improving, however, we see the market pulling back again. As the news gets better—and the prospect of the Fed starting to pull back on its stimulus gets more and more likely—the market gets twitchier and twitchier.
I have held the view that a taper is overdue and should start soon, and that, in fact, that would be beneficial and necessary as a step toward normalizing the economy. I still hold that view, but I have also held the view that the markets had expected, and had priced in, a taper. But I am no longer nearly as convinced of that. I suspect that the markets remain dependent, at least in part, on the prospect of continued Fed support, and that we might get a worse reaction to a taper than I had expected.
I don’t want to go overboard on this. There are other reasons why the markets have pulled back. One of the biggest, in my opinion, is the large number of negative earnings announcements recently. Per David Rosenberg of GluskinSheff last Friday, 94 of the S&P 500 companies have issued earnings downgrades compared with 12 having issued upgrades, which is the worst ratio in the past seven years. I have been talking for some time about the problems with continued earnings growth, and that might be starting to sink in.
Another reason for the market pullback could be the pending implementation of Obamacare, which could negatively affect company performance. The final one, which I don’t think is widely appreciated yet, is the pending sticker shock when people pay their taxes in April. I expect that this will be a major political event, and one that could lead to economic repercussions.
The other significant factor here is the action, collectively, of retail investors. Although they have been flocking to stocks recently, last week, mutual fund investors—largely retail—pulled $6.5 billion out, making for the largest weekly drawdown in 2013. This is a big turnaround from October, when CNN was reporting that investors were on track this year to put the most money into stock funds since 2000. In fact, three of the top five months for inflows to stock mutual funds have happened this year.
Given the strong performance of the stock market so far, many institutional investors are all in—and are likely to remain so—until early next year. Retail investors have also been all in, so the pullback last week could be a worrying sign. If institutional investors decide to take some gains off the table early next year, and retail investors do the same, the current weakness could become something worse.
Right now, technical factors remain supportive but are weakening. With valuations high by historical levels and earnings being downgraded at a high rate, caution remains appropriate on a fundamental basis. Anyone expecting the market to continue its growth next year will have to explain where the earnings growth will come from or why investors will be willing to continue to pay more in a rising interest rate environment. Perhaps the recent weakness reflects difficulty in doing just that.