With the economy facing headwinds, the Federal Reserve being on an aggressive interest rate tightening spree, and with inflation still not fully under control, the default medium term movement of equities should be steady to lower – all else being equal.

Today’s Non-farm payroll numbers for August reported by the BLS came in as expected, slightly above 300,000 jobs created which is not too hot to trigger more aggressive interest rate hikes later this month and is not too weak to trigger concerns about a fast-slowing economy impacting consumption and corporate earnings. The Unemployment rate ticked up slightly from 3.5% to 3.7% because of an increase in the labor participation rate.

However, by no means does this mean a green light for equities to go higher. Today’s jobs number gives less of a reason for stocks to go down rather than giving good reasons for stocks to go up. The decline in Treasury bond yields across the term structure is probably what is giving investors more relief.

This week’s Federal Reserve FOMC meeting was the first headed by new Chair Janet Yellen. Among the other novelties of this meeting was the removal of the Fed’s quantitative guidance on the level of unemployment that the Fed deems noteworthy as an indication of future inflation. The FOMC statement and the subsequent remarks made by Yellen at her press conference gave way to great confusion and misinterpretation among traders and led to a seesaw session on Wall Street with a 100+ point swing on the Dow Jones Industrial average.

Though some of Yellen’s comments are open to different interpretations, the Fed’s actions are crystal clear: The Fed announced a $10 Billion further reduction in its asset purchase program or QE. While many believe the Fed is reducing its asset purchases due to an improving economy and a gradually decreasing unemployment rate – with maximum employment being one of the Fed’s objectives given its dual mandate – however, many forget the Fed’s second mandate which is price stability. Clearly, the Fed is not happy with inflation expectations and thinks they are too low. However, as Bernanke alluded to before, the FOMC has come to the conclusion that, given its costs and benefits, QE is not the best tool to pump inflation and that forward guidance should be relied on more instead. Hence, it was not surprising the amount of time Janet Yellen spent explaining all the nuances of the change from quantitative to qualitative guidance.

Nevertheless, the reality is that the Fed is reducing stimulus while Yellen’s own assessment of the economic recovery is that it has been “disappointing”. If the Fed’s intent behind its multiple rounds of quantitative easing was to reduce interest rates and effectively push other asset prices higher (read stocks) then that was magnificently achieved in 2013 with the S&P 500 rising by more than 30%. However, that did not do much in raising inflation and that is the real reason in my opinion QE is being wound down in favor of forward qualitative guidance.

What matters to investors from the above discussion is the impact that Fed policy, and actions, will have on various asset classes. Everything else being equal, the best interpretation can be achieved if we can gauge investors’ risk appetite. So the best question we can ask is what will the new Fed policy do to investors’ risk appetite? Instead of trying to opine qualitatively on this issue, we should look at what the markets have been performing since the beginning of 2014:

Gold is up nearly 10%, Stocks are unchanged, while 10 Year Treasury bonds are yields have dropped by 7% since the beginning of the year currently yielding around 2.75% after starting the year near a 3% yield. Clearly, investors have adjusted their risk appetite after the Fed announced its QE taper in December 2013.

Gold Versus Change in 10 Year Treasury Yields Versus S&P 500 Jan 2 – March 20Chart Courtesy Yahoo Finance

One would think that Treasury yields would go up once the Fed reduced its bond buying program but the opposite has happened. Surely, it is the lack of inflation expectations but also it’s a reflection of a decrease in risk appetite. Similarly, Gold is not up because of inflation fears but because it is perceived as a safe haven in time of turmoil.  One can argue that current geopolitical risks can be temporary, but nevertheless those risks do impact risk appetite. Lastly, the fact the S&P 500 is practically unchanged is further evidence that investors are not as enthused about stocks as they were in 2013. Back in August of 2013, I was anticipating the Fed to announce a reduction in QE in September and a drop in risk appetite by year’s end. The Fed ended up announcing the taper in December and we are now seeing this anticipated drop in risk taking.

Where to invest in 2014?

If the above scenario holds true, it would be prudent for investors to reign in their risk taking in 2014. Given the reality that short term interest rates are rising, risk appetite is declining and economic growth is sluggish, it would be wise to overweight defensive assets at the expense of more economically sensitive ones. Of the 10 S&P 500 sub-sectors, our favorite sectors to overweight include Utilities stocks for their defensive qualities. Financials as a group will benefit from rising short term interest rates and will likely reward investors with higher dividends and buybacks in 2014. Healthcare and Consumer Staples stocks are equal weight sectors in our opinion while Technology, Industrials, and Consumer Discretionary stocks are our least favorite. Gold continues to be a good hedge with a 10% portfolio weighting whereas allocations to Treasuries (10 Year+) should be higher than 25% while keeping a decent percentage in cash for opportunistic purchases – which we think there will be plenty.

Much has been written about the upcoming reduction of the Federal Reserve’s bond buying program known as Quantitative Easing. There has been a lot of debate on not only when Ben Bernanke will start this much anticipated tapering but also about what impact this will have on the bond and stock markets.

Many commentators believe that as treasury bonds keep falling in price, due to ever increasing interest rates, investors will somehow rush into stocks to escape the drop in the value of their bond holdings. Well, we think quite the opposite is about to happen. The next rotation will be from stocks into bonds and not the other way around. Others interpret rising interest rates as a sign of impending economic growth that will benefit stocks. We are in unprecedented era – interest rates are rising due to prospects of an imminent decrease of stimulus and not because of an abundance of economic growth. Yes, when rates rise in response to good economic growth stocks will do well but if rates rise due to the removal of performance enhancers (QE) then stocks will likely under-perform going forward given current economic and corporate earnings growth prospects.

Based on statements from the Federal Reserve and Ben Bernanke’s latest testimony in front of Congress, I am in the camp of those who believe that the Fed will start reducing its bond buying program in September. In my estimate, it is clear that the Fed is not waiting for robust, or even good, economic reports in Employment or inflation to start its tapering as many believe, but it’s just the lack of terrible economic reports. As it has been often repeated by Fed Chairman Ben Bernanke, one of the main goals of Quantitative Easing was to boost asset prices. With stocks as measured by the S&P 500 rising 16% in 2012 and more than 19% at the end of July 2013 one can’t argue that QE has not achieved its intended goal of boosting asset prices.

7, 10, and 20 year Treasury Bond ETFs have steadily dropped in value since May while Stocks have flat-lined. This phenomenon will reverse soon.

What does this mean?

For Bonds, it is not surprising that as we saw investors front-run the Fed into buying Treasuries before the latest iteration of QE was announced we now are seeing investors exit en masse as the Fed is preparing to reduce its purchases. The 100 basis point increase in 10-year Treasury rates so far this year has not come on the back of robust economic reports as trailing 12-month average monthly non-farm employment growth has been sub 200,000 (189,000 and likely declining) and GDP growth sub 2%. We believe the increase in rates has been purely based on the anticipated reduced demand (purchases) by the Fed and a great deal of this anticipated tapering is probably already priced in the bond market. Risk averse treasury bond investors will reduce maturities, alter makeup of their bond holdings, or go into cash – and not into riskier equities particularly if the increase in yields is triggered by the lack of expected future demand by the Fed rather than healthy economic growth that often leads to monetary tightening and higher interest rates to curb inflation.

For stocks, the impact of the Fed’s tapering can be evaluated based on your answer to the following simple question:

Given that corporate operating earnings for the S&P 500 were up less than 1% in 2012 (yes you read that right) and are up less than 5% for the first half of 2013 according to Standard & Poor’s one can logically conclude that perhaps stocks are a bit ahead of themselves at this point. However, given that stocks are already up so much, the need for further QE is negated based on asset prices alone. Furthermore, if the outlook for GDP and earnings growth in 2014 is cloudy right now then it would make sense to hold back further bond purchases for later when asset prices (read stocks) take a tumble when – or if – this weaker outlook actually materializes. There is no need to keep pumping an already inflated stock market; but it would be better to save some ammunition for later when investor’s 401ks really need it – now they don’t.  History will likely judge quantitative easing as probably the most effective tool ever used to boost asset prices in the US. Keeping this tool effective requires that you stop using it when asset prices are already goosed up. With the S&P 500 up as much as 19% one can argue that the Fed can raise a mission accomplished banner for 2013 and save further QE ammo for later.

Where to invest for the rest of 2013

As mentioned earlier, with the S&P 500 index up 19% at its highest point so far in 2013, the risks going forward are likely to the downside. As interest rates increase, we are likely to see more income focused equity investors attracted to bonds rather than the other way around. Taking profits and reducing equity exposure is probably the conservative way to go. For existing equity exposure, overweight positions in healthcare and consumer staples stocks are probably the safest places to be in. As for bonds, if you have not reduced maturities and bond duration in your portfolio then you have already suffered most of the losses that you are likely to suffer in 2013. I expect 10-year Treasury bond yields to stabilize around the 3% to 3.20% area and actually start declining again as inflows from equities rush into the safety of treasury bonds if stocks start selling off. The areas where it is probably prudent to increase allocations to is the US dollar at this time. As interest rates increase and as inflation remains under control, the US dollar will likely appreciate against other major currencies. In addition, any added volatility in the markets will be dollar positive as well. In tandem with increased US dollar exposure, and as a natural hedge, an increased allocation to European equities based on valuation is also warranted at these levels.

Bernanke’s Legacy

Bernanke’s legacy will be that he not only was the Fed Chairman who restored investor’s 401Ks – or 201Ks as they were referred to in 2009 – back to their original 401K values in only 4 years – quite a feat after arguably the worst financial crisis since the great depression – but he left his position while leaving the same effective tools he utilized to be used just as effectively by his successor.