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.

Stocks have been off to a great start in 2013 with the Dow Jones Industrial average reaching new highs earlier in March and the S&P 500 advancing more than 9% for the year as of March 8. With (Q4) earnings season behind us, it may be safe for a casual observer to assume that these gains in stocks have been fueled by decent corporate earnings. We believe Q4 earnings were terrible but that will be the subject of another article.

As I mentioned in my 2013 outlook piece, stocks have been and will likely continue to be influenced by the actions of the Federal Reserve and its open-ended quantitative easing program. The Fed’s easing program is in turn influenced by the improvement, or lack thereof, in the economy and specifically with the unemployment rate. The monthly unemployment report for February was released last week showing an unemployment rate of 7.7% and an increase of 236,000 jobs in the economy while January’s report was revised lower to show an increase of 119,000 jobs. While February’s report came in better than expected, the economy will need many more strong jobs reports for the unemployment rate to come near the 6.5% threshold that the Fed has set for itself as the point at which to change its interest rate policy.

The Fourth quarter GDP report that was released on February 28 showed rather lackluster growth in the economy at 0.1% after being revised up from a -0.1% rate initially. While this lackluster growth should give further ammunition to dovish Federal Reserve governors who argue for continued quantitative easing, it is also a sign that the efficacy of QE is eroding (at least in the eyes of more pessimistic, glass half-empty type of economists).

So given the above, where are stocks going in the near term?

The reason for the lengthy introduction above is to illustrate that stocks have been going up in the face of mixed results for the economy. We should assume that the Fed will continue with its open ended QE regardless of the next unemployment report or two. Nonetheless, stocks can’t continue to go up, even with QE, if the economy and earnings start to dramatically deteriorate. But with earnings season behind us, we will not get another glimpse into earnings until Q1 earnings season kicks off in mid April and which is expected to go on through the end of May. Similarly, the initial reading on Q1 GDP won’t come in before April 26. Until then, and absent any exogenous event, we are likely to see stocks continue their upward advance over the next 4 to 6 weeks fueled by (likely misplaced) optimism and performance chasing.

Stocks ended 2012 with the best annual performance since 2009 with the S&P 500 index finishing up 16% on a total return basis. The financial and consumer discretionary components of the S& 500 were the best performers advancing 26% and 22% respectively. Utilities were the worst performers declining nearly 3% while energy producers were the second worst advancing only 2.3%. Equity investors clearly embraced risk in 2012 pushing up economic sensitive stocks while shunning more defensive ones. It is noteworthy that last year’s gains were mostly front-loaded with the first half of 2012 containing the bulk of the advance while the 4th quarter experienced a small decline.

Back in 2012 we predicted an S&P 500 advance of 20% by midyear. We came close as the S&P 500 peaked around an 18.5% (total) return in September. Looking further out into 2013 we think the stock market has to deal with 3 main uncertainties that will likely hold back the S&P 500 to no more than a high single digit return. Political and policy uncertainty, fears about corporate earnings growth, and increased ambiguity about the longevity of the Fed’s quantitative easing program and its eventual exit policy will be high on investors’ agenda in 2013.

Political & Policy Uncertainty:

It is no coincidence that stocks were flat to negative during the fourth quarter of 2012. Be it the ramp into Election Day or the lingering and excruciating fiscal cliff negotiations, the reality is that political uncertainty is not cost free when it comes to stocks. Investors typically lose their appetite for risky assets during these periods and head to the exits. The fact that the fiscal cliff deal reached by Congress only addressed the revenue side of the equation and delayed the spending part to later in the first quarter only heightens policy uncertainty. Even worse, this will coincide with the debt ceiling debate which will also fall during the first quarter. While we think that part 2 of fiscal cliff negotiations will be resolved in a less dramatic manner than part 1, the truth is that a varying severity of spending cuts is coming our way whose impact will be felt beyond the first quarter and that is really what will be the most important outcome of the upcoming policy debate. Based on the first few days of trading in 2013, we do not think that stocks have priced in any of this upcoming reality.

Earnings Growth Uncertainty:

In theory, corporate earnings and the trajectory of earnings growth are two main drivers of stock prices. However, in an era of quantitative easing it is expected that asset prices will deviate from that fundamental theory. When quantitative easing becomes endless in nature and seems to be the norm then it is expected that its effectiveness will wither away with time and exhibit negative returns to scale making earnings growth more relevant again. Looking at the diagram below one can’t miss the steady downward trajectory of operating earnings growth form early on in the economic recovery in 2010 till now. The first quarter in 2010 exhibited the first, and best, post-recession quarterly earnings growth with subsequent quarters exhibiting mostly lower and lower quarterly growth with minor exceptions.

Source: Standard & Poors

This does not mean that slow single digit or negative earnings growth will persist in 2013 or beyond. Standard & Poors expects S&P 500 earnings to grow in 2013 by 13.3%, however, we think this is a bit ambitious and more difficult to achieve in the absence of clear catalysts. So far the main catalyst is a bet that the economy will continue to improve with a steady decrease in the unemployment rate. While likely, we expect this outlook to be fraught with risks and very uncertain as we start 2013.

Fed’s Policy Uncertainty

On January 3rd, the FED released the minutes of its December 2012 FOMC meeting that showed some members divided over when to stop its bond purchases. While it is no surprise that the Fed will eventually stop its purchases at some point, this was a reminder that this end-point is coming up soon – but not clear how soon. Regardless when this end-point comes, it is logical to believe, as stated above, that the Fed’s bond purchases will slowly become less effective, everything else being equal, as time goes by. If you subscribe to this logic then assets that benefited from QE will benefit less so going forward and vice versa – everything else being equal being the main caveat here. If the QE trade was to inflate commodities then the 2013 move is to step away form those commodities. If it was to push investors towards riskier assets then scaling back on risk is the move in 2013. I am not advocating to “fight the Fed” but rather to realize that you should at least temper your expectations for the traditional QE-related trades and look elsewhere. Betting with Central banks is a profitable endeavor but that trade in the US is almost exhausted and is closer now to its culmination rather than its inauguration. You should look elsewhere around the globe, particularly in Japan where the Bank of Japan is likely to embark on a more serious version of its own quantitative easing program that is already in place.

Where to put money in 2013

While we expect a high single digit return in the S&P 500 in 2013, it is important to note that the range of returns for the 10 S&P 500 sectors in 2012 was 29%: a low of -3% (Utilities) and a high of 26% (Financials). We do expect less dispersion in the range of performances for the 10 S&P sectors in 2013 but we nevertheless expect that range to be in the high teens. We plan to scale back risk by overweighting defensive sectors such as Utilities, Consumer Staples, and Healthcare while taking a neutral to negative approach to more economically sensitive sectors. We do not anticipate the mass exodus from Treasury bonds to happen in 2013 and think that the status quo in fixed income of 10-year treasury yields of less than 2% to persist for most of 2013. The best trade in fixed income land is NOT to short bonds but rather to bet on an increase in spreads between High Yield and Treasury bonds in the latter half of 2013 – particularly if corporate earnings growth stagnates or disappoints. We are avoiding the QE reflationary trade by staying away from gold but keeping an eye on oil as we see increased likelihood of geopolitical risks impacting oil in 2013.