The Fed Gives Stocks the Green Light

On the back of the worst daily loss since early November, stocks recovered their composure today, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) gaining 0.6% and 0.8%, respectively.

Consistent with that new composure, the VIX (VOLATILITYINDICES: ^VIX  ) , Wall Street's fear gauge, fell 11% to close below 17. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

Bernanke sets the bulls free
Last week, the release of the Federal Reserve's January meeting minutes of the Federal Open Market Committee, which suggested that a hawkish shift had occurred on the rate-setting committee in regard to quantitative easing, threatened to halt the stock market rally.

Today, however, Fed Chairman Ben Bernanke was on Capitol Hill for his semiannual monetary-policy report to Congress, and he made it pretty clear (as clear as a Fed chairman can) that investors have no reason to fear a premature withdrawal of the Fed's massive bond-buying program. Although some members of the FOMC may be concerned about the risks (I suspect these are mainly non-voting members) of quantitative easing, the chairman laid out the Fed's decision-making framework in plain terms:  

The committee also stated that in determining the size, pace, and composition of its asset purchases, it will take appropriate account of their likely efficacy and costs. In other words, as with all of its policy decisions, the committee continues to assess its program of asset purchases within a cost-benefit framework. In the current economic environment, the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery while keeping inflation close to the FOMC's 2% objective.

In other words, as Bernanke put it, "there is no risk-free approach to this situation." But right now, the upside -- supporting economic growth and employment -- is tangible. And the downside -- excessive inflation or inflation expectations and asset bubbles -- remains merely potential. On that basis, an extension of quantitative easing makes sense.

I'm a bit more circumspect about asset bubbles and the "fragility" (to use Talebian vocabulary) that the "Bernanke put" introduces in the stock market, but the Fed chairman's decision-making framework is sound. Besides, investors must take it upon themselves to ensure that their portfolios are resilient in the face of corrections and well positioned to achieve long-term gains.

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